After a rocky start to the summer, stocks have trended higher over the past few weeks. That much is fact. So why do I remain leery of the market? What are MY indicators telling me about this rally? Can this uptrend really hold?
Those are the most important questions I want to answer for you. But to give you a sneak preview: No, this doesn’t look like the start of a major new run!
Warning Sign #1:
Dow Industrials vs. Industrial Activity
The Dow Jones Industrial Average is hovering around the 13,100 level. As the name suggests, of course, the industrials should generally track activity in the manufacturing sector of the economy. If manufacturing activity is rising, revenue and earnings growth will rise. If manufacturing activity is falling, the opposite will occur.
With that said, take a look at this chart going back more than a decade. The blue line is the Institute for Supply Management’s Manufacturing Index (ISM), the most widely followed index tracking domestic production. The red line is the Dow Industrials.
You can clearly see that they do generally track each other. The two glaring exceptions:
The first was in 2007, when the Dow managed to levitate despite a slow, steady downtrend in manufacturing activity because we were in the last throes of the housing and mortgage bubble.
And the second is … NOW! The ISM index has slumped all the way to where it was in the summer of 2009, yet the Dow has still managed to rally.
Let me ask you this then: With the benefit of hindsight, wouldn’t it have made complete sense to heed the ISM’s warning in 2007-2008? Wouldn’t you have been better off if you didn’t chase that last rally on fumes, and sold stocks before the sickening plunge that followed?
Warning Sign #2:
S&P 500 vs. Interest Rates
As I’ve alluded to in earlier columns, I believe bond traders are generally “smarter” than stock traders. They’re usually more level-headed, focused on the fundamentals, and oftentimes EARLY when it comes to major changes in trend. So you can be sure I pay very close attention to what they’re doing with their hard-earned money!
One indicator I watch closely is the 2-10 spread, the difference in yield between 2-year Treasuries and 10-year Treasuries. When the economy is expanding and demand for money is strong, this spread widens out. When the economy is weakening and demand for money is falling, it narrows. And it’s generally a VERY ACCURATE recession warning when the spread goes negative!
With that preamble out of the way, take a look at this updated chart comparing the Standard & Poor’s 500 Index to the 2-10 Treasury yield spread. You can see that over the long term, stocks tend to track this expansion/contraction indicator. That makes sense because profit and sales growth expand and contract with the economy!
The spread diverged from stocks for a while in the blow-off phase of the housing bubble — and now, it’s diverging again. You probably don’t need me to remind you what happened to investors who failed to heed the bond market’s warning last time. They got killed!
Would you agree, then, that it makes sense to pay attention to this warning sign THIS time?
Warning Sign #3:
S&P 500 vs. Corporate Earnings
Corporate earnings are supposed to be the lifeblood of the stock market. After all, shares of stock represent an ownership interest in the profits that a corporation spins off. When profits rise, stocks prices tend to rise, and vice versa.
Now take a look at my third chart. It compares the price performance of the S&P 500 to the year-over-year rate of growth in S&P 500 earnings (excluding financials). Between 2009 and 2011, they tracked each other fairly well.
But look at what has happened since then!
Corporate earnings growth has been dropping like a rock — from 17.2 percent in mid-2011 to 4 percent in the first quarter of this year. With roughly 9 in 10 S&P 500 companies already reporting second quarter earnings, we’ve even swung into the RED! Earnings are shrinking at a 1.6 percent rate, the worst performance in three years!
Yet what has the S&P 500 done in response? It has come unmoored from underlying profits, rising to around 1,400 in the past few weeks.
Once again, I will ask a simple question: Does it really make sense to ignore across-the-board deterioration in corporate profits? Especially when consensus estimates now call for ANOTHER profit decline in the third quarter?
The ONLY Prop for Stocks?
So what’s the only major prop out there for stocks right now? What’s driving the latest round of buying? Simple. Hopes for more quantitative easing (QE) and bond buying here and in Europe. That’s it.
Therefore, anyone on Wall Street chasing stocks higher here is basically betting that printed central bank money can offset deterioration in the real economy and corporate earnings forever. He or she is also betting that “this time is different” when it comes to reliable interest rate indicators that have worked for decades.
Me? I don’t like those odds. So outside of a few selective picks here and there, I’m not eager to chase stocks.
Until next time,
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