Friday, August 1, 2014
A Breakout of Breakdowns in Europe
Faithful readers are familiar with our use of point-and-figure charting. As a quick review, we prefer to use a relative strength methodology wherein each 'x' (or 'o') represents a 2.5% gain (or loss) relative to the benchmark. This results in a reduction of the day-to-day noise in price fluctuations and we are left with a better idea of important trends in a particular stock. After noting a general uptick in new lows and declining shares among MSCI Europe constituents earlier this week (see here), we took a closer look at the technical scores of individual companies. It is not uncommon to see a handful of names with a decline of two or more points over a month's time. However, we usually don't see seventeen companies that have deteriorated so much on a technical basis-- especially when you consider the aforementioned efforts to moderate the noise in price movements. Of note, about one-third of these companies are in defensive sectors (Consumer Staples and Health Care) while another third are in the Industrials sector.
Small Caps Stocks Took A Beating In July
The S&P Small Cap 600 has now underperformed the S&P 500 by over 10% since March. July was particularly brutal as small caps underperformed by nearly 6% in that month alone. This relative underperformance has been somewhat predictable given what the Fed has been up to with the taper program. The underperformance of small caps has been tracking the reduction of the Fed purchases very closely thus far in 2014.
Junk Bond Spreads Accelerating Higher - Not Good for Stocks
Earlier this week as asked what junk bonds know that stocks don't. Since then junk spreads to the 10-year US Treasury bond have widened another 20bps as they have accelerated higher. Given the 88% correlation with stocks over the last year, this is something that we will continue to closely monitor.
Aug 2013-Jul 2014:
Aug 2013-Jul 2014:
Thursday, July 31, 2014
The Middle of the Yield Curve is Acting Like the Fed Just Completed a Tightening Cycle
While yields at the long end of the US Treasury market have been heading lower all year (the 30-year has fallen from 3.93% to 3.32% and the 10-year has fallen from 2.94% to 2.56%) the middle of the yield curve has been acting entirely differently. The 7-year yield has fallen only slightly by about 20bps to 2.23%, while the 5-year yield is actually 1bps higher at 1.75%. Moreover, since the middle of 2012 5-year yields have risen by 216% and 7-year yields have risen by 146% (chart 1 below). The result has been a substantial flattening in the spread between the long end and the middle of the yield curve (chart 2 below).
One interesting observation here is that this flattening is very similar to the flattening that occurred during the last three Fed tightening cycles that preceded recessions, as chart 2 shows. Indeed, as the Fed tightened from '86-'89, the spread between the long end and the middle of the curve inverted. As the Fed tightened from '99-'00 the spread again inverted. As the Fed tightened from '04-'06 the spread barely inverted, but it did flatten substantially. To be fair, Fed tightening from '94-'95 was preceded by flattening in this spread, but a recession did not ensue. Today, while we do not have inversion of the middle and long parts of the yield curve the spread flattening has been large, especially when adjusting for the level of interest rates. It could be argued that with short rates pegged at zero, we may never get to complete inversion of the middle and long ends of the curve. In any case, rates in the middle of the curve rising while rates at the long end are falling is noteworthy and we'll continue to monitor it.
One interesting observation here is that this flattening is very similar to the flattening that occurred during the last three Fed tightening cycles that preceded recessions, as chart 2 shows. Indeed, as the Fed tightened from '86-'89, the spread between the long end and the middle of the curve inverted. As the Fed tightened from '99-'00 the spread again inverted. As the Fed tightened from '04-'06 the spread barely inverted, but it did flatten substantially. To be fair, Fed tightening from '94-'95 was preceded by flattening in this spread, but a recession did not ensue. Today, while we do not have inversion of the middle and long parts of the yield curve the spread flattening has been large, especially when adjusting for the level of interest rates. It could be argued that with short rates pegged at zero, we may never get to complete inversion of the middle and long ends of the curve. In any case, rates in the middle of the curve rising while rates at the long end are falling is noteworthy and we'll continue to monitor it.
All Eyes Should Be On The Participation Rate Tomorrow
In our recent quarterly video we argued that there is far less slack in the economy than the Fed seems to think. This is the first recovery since World War II where the output gap has narrowed because of downward revisions to potential GDP growth. The revisions to the potential GDP growth are largely a function of a steadily declining labor participation rate. Yesterday we learned that the economy grew at a 4% annualized rate in the second quarter, and today we learned that the employment cost index rose at a 3% annualized rate in the second quarter (chart below).
Combining these two pieces of data suggest that:
1) The economy grew faster than potential in the second quarter, thus sending labor costs higher, and
2) The participation rate has not stopped falling, and
3) The output gap is much closer to zero than the official estimates suggest.
