W, Not V and Using the ECRI as a Market Indicator
Gluskin Sheff
David A. Rosenberg
May 25, 2010
The V-shaped recovery lasted two quarters — it’s now starting to look like a W. After swinging wildly on the back of the massive fiscal and monetary stimulus from -29.87% on December 5, 2008, to +28.54% on October 9, 2009, the ECRI leading economic index (smoothed) has slumped all the way back down to 9.0% in the May 14 week (down from 12.15% the week before in what was the steepest one-week slide on record). At 9.0%, it is back to where it was last July when the S&P 500 was hovering near the 900 mark. In the past 30 years, there has only been one other time when the index fell this far over such a time span and it was during the depths of despair in early 2009.
The downdraft in the market in recent weeks reflects the financial risk related to the European debt crisis, the monetary tightening in China and the re-regulation of the financial sector that is currently making its way through to Congress. The next leg down in the equity market specifically and cyclical assets more generally is economic risk. Equities went into this period of turbulence priced for peak earnings in 2011 and with a tailwind of positive earnings revision and positive guidance ratios from the corporate sector. If the ECRI and the Conference Board’s own index of leading economic indicators, which dipped 0.1% in April, are prescient, then they are portending a period of sub-par economic growth ahead (the ECRI is pointing to 1½% real GDP growth in the second half of this year). As the events of 2002 showed, more-than-fully valued markets do not need a double-dip scenario to falter — a growth relapse can easily do the trick. It’s still time to be defensive and too early in this correction to be picking the bottom.
BULL MARKET SELL-OFFS CAN BE SEVERE
History can be a useful tool so we went back to the 1870s to see how severe equity sell-offs can be during bull markets (as an aside, all the data can be found on Robert Shiller’s website for free). While the 1987 correction was the most severe (down more than 30%), we saw several instances where equities corrected by at least 10%. In fact only two of eight times did the correction stop at 10%, with the average correction being 20%.
RETURN TO LENDER
Who would have thought that on a year-to-date basis, the S&P 500 would have generated a 3% net loss and the Treasury market a net positive return of 4% (nearly 7% for the 10-year note, 10% for the long bond and 16% for long-dated zeros). Bonds do have more fun after all.
The rally in bonds is creating at least as much pain for the investment community as the sell-off in equities. As of May 18, the Commodity Futures Trading Commission (CFTC) data show that there are still a net speculative SHORT positions in the 10-year T-note of 206,783 contracts (in the futures and options market). In other words, the potential for a further significant short-covering rally in U.S. Treasuries.
By way of comparison, there is a net speculative long position of 1,238 S&P contracts, a net long position on oil totalling 134,863 contracts, a net long position of 7,233 on copper, as well as 47,085 contracts on the Canadian dollar. All of these are vulnerable to a further short squeeze. We are still long-term bulls of gold, but even here near-term caution is advised considering that there are a near-record 274,769 net speculative long positions in the yellow metal — this has become a very crowded trade; better pricing points likely lie ahead.
ECRI AS AN INVESTMENT STRATEGY TOOL
Many in the past have used an ISM clock (while on Wall Street, I did the same several years ago) but the problem is that the ISM is a perfect coincident indicator. It leads nothing. But the ECRI leading index does look ahead six months and is now pointing to GDP growth of little better than 1½% at an annual rate through the second half of the year, which is anaemic enough to regenerate ...
· A new peak in the unemployment rate (jobless claims have stopped falling and at current levels are consistent with net job loss 75% of the time in the past);
· A new low in housing prices (see page 16 of the weekend FT — the venerable Lex column — for true Bob Farrell-type mean reversion, U.S, home prices still have downside risk of up to 40%!);
· And new concerns over consumer credit quality (we say this as we see the S&P/Experian consumer credit default rate index hit a new high of 9.14% in April — the proportion of credit card debt going bad is rising sharply and this is not receiving the attention it should but is a yellow flag for consumer-oriented lenders and businesses).
This is not necessarily a double dip scenario as much as a growth relapse -- as we saw in 2002, still not exactly an ideal atmosphere for taking on long risk positions.
The ECRI not only leads but is also more timely than the ISM since the data are released weekly and the index covers the whole economy, not just manufacturing.
What we did was divided the ECRI into four different quadrants:
1. From the trough to zero (coming out of recession).
2. From zero to the peak (sweet spot of the cycle -- from the end of the recession to the cycle peak in growth).
3. From the peak back to zero (past the peak in growth; economy slows but not back in recession).
4. Zero back to the negative trough (heading back into recession).
5. From late 2008 to the fall of 2009, we were in stage 2. Since last October, we have been in stage 3 and it looks like we could be here for a while.
In stage 3, historically, the S&P 500 has provided tiny positive returns (average price appreciation of +1.3%). Tech, industrials and energy are the top performing cyclicals and health care and staples are also outperforming sectors in the more defensive area. This cyclical-defensive barbell works well — basic materials, consumer discretionary, financials and utilities tend to lag the most.
In the credit market, this is a period to be focussing on reducing duration and scaling into quality -- Baa spreads tighten, on average, by 11bps but widen in the high-yield space by an average of 13bps.
