The Weight of the Evidence Market Views of Comstock Partners, Inc. Thursday, May 12, 2005
Despite the positive hype, it appears probable that the economy is headed for a significant slowdown or recession that has not been discounted by the market. These are the conclusions we draw from some significant indicators that have shown good lead times in forecasting past economic cycles. Our reasoning is as follows.
The PMI index, which has been heading down for a few months, leads industrial production by about five months. In turn, industrial production leads manufacturing employment by four months. This means that the PMI leads manufacturing employment by nine months. Furthermore rising energy prices tend to lead the economy by about a year, meaning that the increases we have already witnessed are baked in the cake even if oil prices should decline from here.
We have also pointed out in past comments that a period of tight money is almost always followed by an economic slowdown or recession together with a declining stock market. Associated with this is the decline in year-to-year money growth (MZM) to 1.6%, a level that similarly has led to economic slowdowns or recessions over the past 40 years. Another study reveals a 47% correlation between the growth in real M2 and final domestic sales. This is recognized by the Conference Board, which gives this the second highest weighting in its compilation of leading indicators. Real M2 has declined from a growth rate of 4.4% in the first quarter of 2004 to only 0.6% in the first quarter of this year. A similar study indicates a 44% correlation between a narrowing yield spread (the 10-year bond to the fed funds rate) and a subsequent slowdown or decrease in final sales. The spread was 359 basis points in the 2nd quarter of 2004, 183 in the 1st quarter of 2005, and 118 now. In fact, the Conference Board gives this indicator the top weighting of its 10 leading indicators.
The leading indicator index as a whole has now declined year-over-year, and over the last 40 years such an occurrence has always led to an economic slowdown or recession. Moreover these U.S. indicators have been supported by the ongoing weakness in the global economy. The OECD leading indicator has also been sharply lower while the Japanese economy has again been showing signs of sinking despite having shown no significant recovery in a period now in its 17th year. Although the majority of economists insist that the economy is fine shape, we give far greater weight to the indicators cited above.
While a number of bullish commentators have asserted that the market has already discounted all the bad news, this conclusion in not evident in either sentiment or valuation. Indeed, as any listener knows, the commentary on such programs as CNBC is overwhelmingly bullish. Even the so-called bears on that show are only less bullish rather than really bearish. If true bears are that hard to find how bearish can overall sentiment be? At past market bottoms the Investors Intelligence survey generally showed bears at 55% or more with bulls at 20% or under. Currently bears weigh in at 28% while 46% register as bullish. Furthermore at past market troughs equity mutual funds cash holdings were 10% or more of assets, but are only at 4.1% at the latest reading. The VIX remains at a relatively low 16 compared to 40 or higher in previous bear markets. In terms of valuation the P/E on the S&P 500 is still at 19, far lower than in 2000, but still at the top end of the 71-year range prior to the late 1990s. Bear markets end with massive public capitulation, not with the mixture of bullishness and complacency we see today. When we further consider the remaining major financial and economic imbalances and the distinct possibility of a serious financial accident, we think that the market is still highly vulnerable to a serious decline in the period ahead.
Note: A number of the economic correlations referred to in this comment were the work of economists Ed Hyman of ISI and Paul Kasriel of Northern Trust, although the conclusions on the stock market are ours.
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