Weekly Market Commentary - 10 Indicators to Watch for a Spring Slide in the Stock Market

WMC_WP2In each of the past three years, the stock market began a slide in the spring that lasted well into the summer months. This week, we update the status of the 10 indicators we identified that foreshadowed the 10 – 19% declines in recent years.

On balance, the indicators do not yet point to a significant risk of a repeat of the 10 – 19% spring slide this year. But a more modest, 5 – 10% pullback is far from out of the question.

 

 

10 Indicators to Watch for a Spring Slide in the Stock Market

One year ago, we provided our list of the 10 indicators to watch that seemed to precede the stock market declines in 2010 and 2011 and accurately warned of another spring slide in 2012.

We again look to these indicators for signs of a potential spring slide in the stock market this year.

In early 2010, 2011, and 2012, run-ups in the stock market, similar to this year, pushed stocks up about 10% for the year as April began. Specifically, on April 23, 2010, April 29, 2011, and April 2, 2012, the S&P 500 made peaks that were followed by 10 – 19% losses that were not recouped for more than five months. This recurring phenomenon is often referred to by the old adage “sell in May and go away.” Now that it is around the time the prior slides have begun, it is time to revisit the status of our indicators.

Currently, only two of the 10 indicators are waving a red flag, while three are yellow for caution, and the other five are green. On balance the indicators do not point to a significant risk of a repeat of the 10 – 19% spring slides in the stock market this year. However, a smaller decline of about 5% or so is far from out of the question and remains our most likely scenario, as presented in recent Weekly Market Commentaries. We will continue to monitor these indicators closely in the coming weeks.

3-25-13_chart1 green-flag1. Fed stimulus – In 2010 and 2011, Federal Reserve (Fed) stimulus programs known as QE1 & QE2 came to an end in the spring or summer, and stocks began to slide until the next program was announced. Operation Twist was announced on September 12, 2011 and was scheduled to conclude at the end of June 2012, helping to prompt a market slide before it was extended at the end of June 2012. This year, the current program is unlikely to be slowed or stopped until much later this year. Therefore, this is unlikely to be a driver of a slide in stocks this spring.

yellow-flag2. Economic surprises – The Citigroup Economic Surprise Index [Figure 1] measures how economic data fares compared with economists’ expectations and has marked the spring peaks in both economic and market momentum in recent years. While the latestreadings have not surged up near the 50-level that marked the peaks of recent years, the weakening trend does suggest expectations may have become too high. Turning points typically have coincided with a falling stock market relative to the safe haven of 10-year Treasuries. red-flag3. Consumer confidence – In the past few years, early in the year the daily tracking of consumer confidence measured by Rasmussen rose to highs just before the stock market collapse as the financial crisis erupted [Figure 2]. The peak in optimism gave way to a sell-off as buying faded. Investor net purchases of domestic equity mutual funds began to plunge and turned sharply negative in the following months. This measure of confidence is once again beginning to fall from the highs.

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yellow-flag4. Earnings revisions – The earnings estimates moved higher heading into the first quarter earnings season of each of the past few years, only to begin a decline that lasted the remainder of the year as guidance disappointed analysts and investors. This year, earnings expectations have not risen as much as in prior years, which may limit the disappointment. In addition, last week saw disappointing reports from bellwethers such as Oracle and FedEx, among others. It is too early to say whether this indicator is flashing a warning sign.We will be watching to see if estimates begin to taper off.

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yellow-flag5. Yield curve – In general, the greater the difference between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy. This yield spread, sometimes called the yield curve because of how steep or flat it looks when the yield for each maturity is plotted on a chart, peaked in February of 2010 and 2011, and March of 2012. Then the curve started to flatten, suggesting a gradually increasing concern about the economy, as the yield on the 10-year moved down. Although not as steep as in prior years, this year we will be watching to see if the yield curve flattens further after peaking in mid-March.

green-flag6. Energy prices – In 2010, 2011, and 2012, oil prices rose about $15 – 20 from around the start of February, two months before the stock market began to decline. This year, oil prices rose to $98 at the start of February and have eased slightly since then, suggesting less risk to consumers already struggling with higher taxes. However, the national average retail gasoline price has risen 50 cents this year, similar to the average rise from the beginning of the year through March over the past three years. With prices starting to ease along with crude oil the risk is fading, but a further surge in prices at the pump would make this indicator more worrisome.

green-flag7. The LPL Financial Current Conditions Index (CCI) – In 2010 and 2011, our index of 10 real-time economic and market conditions peaked around the 240 – 250 level in April and began to fall by over 50 points. It may still be early, but this year, the CCI recently reached 253 — in line with the post-recession highs with no signs yet of weakening.

red-flag8. The VIX – In each of the past three years the VIX, an options-based measure of the forecast for volatility in the stock market, fell to the low of the year in the low-to-mid teens in April before ultimately spiking up over the summer. In recent weeks, the VIX has declined once again o the lows of the year. This suggests investors have again become complacent and risk being surprised by a negative event or data.

