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Wonky

Would you believe I was on an airplane last Wednesday evening after meeting with a dozen or so clients in Denver, Monday and Tuesday and realized that I never wrote the weekly Red Sky Report?  Wow – I’ve been writing weekly for almost 7 years and I don’t think I’ve every forgotten!  I apologize,  let’s get to it. Things are a bit wonky at the moment between what the market is saying and the economic reports coming to us each week about the state of the economy.  This happens periodically and it’s important to understand the mechanics of the relationship between Wall Street and Main Street.  Let’s do that for this update.

Weak Economic Reports

Last week, we saw more than 50% (15 of 27) of the economic reports come in below expectations or just outright weak relative to their comparisons.  The Chicago PMI (Purchasing Managers Index), a closely watch leading index for business activity, was just awful, second only to October of 2008 in recent history in terms of its month over month drop.  Also raising eyebrows was a surprise increase in the jobless numbers, which created a bit of an unattractive upward spike in the falling pattern of the last few years.  So what are we to believe?  The idea being kicked around now is that the US is slipping slowly toward recession again after a four year weaker than normal recovery.  I don’t see that outcome and neither does the market (more in a minute).  I think there is a good chance that we’re seeing some post holiday seasonal weakness come into play and some nervousness among consumers as they just paid the Christmas Credit Card bill and have taxes staring them squarely in the face.  On the employment front, it’s hard to dramatically improve on a nearly full employment situation so we can expect the rate of decent in the jobless claims to also taper a bit which includes a few surprises like we saw this month.  Interest rates continue to rise slowly especially on short end and the Federal Reserve is still preparing the raise rates to curb potential inflation at the economy HEATS UP.  For the last several years, Europe and China have been exporting their deflationary environments to the US giving us more time to raise rates.  But now that virtually all foreign countries have embarked on new and robust easing measures, that pressure is off.  The Fed will still raise short term rates likely in October or November of this year all things considered.   Aside from the late February slate of weaker than expected economic reports, I don’t see the US economy trending toward recession yet. 

Market Telling Another Story

Stocks in the US and around the world had one of their best Februarys in many years, up 5-7% for the month leaving almost all indices out at all time new highs and up 2-3% YTD.  That strength was lead by the “good” sectors, those that reflect cyclical strength like technology, consumer retail, healthcare, biotech, transportation, materials and industrials.  Meanwhile those sectors that typically reflect a weakening economy, defense and fear, like consumer staples, gold, bonds and utilities, all had a terrible month. So the market story told YTD and especially in the month of February is out of sync with the notion that the economy is angling toward recession, quite the opposite. 

As I said, understanding the typical relationship between the markets and the economy is critical to investors.  Stocks lead the economy by about 6-9 months as they represent a basket of expectations for future earnings.  When the market senses future earnings will be weak, smart investors take profits, stock indices put in peaks and start to head lower even while the economy seemingly expands.  Today we have the opposite situation.  Markets and indices are at all time new highs almost across the board, while high level “economic” reports are showing some short term weakness.  Earnings are still very strong!  We are fully employed and cost of capital is at a 55 year low.  I’ve seen a lot of bad economic environments in the last 21 years of managing money and this is just factually not one of them by any stretch. 

Let’s look at the latest PMI report as an example

As I said the last time the PMI came in this weak month over month was October of 2008.  Now everyone remembers that time as a bad one for everything (stocks, credit, real estate, and eventually the economy).  What you might not know is that the stock market peaked not in 2008 but in October of 2007, a full year earlier.  October of 2008 was the turning point for when the US economy actually buckled into recession.  Now compare that to today.  Today, we have one bad PMI number akin to October of 2008.  But here instead we see a stock market that just made an all time new high last week.  Wonky! 

The condition we need to be watchful of is when the economy is raging higher, the Fed is working hard to put on the brakes after raising rates 3-6 times and yet stocks won’t go higher.  This is not that situation.  Use any pullbacks in prices as opportunities to upgrade positions and buy the dips.  We should be getting one here shortly after an unseasonably strong February. 

That’s it for this week

Sam Jones