Hale Stewart

The Fed wouldn’t have raised rates if they didn’t have confidence that the US economy would be able to handle higher rates. So, let’s take a look at coincident, leading and long leading data to get an idea for the strength of the US economy now, but, more importantly, in the next 12-18 months.

As we near year-end, we have more of the same: a market in desperate need of revenue growth isn’t getting any. Therefore, prices are weaker.

The combination of weak labor utilization, weak inflation and an already challenging environment for the industrial sector (that will be made worse by the resulting stronger dollar) provide a strong counter-argument to timing of this rate increase.

As we go into year end, the world economic situation is tenuous. The US, UK and EU are doing fairly well, but Japan and China are weakening. And while Australia is growing, it's clear the Chinese slowdown is hurting. Overall, as noted by the Dallas Fed, the global economic environment is fragile.

The consensus is the Fed will raise rates at their next meeting. The latest employment report all but baked this into the cake. However, I’m not so sure this is a good idea.

This week’s column focuses exclusively on the technical side of the US market. I’ll be using three weekly charts to illustrate my concerns about the structure of the US equity markets.

This was a very light week of news. Only the BOE had a policy meeting. And other major countries released very few economic numbers.

Chairperson Yellen offered her assessment of the US economy in a speech to Economic Club of Washington. First, the good news. Growth, while moderate, is still positive, printing at 2%-2.5% for the first three quarters of 2015. And real final domestic purchases were over 3% in the 3Q. This tells us that consumers continue to spend and businesses are investing.

Why is the world economy growing below trend? That seems to be the central question economists are asking since the Chinese market intervention over the summer.

For the first time in 36 years, the manufacturing sector is contracting; the ISM manufacturing index printed at 48.6. New orders dropped 4 points to 48.9 while production decreased 3.7 points to 49.2. Only 5 of 18 industries expanded.

One of the central debates occurring within the Fed regards the causation of current inflation weakness. Some, like Fed President Bullard and Chairman Yellen argue low oil prices are solely responsible for the weakness. Ohers like President Brainard and Chicago Fed President Evans see a more nuanced picture involving declining international trade negatively impacting a wide swath of commodity prices. Regardless, this week various organizations published stories to support and counter each argument. As for oil prices, Goldman Sachs sees oil prices at $20 in the next 12 months.

The BEA issued its second GDP report last week, increasing the 3Q GDP estimate to 2.1%. Real gross domestic purchases – a measure of strictly domestic demand – increased 2.8% Y/Y.

The news continues to move in a bearish direction. Although the UK and Australia are in decent economic shape, neither country is setting growth records. And on the bearish side, Mario Draghi stated the EU recovery is weak and may need additional stimulus while Japan entered a technical recession for the second time in two years. And all this is occurring at time when the global growth juggernaut of China is slowing. Overall, the scales appear to be more and more tipped in a bearish direction.

The Conference Board reported the LEIs and CEIs this week: LEIs increased .6% while CEIs rose .2%. The only negative LEI component was the ISM manufacturing new orders index, which subtracted .05% from the total number. But two other leading manufacturing numbers were positive. Perhaps best of all, the average workweek of production workers added to the number. Three of four CEI components expanded; only industrial production contracted.

For the bond market, the release of the Fed minutes was this week’s biggest news. The Fed described employment positively. They also noted personal consumption expenditures and capital expenditures were “solid.” Housing was mixed, but continued to show a general, slow recovery. Industrial production was weak, but largely due to the strong dollar and weak international environment. As for inflation, they noted that overall CPI was weak, but expected it to rise with oil and import prices over the next 12-18 months. As for rates, the Fed felt the next hike would be in December:

Last week, Fed President Rosengren offered his analysis of the US economy: Many headlines have focused on real GDP growing at only 1.5 percent in the third quarter. However, I would like to share with you a measure that focuses on domestic demand – real final sales to domestic purchasers. This statistic is similar to GDP, but excludes fluctuations in inventories and net exports. This leaves consumption, investment, and government spending – in sum, a measure that tries to capture the underlying strength in domestic demand.

Despite the persistence of low inflation, the Fed will probably raise rates in December. This begs the question, why? A Bloomberg article last week provides the answer.

From a policy perspective, the decline in Chinese demand and the relative over-supply of commodities within China adds downward pressure to a variety of commodities. This situation is likely to continue.

If the SPYs hit a record high, I don’t see it lasting, barring a change in the underlying fundamentals.

The problems inherent in the Fed’s reasoning makes it look more and more that they’re using last year’s ideas for this year’s problems. It appears more and more that central bankers need to drastically rethink their models and assumptions.

Normally, analysts’ projections diverge somewhat around a statistical norm. That is, it’s usual for a group of 40 analysts to project the upcoming quarterly GDP growth rate between 1% and 3%. Currently, however, there is a fair degree of uniformity among analysts regarding the outlook. And that’s not a good sign.