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green-flag9. Initial jobless claims – It was evident that first-time filings for unemployment benefits had halted their improvement by early April 2010, and beginning in early April 2011, they deteriorated sharply. In 2012, April again led to deterioration in initial jobless claims as they jumped by about 30,000. While claims have fallen to post-recession lows this year as the labor market has improved, we will again be watching for a move higher in April that would echo the spike seen in recent years. (See this week’s Weekly Economic Commentary for what the Fed is watching in the labor market.)

green-flag10. Inflation expectations – The University of Michigan consumer survey reflected a rise in inflation expectations in March or April of the past three years. In fact, in 2011, the one-year inflation outlook rose to 4.6% in both March and April from 3% at the start of the year. This year, there has been almost no rise in inflation expectations, as they remain about 3.3%. Finally, one issue not addressed specifically in the indicators, but important in the markets, is the surge in European stresses — evident in the spring of each of the past few years. The weakening economic data in

Europe’s core countries such as Germany and France (seen most recently in last week’s German manufacturing and sentiment data), combined with financial stresses in peripheral countries such as Cyprus pose a risk to global markets if too little is done to address the key issues. Europe continues to focus on capping banker bonuses and financial transactions taxes rather than core issues. This could risk a bond market sell-off that could negatively affect stocks here in the United States, similar to the spring slides in recent years.

While this list may seem incomplete, it is notable that many of the most widely watched indicators of economic activity such as manufacturing (the Institute for Supply Management Purchasing Managers’ Index known as the PMI or the ISM), job growth, and retail sales, among others, did not deteriorate ahead of the market decline, but along with it. It is not that they are not important; it is just that they did not serve as useful warnings of the slide to come, while the above indicators did.

Shorter Slide?

While it is possible we will experience another spring slide this year, there are factors that may mitigate any decline short of the 10 – 19% seen in the past few years. Looking back, in 2010 the negative environment that helped fuel the decline included the uncertainty around the impact of the Dodd-Frank legislation, the Eurozone debt problems and bailouts, central bank rate hikes, and the end of the homebuyer tax credit. In 2011, it was the Japan earthquake and nuclear disaster that disrupted global supply chains and pulled Japan into a recession, the Arab Spring erupted pushing up oil prices, the budget debacle and related downgrade of U.S. Treasuries, rising inflation, and central bank rate hikes that contributed to the decline. In 2012, the Eurozone debt problems coming to a head, China’s slowdown, the European recession, the election uncertainty, and anticipation of the 2013 budget bombshell of tax hikes and spending cuts weighed on markets.

Some of these challenges presented in prior years are repeated again this year — potential for flare-ups over European problems and the debt ceiling come to mind. However, there are some positives this year that may help offset some of the negatives making for a potential decline that may be less steep than those of recent years. First, job growth finally appears to be reaccelerating with three of the past four months posting more than 200,000 in net job creation. Second, the housing rebound is now wellentrenched, supporting economic activity and household confidence. Finally, business spending growth appears to be reaccelerating and likely to support manufacturing activity, which had fallen in May through July of the past few years and contributed to the market decline.

Given this year’s nearly double-digit gain in the S&P 500 and the possibility of another spring slide for the stock market, investors may want to watch these indicators closely for signs of a pullback despite the current upward momentum in the stock market and solid economic growth.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The company names mentioned herein was for educational purposes only and was not a recommendation to buy or sell that company nor an endorsement for their product or service.

Stock and mutual fund investing involve risk, including loss of principal.

International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. “Operation Twist” describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

INDEX DESCRIPTIONS

The Barclays U.S. 7-10 Year Treasury Bond Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of between 7 and 10 years, are non-convertible, are denominated in U.S. dollars, are rated (at least Baa3 by Moody’s Investors Service or BBB- by S&P), are fixed rate, and have more than $250 million par outstanding. The Index is weighted by the relative market value of all securities meeting the Index criteria.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.

Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.

The VIX is a measure of the volatility implied in the prices of options contracts for the S&P 500. It is a market-based estimate of future volatility. When sentiment reaches one extreme or the other, the market typically reverses course. While this is not necessarily predictive it does measure the current degree of fear present in the stock market.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The Rasmussen Consumer Index and Investor Indexes, measures the economic confidence of consumers on a daily basis. The Rasmussen Consumer Index and Investor Indexes are derived from nightly telephone surveys of 500 adults and reported on a three-day rolling average basis. The baseline for the Index was established at 100.0 in October 2001.

The Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the University of Michigan. The MCSI uses telephone surveys to gather information on consumer expectations regarding the overall economy.

 

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