The second and third points are important because Janet Yellen is engaging in a big gamble that a cyclically improving economy will elicit a supply side response, thus depressing the early signs of cost-push inflation. Today's ECI would seem to challenge the hypothesis that there remains a huge amount of slack in the labor markets.
If Yellen is wrong and the falling participation rate is a structural phenomenon, then the Fed will be forced to begin tightening monetary policy with the economy languishing at a 2% growth rate. Perhaps this scenario of the recovery running out of track is what sent stocks 2% lower today and volatility surging by almost 30%. This puts a huge amount of weight on the participation rate component of tomorrow's labor market report. If the participation continued to fall, it will be hard to ignore the appearance that the Fed is making a big mistake and may have to jerk the reins sooner than is currently expected.
Combining these two pieces of data suggest that:
1) The economy grew faster than potential in the second quarter, thus sending labor costs higher, and
2) The participation rate has not stopped falling, and
3) The output gap is much closer to zero than the official estimates suggest.
The second and third points are important because Janet Yellen is engaging in a big gamble that a cyclically improving economy will elicit a supply side response, thus depressing the early signs of cost-push inflation. Today's ECI would seem to challenge the hypothesis that there remains a huge amount of slack in the labor markets.
If Yellen is wrong and the falling participation rate is a structural phenomenon, then the Fed will be forced to begin tightening monetary policy with the economy languishing at a 2% growth rate. Perhaps this scenario of the recovery running out of track is what sent stocks 2% lower today and volatility surging by almost 30%. This puts a huge amount of weight on the participation rate component of tomorrow's labor market report. If the participation continued to fall, it will be hard to ignore the appearance that the Fed is making a big mistake and may have to jerk the reins sooner than is currently expected.
Stock Market Breadth Is Decaying To 2008 Levels
As we are approaching the closing bell today and looking at the worst day for the S&P 500 since April 10th, and possibly only the 4th roughly 2% down day of the year, we thought it would be a good time to highlight the deteriorating breadth in the stock market.
Specifically, we are looking at the percent of companies outperforming the MSCI World Index across a variety of time slices. The first chart is the most eye-popping. Currently, only 44% of the stocks in the MSCI World are outperforming the index. This is the fewest number of outperforming stocks since October 28th, 2008. As this chart shows, the breadth indicator tends to only slightly lead the MSCI World Index by about a month.
Finally, the the data is nearly as bad looking at it from a 200-day perspective and from a 100-day perspective breadth has significantly deteriorated over the past two months.
Specifically, we are looking at the percent of companies outperforming the MSCI World Index across a variety of time slices. The first chart is the most eye-popping. Currently, only 44% of the stocks in the MSCI World are outperforming the index. This is the fewest number of outperforming stocks since October 28th, 2008. As this chart shows, the breadth indicator tends to only slightly lead the MSCI World Index by about a month.
Finally, the the data is nearly as bad looking at it from a 200-day perspective and from a 100-day perspective breadth has significantly deteriorated over the past two months.
Wednesday, July 30, 2014
Outperformance of Emerging Markets Continues
Since the end of 2010 betting on the outperformance of developed market (DM) stocks relative to emerging market (EM) stocks has been a sure bet. Not so much in 2014. So far this year EM stocks have outperformed the DM by about 2.5%, but since March EM has outperformed DM by nearly 9% (chart 1 below). On a YTD basis the UAE, India and Indonesia round out the top while Russia and Hungary bring up the rear (table 1 below). On a QTD basis we still see the UAE at the top and China has made its way to the top of the list as well, but Russia and Hungary still round out the bottom.
MSCI EM sorted by YTD performance high to low:
MSCI EM sorted by QTD performance high to low:
MSCI EM sorted by YTD performance high to low:
MSCI EM sorted by QTD performance high to low:
Composite PMI Says Emerging Market Output Expanding At Fastest Rate In 15 Months
The Markit Composite PMI for the Emerging Markets are indicating that output expanded at a greater rate in June than it had in May. The output index is at it's highest level since March 2013. New orders also increased in June and the future orders bounced back, albeit at a very high level already, from it's 25-month low. Inflation isn't on the scene yet but concerns are building as output prices have closed the gap relative to input prices.
Kicking The Bear While It's Down
Whether the EU's newly imposed sanctions on Russia will affect its own recovery remains to be seen. Russia is, after all, Europe's third largest trade partner--not to mention the fact that it supplies about one-third of the natural gas imported by the EU. It appears likely, however, that efforts to inflict damage on important economic sectors such as Energy and Financials will result in exacerbating an already rather negative environment. A quick look at performance among Russian constituents of MSCI EMEA that are targeted by the latest sanctions paints a bleak picture.
Energy Sector Performance
Financial Sector Performance:
Utilities Sector Performance:
Energy Sector Performance
Financial Sector Performance:
Utilities Sector Performance: