by Randall W. Forsyth
It's summer, the time for amusement parks and roller-coaster rides. So, too, it seems for the stock market as July is turning out to be fun after the second quarter's scary slide.
Key technical gauges of the stock market have begun to turn positive. The major stock market gauges have poked above their 200-day moving averages. The Dow Theory gave buy signal with the Industrials and Transports closing Monday above their June highs.
Richard Russell, the octogenarian publisher of the Dow Theory Letters, told his subscribers that he didn't expect a buy signal but they might as well buy some (NYSE: DIA - News) that track the DJIA "to get in on the fun."
But for himself, Russell wrote: "In view of my financial position and my age, I don't feel any urge to play the upside of this market, this despite the Dow Theory bullish signal. That fact is that at this stage of my life, risk vs.reward plays a very large part in my actions."
That's consistent with the advice from the doyenne of market analysis, Louise Yamada, offered here recently ("First, Protect Capital," July 23.) To repeat, she cites two kinds of losses, of opportunity—from sitting out a rally—or of capital. There always be future opportunities, but if you've lost capital you won't be able to take advantage of them.
Indeed, one leading fundamental strategist urges investors to resist the increasing bullish calls.
"We are at the most dangerous state in the Ice Age—the 'post-bubble' cycle," writes Albert Edwards of Society Generale.
"For although it is clear that leading indicators have turned downwards, the choir of sell-side sirens is singing its song of reassurance. The lesson from Japan was that once the cyclical rally is over, any downturn in the leading indicators should find you stuffing beeswax in your ears to block out the lilting melody so as to avoid the jagged rocks of recession."
Edwards's key thesis is that Western economies have entered an Ice Age of secular stagnation and deflation such as has gripped Japan for a decade. While there are significant differences, there are parallels in the unwinding of extreme equity valuations "in a post-credit bubble world."
Even so, Edwards contends that even a secular decline is punctuated by sharp but short-lived cyclical rallies that reverse as the transitory economic thaws end. Japan has seen 40%-50% tradeable pops in the Nikkei but the key always to get out as soon as leading indicators turned lower.
That's clearly happened in the Economic Cycle Research Institute weekly leading indicator, which is now in "recession" zone, according to Edwards, but also is a matter of heated debate. For its part, ECRI doesn't look for a double-dip but still a second-half slowdown.
And as I wrote in the Current Yield column in the print edition of Barron's this week ("Treasuries at Odds With Stocks", July 26) the ECRI weekly leading indicator may be overly influenced by mortgage applications.
But that is a counterpoint to the distortion of perhaps the best leading indicator—the slope of the yield curve—which in normal times would be pointing to a boom. These are anything but normal times, as evidenced by the Federal Reserve holding its federal-funds rate target near zero. Were that not the case, the yield curve would not be nearly so positive, either in its slope or in its implications for the economy.
Other leading indicators from the Organization for Economic Cooperation and Development and the Conference Board are rolling over at "a far more moderate, reassuring pace." But one of Edwards's favorite leading indicators is the change in equity analysts' optimism. He finds the six-month change in the OECD leading indicator for the U.S. follows the analyst optimism closely (as measured by their upgrades as a percentage of all estimate changes.)
And the analysts' estimate changes have been sharply lower. While that's given corporations a lower hurdle to clear to beat forecasts, it points to weaker economic growth. Moreover, Edwards says "the current rate [his emphasis on the second derivative] of erosion of analyst optimism is consistent with a full-blown bear market.
What will become clear is the economy's underlying weakness. Real gross domestic product growth "of around 4% was hugely driven by the end of inventory liquidation and contrasts with the sub-2% rebound in final sales [GDP minus inventory change.]" That's with the biggest-ever peacetime stimulus, so "it doesn't take a genius to work out that as the stimulus ends (it doesn't even need to be reversed), we are going to see a slump in GDP growth."
Does that mean a double-dip? That's not crucial Edwards says bulls are missing an important nuance—it doesn't take a recession for the equity market to slump. Nominal final sales are "shockingly low," running at below normal recession levels, which help explain the revenue warnings during the current earnings season, he adds.
Whether you agree or not, Edwards can't be accused of being the two-handed economist so detested by Harry Truman.
"My view on the outlook could not be clearer. They may be wrong, but at least they are clear. We still call for sub-2% 10-year bond yields and equities below March 2009 lows."
So, enjoy the ride on the Dow technical roller-coaster. Just know when to get off.