Four PIGS in a bed and the little one said, “roll over, roll over,” so they all rolled over and Greece fell out, sending financial markets into a tailspin, and just as some semblance of normality was returning, the rating agency, Fitch, placed a Spanish fly in the ointment by removing the Mediterranean sovereign’s ‘AAA’ credit rating. The Greek’s fiscal challenges have stalked investors all year, but the supposedly containable Athenian problem proved to be the canary in the coalmine, as the local problem has since morphed into a full-blown eurozone crisis.
The rising stress is evident in the performance of the major stock market indices, which have suffered double-digit percentage point declines from their recent cyclical peak. Indeed, the Dow Jones Industrial Average has not performed so badly during the month of May performance since the Germans invaded France in 1940, while the S&P 500 has not fared as poorly at this time of year since President John F. Kennedy took on the mighty steel industry titans in 1962.
Some market commentators are quick to assign all blame for the stock market’s ills to eurozone stress, but global market action suggests otherwise – all major stock market indices have dropped below their 200-day moving average, stock prices in China have lost more than 25 per cent since August, global sector price correlations are at their highest level in more than three decades, the yield curve has flattened, corporate credit spreads are moving higher, and commodity prices are exceptionally weak with the Journal of Commerce Industrial Price Commodity Smoothed Price Index falling by a whopping 57 per cent in just four weeks. Perhaps it is not just the PIGS that are rolling over; the same may also be true of global economic momentum.
The merchants of perennial blue-sky thinking on Wall Street will undoubtedly argue that since corporate earnings continue to surprise on the upside by a wide margin, the market setback is irrational given the disconnect between fundamentals and prices. Indeed, David Kostin, the US equity strategist at Goldman Sachs, recently raised his 2010 and 2011 operating earnings-per-share estimates for the S&P 500 from $76 to $78 and from $90 to $93 respectively, and continues to believe that the American stock market will generate a total return of 20 per cent over the next 12 months. Kostin is not alone, and almost all of his competitors view the recent volatility as nothing more than a normal correction in an ongoing bull market; exploit the disconnect and buy the dip is the standard counsel.
The problem with this line of thinking is patently obvious. Stock prices are forward-looking and typically do disconnect from corporate profitability, such that the correlation between year-on-year earnings growth and twelve-month stock market performance is practically zero. Indeed, the current cyclical bull began at least one quarter before the economy troughed last summer, and at least six months before corporate profits reached their cyclical nadir during the third quarter of 2009. Investors would be well-advised to dismiss the perma-bulls’ impotent analysis, and look to reliable forward-looking gauges for more instructive guidance; the message emanating from leading indicators however is not as rosy as the picture painted by the merchants of fairytales.
The Economic Cycle Research Institute’s (ECRI) weekly leading index growth rate peaked last October at almost 29 per cent and has since dropped to just five per cent, a level that is consistent with real economic growth of less than two per cent in the second half of the year. The signal apparent from ECRI’s leading index is corroborated by the six-month rate of change in the Conference Board’s leading indicator, which has dropped from more than eight per cent last autumn to just four per cent today. Of importance to equity investors is the fact that neither reading is consistent with the perennial bulls’ fanciful stock market index targets for the months ahead; meagre returns and elevated volatility are far more likely given the current downward trend in the leading economic indicators.
The leading indicators do not as yet suggest that either a double-dip or a further savage downdraft in stock prices is imminent, but the impending growth slowdown suggests that market leadership will change with high-quality growth names being preferred to low-quality cyclical issues. A growth scare should focus investors’ attentions on names with relatively predictable earnings, while heightened market volatility should increase the demand for quality stocks with relatively higher credit ratings. The appeal of high-quality growth stocks is enhanced further by attractive relative valuations with the price/earnings multiple premium on this market segment at the lowest level since the early-1990s.
It is too early to call for the secular bear market to resume, but the leading indicators deserve close monitoring given that officialdom’s fiscal and monetary ammunition has already been largely spent, and a further downturn would almost certainly tip the economy into deflation and precipitate an exodus from risk assets. The message at this juncture is for investors to appreciate that the dash to trash is over, and that the time is right to roll-over to quality.