The main US news this week was not economic, but political: Kevin McCarthy withdrew his bid to become Speaker of the House. As of this writing, several candidates have announced their desire to seek the position, but there is no clear front-runner. This couldn’t happen at a worse time: within the next 60 days, the debt ceiling must be raised and Congress must vote on a budget. And the leadership vacuum is occurring when 3Q US growth is projected to be weak.

The latest Fed Minutes noted the US is still in fairly good shape. The US consumer continues spending, unemployment is low, retail sales are expanding moderately, and purchases of durables goods (vehicles and houses) are positive. The primary negative is weak wage growth. But the strong dollar, weak overseas economies and slowdown in the oil patch is hurting the manufacturing sector.

This week, it was the IMFs turn to downgrade their global growth projections, which they did on October 6: The IMF’s latest World Economic Outlook (WEO) foresees lower global growth compared to last year, with modest pickup in advanced economies and a slowing in emerging markets, primarily reflecting weakness in some large emerging economies and oil-exporting countries.

This week’s economic news was mostly positive. Manufacturing is still expanding and consumers are still spending, especially on durable goods. But the stronger dollar and weaker international environment are clearly taking their toll, as the ISM is just barely in expansionary territory. The markets are in somewhat precarious shape as we enter earnings season; they remain expensive and therefore need to see topline revenue growth. Unfortunately, that doesn’t appear to be coming.

A rate hike of at least 25 basis points was a done deal a few months ago. But recent global and domestic events have greatly lowered that possibility. It began with the Chinese equity sell-off followed by the surprise yuan devaluation. Recent Chinese manufacturing weakness adds to the mix. Although some recent US news has been positive, continued price weakness, lower industrial production and a recent employment slowdown show the US is not immune to the slowing international environment.

Overall, the tone of news continues to lean negative. China continues to slow. Japan is clearly having problems regaining momentum after last year’s sales tax increase and Canada just missed being in a technical recession. The EU and UK are growing moderately, but not impressively. And it appears even the US is starting to import some of the global weakness.

Despite recent financial turmoil, no one has provided a concise explanation of the commodity super-cycle, one of the primary macro-economic forces causing recent volatility. That is, until now. In a September 21 speech, Bank of Canada Governor Stephen Poloz offered the following explanation:”

The U.S.’ immunity to international economic weakness continues. In their latest policy statement, the Fed once again described U.S. growth as “moderate.” With the exception of industrial production, this week’s economic releases confirm that assessment.

Analysts’ recent adjustments lowering global growth projections are in line with recent events; China’s economy continues slowing. This lowers commodity prices, which decreases economic growth of commodity exporting countries. Hence, the primary causation of Australia’s below trend growth and Japan’s weaker economic performance. The US is somewhat immune; Chinese trade accounts for a fraction of US GDP, limiting the impact. The EU is a bit more exposed, due to their increased reliance on trade.

There has been a slight but important shift in news coverage over the last few months. It started with the wild gyrations of the Chinese stock market, which, in retrospect, granted journalists permission to write more negative stories about the global economy. Since then, we’re seen more discussion about EM capital flight, the fiscal troubles of Brazil and the potential issues related to Russia. The news is hardly catastrophic; it simply represents the natural ripples flowing out from China’s attempt to change its economic model and the potential Fed rate hike coming down the pike.

The Federal Reserve released the latest Beige Book on Wednesday which showed a modestly expanding economy. While construction, aerospace and the auto industry led to manufacturing growth, cheap imported substitutes and the strong dollar continue providing headwinds. Retail, tourism and service sectors reported moderate growth. Housing sales and construction continue growing, but low inventory is driving prices higher. The imminent Fed rate increase is pulling some projects forward. The overall trend of loan growth and declining delinquencies continues.

The potential negative impact of China’s slowdown is sinking into policy maker’s decision making process and trader’s analysis. Money is flowing from emerging to developed economies; emerging markets and currencies are underperformers relative to developed markets. The potential for China to export deflation is being discussed. And central bankers are acknowledging the slowdown by lowering growth forecasts and opening speculating about additional monetary stimulus. As we leave the summer doldrums and enter the last four months of trading, the environment has clearly changed.

The fundamentals overall are slightly positive because they give companies an environment where they can grow top line revenue. The problem is most companies are just barely doing so. Even excluding the energy sector, top line revenue was only up 1.1% last quarter. Yes, it’s positive, which is obviously better than the alternative. But with market is already pricey; a 1.1% revenue increase doesn’t add a lot of upside room.

