Weekly Market Commentary: 10 Indicators to Watch For Another Spring Slide

          _ In each of the past two years the stock market began a slide in the spring, a phenomenon often referred to by the old adage “sell in May and go away,” which lasted well into the summer months. Are stocks poised to repeat the pattern this year? We have identified 10 indicators to watch closely in the coming weeks that may warn of an impending slide.

What to Watch

In both 2010 and 2011 an early run-up in the stock market, similar to this year, pushed stocks up about 10% for the year by mid-April. On April 23, 2010 and April 29, 2011, the S&P 500 made peaks that were followed by 16-19% losses that were not recouped for more than five months. While late April is still four weeks away, judging by what indicators seemed to precede the declines in 2010 and 2011, we have identified 10 indicators to watch over the next four weeks.

The 10 indicators include:

  • Fed stimulus – In each of the past two years, Federal Reserve (Fed) stimulus programs known as QE1 and QE2 came to an end in the spring or summer and stocks began to slide until the next program was announced. The current program known as Operation Twist was announced on September 12, 2011 and is scheduled to conclude at the end of June. The stock market may again begin to slide until another program such as QE3, the scope of which was recently hinted at by the Fed, is announced.
  • Economic surprises – The Citigroup Economic Surprise index [Chart 2] measures how economic data in the United States fared compared to economists’ expectations. A rising line indicates that the data is consistently exceeding expectations. A falling line suggests expectations have become too high. The index moved to what has historically marked the peaks in optimism about a month or two before the peaks in the stock market in 2010 and 2011. This year, it appears the index may have already started to retreat from a peak since early February; if this index again leads by two months the slide may soon begin.

  • Consumer confidence – In 2010 and 2011, early in the year the daily tracking of consumer confidence measured by Rasmussen [Chart 3] rose to highs last seen on September 5, 2008, just before the stock market collapse as the financial crisis erupted. The peak in optimism gave way to a sell-off as buying faded. Investor net purchases of domestic equity mutual funds began to plunge and turned sharply negative in the following months. This measure of confidence is once again close to the highs seen in early 2010 and 2011; we will be watching for a turn lower in the index that would indicate the start of an erosion of confidence.
  • Earnings revisions – The first couple of weeks of the first quarter earnings season (April 2010 and April 2011) drove earnings estimates higher in both 2010 and 2011. Earnings estimates for S&P 500 companies over the next year rose a greater-than-average 3-5% over the first couple of weeks of reports. But as the second half of the earnings season got underway in May 2010 and May 2011, guidance disappointed analysts and investors as the pace of upward revisions declined sharply. This year, we will be watching to see how much earnings expectations rise as the initial reports come in and if they begin to taper off sharply.
  • Yield curve – In general, the greater the difference, or spread, between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy [Chart 4]. This yield spread, sometimes called the yield curve because of how steep or flat it looks when the yield for each maturity is plotted on a chart, peaked in February of both years at 2.9%. Then the curve started to flatten, suggesting a gradually increasing concern about the economy. This year the market is pricing a more modest outlook for growth, but we will be watching to see if the recent slight decline in the spread (currently about 190 basis points) begins to decline.
  • Oil prices In 2010 and 2011, oil prices rose about $15-20 from around the start of February, two months before the stock market began to decline. This year oil prices have climbed back to the levels around $105-110 that they reached in April of last year. However, they have risen only about $10 since around the start of February 2012. A further surge in oil prices would make this indicator more worrisome.
  • The LPL Financial Current Conditions Index (CCI) – In 2010 and 2011, our index of 10 real-time economic and market conditions peaked around the 240-250 level in April and began to fall by over 50 points. This year, the CCI recently reached 249 and has started to weaken and currently stands at 232.
  • The VIX – In each of the past two years the VIX, an options-based measure of the forecast for volatility in the stock market, fell to a relatively low 15 in April. This suggested investors may have become complacent and risked being surprised by a negative event or data. This year, the VIX has recently declined once again to 15 in the past two weeks.
  • Initial jobless claims – It was evident that initial filings for unemployment benefits had halted their improvement by early April 2010, and beginning in early April 2011, they deteriorated sharply. So far, in 2012 initial jobless claims continue to improve at a solid pace, but it may yet be too early, and so we will be watching for any weakening as April gets underway.
  • Inflation expectations The University of Michigan consumer survey reflected a rise in inflation expectations in March and April of the past two years. In fact, in 2011, the one-year inflation outlook rose to 4.6% in both March and April. This year, inflation expectations have also jumped higher so far in March, reaching 4%.

While this list may seem incomplete, it is notable that many of the most widely watched indicators of economic activity such as manufacturing (the Institute for Supply Management Purchasing Managers Index known as the PMI or the ISM), job growth, and retail sales, among others, did not deteriorate ahead of the market decline, but along with it. It is not that they are not important; it is just that they did not serve as useful warnings of the slide to come, while the above indicators did.

So far, about half of the 10 indicators point to a repeat of the spring slide this year, while the other half do not. We will continue to monitor these closely in the coming weeks.

Shorter Slide?

While it is possible we will experience another spring slide this year, there are factors that may mitigate the decline short of the 16-19% seen in the past two years.

Looking back, in 2010 the negative environment that helped fuel the decline included the end of the Fed’s QE1 stimulus program, the uncertainty around the impact of the Dodd-Frank legislation, the eurozone debt problems and bailouts, central bank rate hikes, and the end of the homebuyer tax credit. In 2011, the negatives included the end of the Fed’s QE2 stimulus program, the Japan earthquake and nuclear disaster that disrupted global supply chains and pulled Japan into a recession, the Arab Spring erupted pushing up oil prices, the budget debacle and related downgrade of U.S. Treasuries, rising inflation, central bank rate hikes, and the eurozone debt problems coming to a head.

Looking ahead, the negatives we face in 2012 already include the end of the Fed’s Operation Twist stimulus program, rising oil prices, China’s slowdown, the European recession, the election uncertainty, and anticipation of the 2013 budget bombshell of tax hikes and spending cuts. However, there are some positives this year that may help offset some of the negatives making for a potential decline that may be less steep than those of the past two years. First, central banks are now cutting rather than hiking rates, which should help to temper global recession fears evident during the past two years’ spring slides. Second, housing is showing signs of improvement as both new and existing home sales are rising at about a 10% pace. Third, while energy prices are up this year (same as last year) food prices are decelerating, which helps to explain why consumer sentiment is going up in the face of higher gasoline prices. Finally, auto production schedules are robust for the next quarter and likely to support manufacturing activity, which had fallen in May through July of the past two years and contributed to the market decline.

Given this year’s double-digit gains and the possibility of another spring slide for the stock market, investors may want to watch these indicators closely for signs of a pullback despite the current upward momentum in the stock market and solid economic growth.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Standard & Poor’s 500 Index is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results.
Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.
The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Yield Curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
The VIX is a measure of the volatility implied in the prices of options contracts for the S&P 500.  It is a market-based estimate of future volatility.  When sentiment reaches one extreme or the other, the market typically reverses course. While this is not necessarily predictive it does measure the current degree of fear present in the stock market.
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
This research material has been prepared by LPL Financial.
The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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