Taking Stock of the Situation

This is one of those tricky times when it appears that both data and price action are pointing in a multitude of directions. Let’s go over some of the key variables.

First, to set the stage, I think it’s important to note that peak economic growth is probably behind us for this cycle. Thanks to fiscal stimulus measures that should’ve been reserved for periods of economic weakness, but were instead used as afterburners, the U.S. economy reached an annualized growth rate of 4.2% in the second quarter.

That rate of growth slowed to 3.5% in the third quarter (we’ll see a revision on December 21st), and is expected to slow further to around 2.7% for Q4. Most economists are anticipating a continued slowdown during 2019, with growth estimates ranging from 2% (Bloomberg consensus) to 2.5% (IMF).

Against that backdrop, we’ve seen a sharp deterioration in price action, and the rolling over of a few leading indicators. We’ll discuss price action first.

In a continuation of the incredible volatility that has plagued 2018, the Industrials and Transports have recently slumped once again, falling below their initial correction lows from late October (see chart below).

Charts of Industrials and Transports

Based on my interpretation, this qualifies as a Dow Theory sell signal. But there are some caveats.

The primary caveat has to do with time. Based on the writings of Robert Rhea, who organized the work of Charles Dow and William Hamilton into a set of assumptions and theorems, primary moves last from a few months to a few years, while secondary reactions last from a few weeks to a few months.

Looking at the price action above, we can see that the Industrials have taken approximately two months to trace out this bearish action, while the Transports began their decent a bit earlier, putting their elapsed time closer to three months.

This lands in that middle-ground area where the move could be interpreted as a longer secondary correction (in which case we still haven’t seen the initial correction lows), OR it could be representative of a rolling over of the Primary Trend.

I have espoused on previous occasions that I believe the pace at which information is discounted by the market continues to increase, which lends credence to the idea that this price action is representative of the Primary Trend. But either way, the price action above is not a good sign.

The second caveat with respect to Dow Theory is that sell signals do not always indicate the onset of a bear market. Earlier this year we saw similar behavior in the Industrials and Transports when the Transports confirmed a lower-low in the Industrials by just 5 points on April 9th. The two averages subsequently reached new highs.

We also saw a Dow Theory sell signal back in 2015 that didn’t lead to a bear market, though we did see an earnings recession and the market moved sideways for quite some time.

Considering that our economy still remains on relatively sturdy footing, my guess is that we’ll see this Dow Theory signal play out in the same way – a prolonged period of rangebound prices.

I think it’s worth pointing out that this break to new lows is also being seen in the broader S&P 500, as well as the NYSE advance-decline line. So we do have confirmation from the broader market …

S&P 500 and NYSE Advance Decline Line

Moving on, let’s take a look at some of the more recent developments with regard to leading economic indicators. The first thing I’d like to mention is that the yield on the 5-year Treasury note is still below that of the 2-year note, indicating inversion.

Again, this is not the typical spread that yield curve prognosticators follow, but as shown last week, it’s still a very reliable recession indicator. In case you’re wondering, the 10’s-2’s spread (most closely watched by the markets) is positive by 10 basis points, and the 10’s-3 month spread (most closely studied by academics) is positive by about 46 basis points, or roughly half a percent.

So the yield curve is feeling queasy about economic prospects, but interestingly, we’re still seeing some strong readings in other leading indicators. Two of the most important are the ISM manufacturing and services indexes. In the chart below you can see that both of these remain well in expansion territory (above 50).

ISM Manufacturing and ISM Services Indexes

One of the other most-watched leading indicators comes from The Conference Board, and is actually a composite of 10 separate leading indicators. The most recent data released showed an increase of 0.1% for October, which represents improvement, though it also marks a sharp deceleration from gains during the past two months.

A chart of The Conference Board’s LEI is shown below and as you can see, the LEI tends to roll over well in advance of approaching recessions.

The Conference Board's Leading Economic Index

This particular index has provided such a long lead time prior to previous recessions that it makes me think a recession is still not on our doorstep. But what’s interesting is that if this indicator rolls over during the next few months, it could imply a recession beginning about two-years out, which would equate to the message currently being sent by the 5’s-2’s inverted spread.

Other indications, such as slowing job growth and a subtle trend higher in unemployment claims, would further support a cyclical peak around that time … so perhaps we should plan on a recession in 2020?

Amidst all this postulating, we need to remember that the future is not set in stone but rather is dependent on actions taken between now and then. Specifically, changes in monetary and trade policy will have enormous ramifications.

As discussed last week, the Fed has backed off their hawkish rhetoric and is reportedly considering communicating a “wait and see” approach to further rate hikes. This is an important development that will have ripple effects across the broader economy. The last thing investors want to see is a Federal Reserve hell bent on raising rates into a slowing economy.

While we’re on the topic of rates it’s important to note that the yield on the bellwether 10-year note has also backed off. This is another positive sign as it suggests consumer borrowing costs, especially on longer-dated debt such as mortgages, will see some relief.

10-year Treasury Note Yield

As for trade, that is a big question mark and seems to be having an unduly large effect on the markets. Perhaps the gravitas is warranted, however, as consensus estimates point to a one percentage point decline in GDP if the threatened 25% tariffs on all Chinese imports go into effect.

That would indeed be detrimental to both the stock market and economy, but let’s not forget that our President views the stock market as a barometer of his presidency. In trying to discern potential outcomes in a negotiation like this, sometimes it’s more effective to analyze the motives of the parties involved rather than the terms of the agreement. I have a hard time believing that Trump will go so far as to sabotage his own ratings.

Finally, let’s quickly discuss oil. Oil has found support in the $50 area and this is a good sign. $50 is high enough for U.S. shale companies to remain solvent, but not high enough for many to continue drilling new wells.

Light Crude Oil Price

This means that we’re likely to see a decline in energy-related capital spending, but remember that low oil prices are a boon to the rest of the economy. If oil prices remain suppressed, it will avert fears of rampant inflation (which takes pressure off the Fed to raise rates) and it will also lead to a slight but notable increase in many companies’ margins, particularly those in the transport sector.

When taking all of the above into consideration, it seems to me that we are much more likely to be in a trading range type environment for the foreseeable future than to experience a vicious bear market, or a prosperous bull market.

As a result, I think that an increasingly conservative investment stance is warranted, but that you can take your time making these changes. Any reductions to exposure should be done on strength (I’ll try to point out opportune times moving forward), and all but the most aggressive traders may want to suspend the idea of buying into weakness, at least until the longer-term outlook becomes more certain.



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