All US equity funds broke to new highs this week with strong market breadth. After lingering at the price of the previous two peaks, the S&P 500 (TSP C fund) worked its way through resistance and then again lingered at its all time high on Friday. There was no doubt Friday afternoon it would close at a new all time high. Wall Street wanted the headlines over the weekend – there is nothing like new highs to bring in more buyers. To be clear, the latest rally was broad based which shows the market has strength. But the market is approaching short term over-bought conditions and may consolidate gains or correct back once again this week. The chart above provides a possible channel (dashed lines) going forward since it broke its longer term trend line in October. It is a rising channel, but less steep.
The SP500 Bullish Percent Index surged higher with the latest rally and is plotted above in the alternating red-black line. The S&P 500 is overlaid and shows a rally slowly losing momentum, but it has room to run higher in the coming weeks/months. As the bull market advanced the last two years, the bullish percentage has diverged showing increasing weakness as one would expect in an aging bull market. Its decline during the sideways pattern was worrying, but the bullish percent index bottomed on the last day of February and has surged since. The bullish index shows the percent of stocks in the S&P 500 index with a bullish point & figure chart.
The NYSE Advance-Decline Volume Index also surged higher with the latest rally and gives no signal of weakness at this time. Unlike the other two indexes that traded sideways, the NYSE New Highs-New Lows Index continued to rally during the sideways price action and was probably the best indicator that the market would break out higher (plotted below in red-black line).
In the short term the market breadth indicators can give the best signals as to what is really happening in the market. They do not always give signals, but divergences between the price index and the breadth indicators are important to consider.
My long-term view is the market remains detached from the economic fundamentals. This occurs at market tops and can last for years, so we can not use fundamentals for market timing. But one should begin to shift to lower exposure levels as fundamentals weaken and indications of market risk aversion grow. We see this now, but again the market can advance for months or longer. One nice benefit of our seasonal strategy is we get to watch these other signals from the safety of the sideline half the year. A lot can happen in six months, and if all remains clear we can usually get back in the funds near where we existed.
My view is the business cycle has been replace by a much larger financial cycle and the amplitude of the bull/bear markets have become larger. The business cycle was driven partially by an inventory cycle in the past. With better inventory control and a transition from manufacturing to a consumption economy, U.S. earnings are less driven by the old business cycle. On the other hand, the global economy still can experience a business cycle and I believe the global economy is in a recession due to a reversal of over-building and over-capacity caused by mal-investment due to the easy money policies.
The U.S. economy is not in recession, nor is it accelerating and justifying the high valuations U.S. stock command at this time. At some point, the laws of financial physics will catch up and a new bear market will commence. The same forces that increased the amplitude of the bull market will reverse and ensure another deep bear market. We will talk about some of those forces in the future, but it is important to understand the only way to stop a bust is to not allow the boom that always proceeds it. Slow steady growth is the best, but Wall Street can not skim as much of the profits off the top and prefers bubbles.
The Federal Reserve became much more proactive in the 80’s and attempted to erase recessions and stock market plunges with monetary policy and the Greenspan put (lower interest rates). The effect of the pro-active central bank was the creation of the financial cycle, which I see as a super credit cycle. With the roll back of Depression era regulations designed to keep banking conservative and boring, the financial cycle expanded rapidly and now the financial cycle is global phenomena. Today once again, the credit boom is engulfing the world except this time it is the balance sheets of nations, and not just financial institutions and corporations or individuals. Much of the new debt has been used to inflate the financial sphere and has not gone into economic investment in the U.S.
If we overlay the Economic Cycle Research Inc. (ECRI) Weekly Leading Index (WLI) over the S&P 500 index we see the weakness of the current recovery from the Great Recession. It highlights how low interest rates and Quantitative Easing have inflated financial assets while doing little for main street. Research has shown that rising stock prices have a very small effect on spending, yet the Federal Reserve admits to targeting the stock and bond markets. The fact is lower interest rates have a greater negative effect on spending among savers and those on fixed income. Countries whose population have the highest savings rates (Japan, China & Europe) are seeing the greatest deflationary effects due to low earnings on savings.
In the relative performance chart below, I have added the ECRI WLI. The TSP I fund and ECRI WLI turned down in July and credit spreads began to widen. The TSP S fund began to trade sideways at this time also. The ECRI WLI was designed to predict US recession, but surprisingly it appears more correlated to the global economy than the U.S. economy recently. Since the stock market is also a leading indicator of the economy, one would expect more weakness in the indexes. But as we see in the chart above, the economy is not driving the stock market, the financial cycle is.
What about earnings? Forward 12-month Earnings Per Share forecast have been declining. The small rally in oil prices this month may be the cause of the stock market rally since much of the decline in forward earnings come from the energy sector. But they are not the only sector with weakness. My concern goes further since the final numbers reported are Earnings Per Share (EPS) and not total actual earnings.
One of the effects of the new financial cycle is borrowing cheaply to buy back your own company shares in order to send EPS higher. Since most CEO’s pay is tied to EPS, they have incentive to buy back shares even when their company’s stock is over-valued. This is one of the perverse reasons the financial markets have become detached from economic reality.
The Atlantic magazine recently ran an article called “Stock Buybacks Are Killing the American Economy” and they provided some good supporting facts. Here is an exerpt:
Over the past decade, the companies that make up the S&P 500 have spent an astounding 54 percent of profits on stock buybacks. Last year alone, U.S. corporations spent about $700 billion, or roughly 4 percent of GDP, to prop up their share prices by repurchasing their own stock.
In the past, this money flowed through the broader economy in the form of higher wages or increased investments in plants and equipment. But today, these buybacks drain trillions of dollars of windfall profits out of the real economy and into a paper-asset bubble, inflating share prices while producing nothing of tangible value.
Meanwhile, the shift toward stock-based compensation helped drive the rise of the 1 percent by inflating the ratio of CEO-to-worker compensation from twenty-to-one in 1965 to about 300-to-one today. Labor’s steadily falling share of GDP has inevitably depressed consumer demand, resulting in slower economic growth. A new study from the Organization for Economic Co-operation and Development finds that rising inequality knocked six points off U.S. GDP growth between 1990 and 2010 alone.
Consider that from 2006 to 2008 America’s financial sector repurchased $207 billion shares and by 2009 the American taxpayer had to inject $250 billion into the banks to save them. The EPS that analyst use to value stocks and to determine PE ratios does not deduct the 54% of earnings not coming to you in dividends or re-invested for future real earnings growth. Instead it makes the company look like it is growing faster than it is and this leads to a higher PE ratio by itself.
So while market internals are supportive today, we will remain on alert for the end of this financial cycle. Zero Hedge quoted Goldman Sacs on 3 February stating that 17% of the buying that day was from stock buy backs sometimes approaching 33% of flow. I have to wonder if the latest breakout rally was partially engineered, but that would be market manipulation and we know Wall Street would never do that. My bias is to go light on equities, but if we have a correction and the internals stay strong we may increase exposure near term. In the mean time we have our seasonal models that should continue to beat the market over the full market cycle, and keep us out of the market during the weak season in equities.