The strongest news of the week was the upward revision of 2Q GDP from 2.3% to 3.7% (Q/Q). All sectors contributed. Personal consumption expenditures increased 3.1% with contributions from durable goods purchases (+8.2%) and non-durable goods (+4.1%). Residential construction increased 7.8% while non-residential was up 3.1%. Equipment was down .4%, but this can be attributed to oil sector’s weakness. Finally, exports increased 5.2%. Overall, this report was very encouraging, especially considering 1Q weakness.

For the last several months, I have expressed three concerns regarding the markets. The high current and forward PEs of the major averages were the first. This was followed by the declining top line revenue of the S&P 500 companies. And third were deteriorating market technicals; a weakening advance/decline line, fewer stocks participating in rallies and various averages (the transports, IWCs and IWMs) declining. All of those factors came home to roost this week as the markets sold-off in a fairly sharp manner.

The most important overarching story of the week was the emerging market capital flight, which is occurring at startling pace.

Retail sales increased .6% M/M. But this statistic has shown some weakness over the last year: The best news in the report was the 6.9% Y/Y increase in auto sales. But over the last 12 readings, 6 have either been negative or 0%. And some of the increases have been small, totaling .4% and .5%. While the .6% was OK, this data series continues to point to a US consumer who is a bit more concerned about the overall economic situation, to the point where he is slowing his purchases.

This weekend was my summer vacation, when I (try) to completely unplug from news, internet and other variety of my daily routine. I was pretty successful at the task, although I did keep up with general events thanks to CNN. With the exception of China’s devaluation, there was little meaningful economic news, making my catch-up column a bit easier. But perhaps more importantly, when I returned I was struck just how little things had really changed in a 7 day period.

The week started off poorly with the Chinese PMI dropping from 49.4 to 47.8. The overall trend for this indicator is clearly lower.

The ISM’s US manufacturing number decreased from 53.5 to 52.7, but remained above the key 50 level. New orders and production continued their lengthy periods of expansion. 11 of 18 industries grew. The anecdotal comments are interesting:

The Fed’s policy statement was the main economic event this week; its opening paragraph began, “Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.”

One of the biggest stories to emerge has been the decline in Emerging Market Currencies. The IMF noted this in their latest World Economic Outlook.

The Conference Board released the leading and coincident indicators, both of which provide an excellent summation of current and future activity.

At the macro level, the IMF lowered their global growth outlook. The first quarter slowdown in the developed world (largely the US but to a lesser extent Canada) led to decreased 2H15 projections, while the commodity slowdown will negatively impact the developing world. As further evidence of this, note that Latin American currencies are broadly selling off. Low inflation gives central banks plenty of policy room. The wild cards continue to be the cumulative impact of the Chinese slowdown along with certain geopolitical factors such as the Middle East turmoil and Greek situation.

The Federal Reserve issued two important documents last week: the Beige Book and Chairperson Yellen’s latest Congressional testimony. The Beige Book was largely positive. Non-financial service growth is moderate. Real estate is growing and the employment picture was generally positive. Strong demand for autos sales helped increase consumer spending. The only negative was manufacturing which was uneven due to the strong dollar and weak energy sector.

Obviously, the big news this week was the Greek deal. This only delayed the inevitable. The plan calls for additional austerity measures, which have been completely ineffective. Greek unemployment is over 25%; the economy is in the middle of a depression, and the debt/GDP ratio increased from 105% in 2008 to 177% currently. The country will simply continue on this path for the foreseeable future, leading to another inevitable conflict with the lending troika. The ECB also issued its policy statement this week, which kept rates unchanged.

Aside from two Federal Reserve releases, the only major news announcement was the ISM services index, which printed a very strong 56% headline number. New orders were a bullish 58.3 while employment was 52.7.

Greece is obviously the big story of the week. As of this writing, it appears a compromise might be in play. But this is a very fluid situation, so that could change within an hour. Several weeks ago, I noted that given the massively high unemployment rate and GDP contraction, there is little left for Greece to cut without becoming a failed state. Be that as it may, it appears even more cuts are coming.

The biggest news last week was the employment report, which contained a headline number (223,000) a bit weaker than we’ve gotten used to. But, there is a very reasonable explanation.

Greece is obviously the big wild card going into next week. And while the damage appears to be contained for now, there is no guarantee we won't see a negative feedback loop filter out into the market and EU economy. Canada's four months of GDP contraction are also getting a bit concerning. Even though we knew this was coming, it's still a most unwelcome development. However, other economies are at least holding their own for now.

First quarter economic data was largely bearish, as confirmed by last week’s third revision to GDP data. While the .2% decrease was better than the -.7% in the second revision, it was still negative.

It appears more and more likely that Japan has shaken off the negative impact of the sales tax hike from a year ago. The EU appears to be growing. Australia, while still growing at a ~2% clip, is feeling the negative impact of the commodity bear market. The US has shaken off the weak 1Q number.

