Was That The Correction?
Fortigent
By Chris Maxey
January 24, 2011
EQUITY RALLY FINALLY RUNS OUT OF STEAM
It was a mixed week in the equity markets with the Dow Jones Industrial Average rising 0.7% but the S&P 500 Index falling 0.8%. This represented the first decline for the S&P following seven consecutive weeks of advances.
Economic data was light due to the MLK holiday on Monday, but there were still several important items for the market to digest.
Chief on the docket was housing, which has provided both signs of encouragement and weakness in the past month. Existing home sales jumped 12.3% in December, to a seasonally-adjusted annual rate of 5.28mln.
Source: Econoday
An uptick in mortgage rates, from a recent low of 4.17% in November, to 4.86% more recently appears to be encouraging buyers to enter the market before it is too late. Due to the strong showing in December, overall housing inventory fell quite considerably in the month, reaching its lowest point since March.
Although December provided an indication that home sales are improving, 2010 was still the worst year in more than a decade for existing home sales, so one month should be considered in the context of the broader market weakness.
Following existing home sales, the Conference Board’s Leading Economic Index (LEI) registered a sharp 1.0% gain in December. A vast majority of the ten underlying trend components were positive in the month, with improvements in housing permits, initial claims for unemployment benefits and consumer expectations providing the greatest boost.
Source: Conference Board
The spread between interest rates, measured as the differential between the Fed Funds rate and the 10-yr Treasury, was also a positive contributor to the index in December; however, the extremely steep yield curve is being viewed as a harbinger of bad things to come by certain analysts. According to a recent Wall Street Journal report, one reason the yield curve is so steep is that investors are leery about holding US debt with maturities longer than five years simply out of fear that one of the major ratings agencies will downgrade its coveted AAA rating.
Moody’s already sent a shot across the bow this year, when it said that “if there are not offsetting measures to reverse the deterioration in negative fundamentals in the US, the likelihood of a negative outlook over the next two years will increase.”
That is not the only source of the steep yield curve, though. With the Federal Reserve unlikely to move away from its zero interest rate policy in the near future, and economic data showing improvement, investors are betting that a recovery is in the works. In the long term, though, unless the US is willing to tackle its enormous debt load, ratings downgrades could trump improved economic growth.
One indicator that received considerable attention during the summer months was the ECRI Weekly Leading Index. After plunging deep into recessionary territory, it was considered a near certainty that the US would encounter the dreaded “double-dip” recession.
Since that time, however, the economy continued to bump along at its meager growth rate and the ECRI recovered from its depths.
Source: Economic Cycle Research Institute
Of course, with the ECRI recently trending into positive territory, the index is now going unnoticed, but it provides another reason to believe that economic growth will continue along its current trajectory.
With virtually every market strategist calling for a drop in the equity markets, last week’s paltry 0.7% pullback in the S&P can hardly be considered a market correction. Reasons to expect a pullback run the gamut from frothy valuations to extreme bullish sentiment.
The most straightforward rationale for being cautious at this juncture is simply the furious speed with which the markets rebounded from the March 2009 trough. On average, the trough to peak recovery lasts 3.8 years and with this recovery only 1.8 years old, the markets look ready to maintain the upswing.
Source: The Big Picture
Unfortunately, those rebounds usually occur at a far more measured pace. Average gains over the subsequent 24 months after the market hits bottom are 56.1%, far less than the 90% recovery in the only 22 months since this bull market hit bottom.
Source: The Big Picture
The initial rally tends to account for the bulk of performance over the cycle and between the second and third year after the low, performance slows dramatically, averaging less than a 10% gain.
On the flip side, investor sentiment, which remains in extremely bullish territory, is finally beginning to trend lower. Nearly 51% of retail investors were bullish on the six-month outlook for equities, the 20th consecutive week above the long-term average. Apparently, even retail investors are losing faith in the outlook based the recent outperformance of equities.
Source: Pragmatic Capitalism
HAS THE BALTIC DRY INDEX RUN AGROUND?
The Baltic Dry Index is frequently referenced for its ability to predict future economic activity due to the fact that 90% of goods are transported by ship. It is essentially a real-time snapshot of the cost of shipping goods to ports around the world. After recovering in 2009, the Baltic Dry recently encountered rough seas and has been on a consistent decline since early November. While this is raising fears of a global economic slowdown, the story is never actually that simple.
In 2007 and early 2008, when the economy was humming at a gangbusters pace, the Baltic Dry Index duly benefitted, increasing more than 100%. After peaking out in June 2008, however, the index endured an unprecedented plunge, raising the alarm bells that the global economy was about to endure a harrowing ride.
By early November 2008, the Index began to recover and global growth followed shortly thereafter.
After enduring several fits and starts, the Baltic Dry Index appeared to be on its way to a comfortable recovery, owning to the demand for natural resources from China.
Source: Bloomberg
With prices in 2007 and 2008 running 8x higher than they are today, shipping companies were eager to order as many ships as possible, believing, just as most others were willing to, that economic growth would continue into perpetuity.
Sadly, ships do not materialize from thin air, typically requiring anywhere from two to four years for delivery. 2011 represents the sweet spot of those deliveries, with the global fleet of capsize ships expected to jump more than 35%. It is not difficult to realize that the global economy is experiencing a tumultuous recovery of its own, one that is hardly ready to absorb that additional supply of ships.
While global shipping activity is on the rise, the drop in daily shipping rates is attributable to a simple case of supply and demand, not a sudden drop in global trade as some might have you believe.
THE WEEK AHEAD
There is a full slate of economic and corporate news to digest this week. Markets will also focus on the Swiss Alps for news from the upcoming World Economic Forum.
Economic data for the week encompasses a wide range of indicators. Consumer confidence will be released on Tuesday. New home sales for December are likely to show a decent gain based on the jump seen in existing home sales. The Federal Reserve holds its regularly scheduled policy meeting on Tuesday and Wednesday. There is no likelihood of an interest rate increase but any news on the economy will be closely watched. Gross Domestic Product for the 4th quarter will be unveiled on Friday. The range of expectations is unusually wide due to the uncertainty about economic activity in the fourth quarter.
Earnings season hits high gear this week as a host of companies are scheduled to report. The list is comprised of American Express, McDonald’s, 3M, Johnson & Johnson, Siemens, US Steel, Yahoo, Boeing, ConocoPhilips, Starbucks, US Airways, Xerox, AT&T, Canon, Caterpillar, Colgate-Palmolive, Eli Lilly, Lockheed Martin, Microsoft, Procter & Gamble, Tyco, Chevron and Samsung Electronics.
Several Treasury auctions will be conducted this week, including $35bln of 2-yr notes (Tuesday), $35bln of 5-yr notes (Wednesday) and $29bln of 7-yr notes (Thursday).
Barack Obama will deliver his State of the Union address on Tuesday. On Wednesday, the World Economic Forum kicks off in Davos, Switzerland. The event that brings together business and political leaders from around the globe is notable for being high on rhetoric but lacking in action.
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