Nothing is to say that we will automatically revert to stage 4 just because we are in stage 3 right now but we are only nine -percentage points away, even with policy rates still close to 0%. Then again, this was a credit cycle, not a rates cycle. It was credit that created the 2003-07 boom, and it was credit that created the 2007-2008 bust. A 5.5% peak in the funds rate was hardly the culprit, and we know that it was not a 0% rate in late 2008 that triggered the 2009 renewal in economic activity and investor risk appetite but rather the Fed’s massive expansion of its balance sheet and the government’s willingness to push the fiscal deficit to record peace-time levels. In this sense, any analysis that relies on the classic post-WWII recession-recovery experience -- even this one -- has to be viewed in the context of a secular credit contraction which began two years ago.
In stage 4, the S&P 500 on average declines 6.3% with eight of the 10 sectors declining — a barbell of being long energy on the cyclical side and consumer staples on the defensive side has worked well. Consumer cyclicals, technology, industrials and financials are crushed in this segment of the ECRI cycle; telecom, utilities and health care do not perform as well as staples but are areas where at least you don’t typically get beaten up (for relative-return folks). The CRB is down an average of 3% but gold and oil tend to be supported by a weaker U.S. dollar. The yield on the 10-year note rallies an average of almost 40bps; as with equities, corporate bonds are hurt in this quadrant -- Baa spreads widen about 60bps and high-yield by close to 100bps. We have to be mindful that this can very well be the next phase of the cycle even without the Fed raising rates.
The ECRI bottomed this cycle a good four months before the equity market did and for those folks that paid attention, like Jim Grant, kudos to them. Because from the trough to zero — stage 1 — the equity market rallies on average by 12% with all 10 sectors in the green column, led by tech, consumer discretionary and basic materials. Energy, telecom and utilities tend to lag behind. Financials are basically market performers. The government bond market is still rallying in this segment and the curve is steepening — that along with a slight softening in the U.S. dollar provides a positive liquidity backdrop, which in turn is conducive to spread narrowing in the credit market (average tightening of around 50bps in investment-grade and 200bps in junk).
The market really takes off once the ECRI crosses above the zero line on the way to the peak, which is stage 2 or the “sweet spot”. In this phase, risk-taking works best with the S&P 500 rising 22% through this interval and every sector is up double-digits in terms of average price gains. Financials, basic materials, industrials, technology, and consumer discretionary typically provide the greatest alpha in this most intensely pro-cyclical phase of the cycle — utilities and telecom lag the most as does energy within the economic-sensitive space (energy tends to be a stage 3 and 4 outperformer). Again, the credit market mirrors the positive backdrop in equities — Baa spreads come in by more than 30bps and by nearly 170bps in the high-yield space.
LAST HURRAH FOR THE HOUSING SECTOR
U.S. existing home sales soared 7.6% in April to a seasonally adjusted annual rate of 5.77 million units, above expectations. The surge was already foreshadowed by the earlier release of the pending home sales figures and entirely reflects the rush of activity ahead of the April 30th expiration of the homebuyer tax credit ($8,000 for first time buyers who made up close to half of the April sales tally (repeat buyers represented 36% of the pie last month -- they get a $6,500 tax credit). We already know what housing activity looked like following the April 30th deadline with mortgage applications for new purchases down to a 13-year low as of mid-May. Moreover, the one critical fly-in-the-ointment in April was the surge in supply — inventories climbed 11.5% to their highest level since July 2009 (+12.8% for single-family homes to their highest level since Nov/08) — and back up to 8.4 months' supply from 8.1 months in March. This excess supply casts a cloud over the outlook for home prices in coming months.
As a sign of just how sick the housing market really is, almost all (that is nearly 100%) of the mortgages issued last quarter were insured by the government under Fannie, Freddie and the FHA. In fact, FHA lending ($52.5 billion) actually exceeded the combined volume of government-supported Fannie Mae and Freddie Mac ($46 billion) in a home-lending market that's still a "government-financed market," David Stevens, the agency's head, said today at a conference in New York, citing research by consultant Potomac Partners. "This is a market purely on life support, sustained by the federal government," he said at the Mortgage Bankers Association conference. "Having FHA do this much volume is a sign of a very sick system." And you thought we were bearish on the real estate backdrop.
And the strains are not limited to the single-family market. Defaults on apartment-building mortgages held by U.S. banks climbed to a record 4.6 percent in the first quarter, doubling from a year ago. This already exceeds the 3.4% S&L-induced peak seen in 1993.
THE CHICAGO BULLS?
The Chicago national activity index improved to +0.29 in April from +0.13 in March — the best tally since December 2006 and the first back-to-back positive readings since the opening months of 2007. The Chicago Fed suggests that we concentrate on the three-month smoothed index, which went from -0.09 in March to -0.03 in April — still underscoring a below-average pace of growth but you still have to go back to February 2007 to see the last time that the index was this “strong”.
Production and income are on an improving trend but we do see that the sales component has slowed for two months in a row. Not only that, but the consumption and housing segment actually fell to a three-month low and at -0.41 is actually still lower today than it was at the depths of the past five recessions (as the chart below illustrates). One has to wonder what happens once the inventory cycle runs its course and the production index stops proving support.
(c) Gluskin Sheff
