Alan's Finance Blog

Leading Economic Indicators Keep Rising, but …

Last Thursday the Conference Board published its Leading Economic Index (LEI) for the U.S. In January this historically-reliable indicator increased 0.3 percent after shooting up 1.2 percent in December and 1.1 percent in November. This was the tenth consecutive rise!

Five of the ten components made positive contributions: The interest rate spread, stock prices, supplier deliveries, factory workweek, and consumer expectations.

The LEI’s much more important year-over-year percentage change also rose … from 6.7 percent in November, to 8.1 percent in December, to a very healthy 8.7 percent in January. And as you can see on the chart below, it’s approaching a high level by historical standards, too.

So the LEI is probably reaching its zenith in the year-over-year change. I would also note that six-month percentage change weakened from 6.2 percent in December to 4.8 percent in January.

So what does all of this mean?

First, it means that the big economic picture is still looking good. The bounce will probably continue for at least another two quarters, thus supporting a continuation of the medium-term stock market rally.

But thereafter the outlook isn’t so bright …

The Huge Interest Rate Spread
Is Important for the LEI

When you look deeper beneath the surface of the LEI, the picture is becoming even more ominous. Especially noteworthy is the contribution of the positive spread between short-term and long-term interest rates. Without it, the LEI would have been down 0.1 percent last month.

You might ask then: What’s wrong with that?

Well, there is nothing wrong with long-term interest rates moving higher than short-term rates. In fact, this is a major tool of monetary policy to subsidize the banks and get bank lending going again. But herein lies the problem …

Too much easy money can ultimately damage the banking sector.

In a post-bubble world, monetary policy has much less traction than under normal conditions. If too much debt and too many bad loans are weighing on the banking sector’s balance sheet, monetary policy becomes a rather toothless tiger.

That’s why relying on monetary indicators in forecasting the economy or the stock market becomes dangerous. Moreover, it’s very important to watch the particulars of the LEI.

For instance, the way I use the LEI gave me a bullish signal for the economy after the release of the June 2009 reading in mid-July. And it worked.

However, if the index were to continue to rise while the yield curve (the most heavily weighted component) remained steep and most of the other components began turning down, I would begin to doubt the validity of the LEI’s positive readings.

Remember, Secular Downtrends are Very Volatile

During secular economic downtrends and major crises, volatility increases dramatically — not just in the financial markets, but also in the economy. At least that’s what history tells us.

The LEI has just flashed a warning sign.

For example, if you look at the 1930s or the 1970s in the U.S. or the past 20 years in Japan, you can unequivocally see it.

All of these secular economic and stock market downtrends have been severe. Yet all of them have, from time to time, been interrupted by huge jumps in GDP growth — like the 5.7 percent reading for U.S. in the fourth quarter of last year.

I think the weakening in the six-month rate of change of the LEI has to be treated as a first warning sign. A warning sign telling us that the economy is not on a durable growth path. A warning sign, that the second half of this year may become very disappointing.

And with the S&P 500 trading at a 12-month trailing price-earnings ratio of 24.7 and yielding just 2.1 percent, all that’s needed for a major stock market downturn is a slowdown and some disappointment in rather exuberant analysts’ earnings estimates and strategists’ economic outlooks.

Best wishes,

Claus

Fed Promises Easy Money for an Extended Period

by Claus Vogt

Every few weeks the world’s most powerful and influential central bankers — those in charge of the world’s number one reserve currency, the U.S. dollar — come together in what’s called the Federal Open Market Committee (FOMC).

They discuss the economy, interest rates, financial markets and whatever else they deem important. Then they decide to set the Federal Funds Rate at a level they think is appropriate.

And last week was their week. So today I want to analyze what their decisions mean for the stock market and for you as an investor.

The Fed Statement Reassures
A Very Lax Monetary Policy …

The FOMC meets regularly to decide where to set the Federal Funds Rate.

After each FOMC meeting, the Fed releases a statement. And the one for September 23, 2009, is very telling in my opinion. Here’s its most important part:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

As you can see, the Fed is promising a continuation of its extremely lax monetary policy “for an extended period.” So all the recent media talk about a soon-to-begin exit strategy or a normalization of monetary policy was obviously premature. The Fed is reassuring us that there will be easy money for as far as the eye can see.

Why?

Two reasons come to mind:

First, the Fed is still very concerned about the economy … the employment situation is dire … and a double-dip recession is a real possibility.

Second, and more important, is that they know how precarious the banking situation still is. They know that the bad debt problems have not been solved … that most banks would go bankrupt if they had to implement mark-to-market rules … and that the banking system is still on life support.

This Is Important News
For the Stock Market

Since the Fed is confronted with two major problems — a shaky economy and an unstable banking system — it’s not worrying about a possible stock market bubble in the making.

Why is this so important?

Just look at the charts below. The stock market has rallied some 60 percent since the March low. But earnings are still very depressed. Hence the classic version of the P/E ratio — using twelve months trailing GAAP earnings — shot to the stratosphere!

Source: www.decisionpoint.com

Twelve-month trailing earnings as of the first quarter 2009 were a mere $6.86 for the S&P 500 making for a P/E ratio of 154. According to Standard and Poor’s, these earnings are estimated to rise to $7.51 in the second quarter, and $7.61 in the third quarter. Then they’re expected to jump to $39.35 in the fourth quarter and $43.58 in the first quarter 2010. Based on this last figure the P/E ratio will decline to 24.

Historically the normal range for this very P/E ratio — based on 12-month trailing GAAP earnings — has been between 10 (undervalued) and 20 (overvalued). Hence even if the corporate sector will see the estimated jump in earnings, the stock market is still very expensive.

Classic stock market valuation metrics show that this is a highly overvalued market. And overvalued markets can stay overvalued for a long time and even become more overvalued — as long as the Fed does not take away the proverbial punch bowl.

This means one of two things …

We’re Witnessing the Next Bubble, Or
Earnings Have to Increase Dramatically!

Fed chief Bernanke’s inflationary stance could be the fuel that ignites the next stock market bubble.

Right now I can’t rule out either one. I do, however, lean towards the first. And in reading the Fed’s FOMC statement one thing becomes obvious: If we’re on our way to a new stock market bubble the Fed will not prick it any time soon.

The September 23 statement that I cited earlier is as clear as you can expect from the Fed. Much clearer than anything Greenspan said during his long reign. His famous “irrational exuberance” speech, which was never followed by any action, is a perfect example.

Bernanke is much different …

From the very beginning of his career at the Fed he made it known that he’s a first class inflationist, and he strongly believes prosperity can be achieved by printing money. Now the Bernanke Fed is clearly reiterating this inflationary stance. By doing so the Fed is rubberstamping the current stock market rally and apparently not worrying about a possible bubble!

There is an old Wall Street saying: “Don’t fight the Fed.” I think it’s wise to heed it in today’s environment.

Best wishes,

Claus