Let’s start by looking at the leading indicators which were up .7. The breadth of the LEIs was very positive; there were no negative numbers while only 1 (the average work week) was 0.0.

As with any Fed week, this week’s news was dominated by the Federal Reserve’s policy announcement. But, after 2:15 EST on Wednesday, everybody realized nothing had changed; the Fed was still waiting for better unemployment numbers and higher inflation. In other words, the dovish stance persisted. Other US news was mixed. News from Europe was positive; the EU and UK continue expanding, the latter solidly so. Finally, Japan (finally) appears to have gotten over the sales tax problems.

Although there were few economic numbers this week, what was released was positive. Retail sales bounced back and the JOLTs survey continued to show an improving labor market. But additional signs of stock market topping emerged. Ideally, the market still needs an expanding economy that translates into higher revenue growth rather than margin expansion to move meaningfully higher.

The Federal Reserve released the latest Beige Book, which offered the following overview of the economy.

Clearly, this expansion has matured. Corporate after-tax earnings are slowing while the combination of the strong dollar and oil price drop is hurting industrial expansion. The lack of stimulus from the oil dividend indicates consumers still aren’t very confident, even though they have more money to spend and unemployment is nearing “full” employment levels. The markets continue to have problems holding onto new highs, which means traders are at minimum cautious about future growth prospects.

Last week’s fundamental news was encouraging. Although we’re still in a shallow industrial recession, other sectors of the economy are printing solid results. However, large multi-nationals face sufficient headwinds from a strong dollar, weak international environment and declining oil prices to prevent a sustained advance.

Last week’s economic news continued to disappoint. Retail sales were weak, industrial production was flat and capacity utilization decreased. As we near the end of the earnings season, the S&P 500 revenue numbers show a decline. While the SPYs made a new high, the mid-caps, small caps and transports failed to confirm, indicating the large cap move higher stands little chance of meaningful follow-through.

Last week’s economic releases provided much needed bullish news with strong headline numbers from the ISM Services Index and the monthly employment report. But the 1.9% Q/Q decline in productivity was concerning. On the earnings front, with a little over 90% of the S&P 500 companies reporting, total revenues are off 4.1% Y/Y. Adding to the negative backdrop is that future earnings projections continue to move lower. This weak performance on the company level sent the markets lower, with the small caps consolidating recent declines while mid-caps joined in recent trend-breaking.

The market has been trading at fairly expensive levels since the first of the year. With a current PE of nearly 21, it clearly needs economic and earnings growth to move higher. Unfortunately, last week’s news and the general earnings backdrop are not cooperating. First quarter GDP was reported at a meager .2% while Y/Y revenue growth contracted 4.1%. This led to small caps (both the IWM and IWC) breaking uptrends while the larger averages continued to languish. We’re again left with a picture of markets starved for bullish news and not receiving any.

After a series of first quarter economic disappointments, last week’s financial news provided much needed ammunition for optimism. The latest new and existing home sales numbers indicated the housing market is healing while the slight uptick in durable goods orders stopped that data series’ recent set of declines. The markets rallied as a result, printing at or close to new highs. The market’s technical picture, however, is still unconvincing; the SPYs chart looks like a short term top while the Transports and Dow’s failure to confirm the QQQ’s recent advance adds to the caution.

After consolidating since the beginning of March, it appeared that SPYs broke out on Wednesday. It was a false break-out. Wednesday’s daily candle was weak, with a small body and high shadow. Rather than continuing the move higher, Thursday printed a similar candle. The markets gapped lower on Friday, sending the daily chart back into its previous consolidation pattern. Several weak economic numbers contributed to the markets sell-off, including industrial production, further weakness in retail sales and increasing negativity in the LEIs components.

Any rally still faces strong headwinds. With a PE of 20.47, equities are already expensive. The strong dollar and weaker overseas economies are hampering general earnings growth while oil’s price drop is decimating the energy sector. And the percentage of NASDAQ and NYSE stocks about the 50 day EMA is approaching overbought levels. Without a meaningful change in either the earnings or valuation environment, any advance appears limited to at most 5%. That places a premium of stock picking and allocation.

True, the XLKs, XLIs and XLYs are consolidating at the top of a rally, implying the current price movement could simply be a pause before a move higher. But this would be occurring against a weakening economic backdrop, already expensive market valuations and declining corporate earnings. This makes a sustained move higher improbable unless the fundamentals change to a more bullish posture or earnings surprise to the upside.

Writing about market consolidation is very difficult. There are no strong rallies, massive volume spikes or huge losses to get the reader excited. Instead, the entire analysis focuses on prices pin-balling between two trend lines, usually on decreasing volume and weakening technical indicators. So if you’re looking for an article the grabs your attention by telling a story of an incredibly strong surge in bullish price action, move elsewhere. Because this week we again have a market that is consolidating.