ADSAnalytics LLC Blog

A rule of thumb has it that the best time for equities is when:

1. there is a greater than average degree of slack in the economy, allowing room for expansion without driving up inflation
2. the rate of output is above the trend rate
3. the rate of output is increasing

We check these criteria in the charts below:

We use capacity utilization as a proxy for slack and find that we are below its long-term average.

The yoy% change in Industrial Production is above the trend rate (though not shown here, mom% and qoq% changes are below their respective trends).

The velocity of output is dropping.

In summary, we find that condition 1 is fulfilled, condition 2 is a tie and condition 3 fails.

So, at best a 50/50 time for the equity market.

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This summary report is one of the tools we use to gauge the current stage of the business cycle (stay tuned for the Expansion Tracker). This is, of course, relevant to our ability to project the direction of the asset markets.

The table below will be married with another table showing what each indicator is expected to do in each part of the cycle – the actual current performance of the indicator will allow us to gauge what each indicator is telling us about the current stage of the cycle. We do not expect an entirely consistent story across all indicators, however, on an aggregate basis we hope this is useful.

What is the current environment telling us?

• Consumer demand is mixed
• Credit is expansionary – borrowing is up and standards are easier
• Inventories are up
• Inflation is flat or lower
• Economic activity is strong
• Interest rates are higher
• Money supply is up
• Slack is lower
• Asset markets are signaling an expansion

In sum, we would gauge we are in mid-cycle of the current expansion – however, we will wait to quantify this in a later post.

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We take a quick look at our recently updated Equity Flow-of-Funds Report.

This report summarizes flows into the equity market from its various participants in order to gauge whether conditions are overbought or oversold.

The bullet points are:

• Mutual funds have continued selling stocks and buying bonds
• Large speculators are buying, small speculators are selling
• Foreigners are buying US stocks, selling ex-US stocks
• Households are buyers
• Margin debt is up
• Hedge funds have gotten slightly shorter (though still net long stocks)
• M&A is down
• IPO supply is down

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One popular narrative has it that a set of long-running imbalances, aided by the final catalyst of Fed tightening, was what ultimately drove the US into a deep recession.

So, we check up on some of these imbalances to see if / how much they have unwound since the start of the crisis.

The share of GDP from financial services has fallen only slightly since the pop. While the unwinding of the share of this sector has been unimpressive, this probably owes as much to the lackluster performance of the other sectors of the economy as well as the more general trend away from the tradeable jobs sector into the service sector of the US economy.

The savings rate jumped higher since the bubble burst, however, it has since collapsed – somewhat surprisingly as our model is predicting a much more gradual descent. Squeezed incomes and high unemployment are the likely culprits behind this trend.

The share of the economy coming from Residential Investment has more than halved and has stabilized at what appears to be a much more sensible and sustainable level. We are predicting a small rise in the share of this sector, which would be welcome given the historically strong role the housing sector has played in economic expansions.

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With equities taking a breather after the huge run-up over the last few months, we take a quick look at various leading indicators of economic activity to gauge where the economy, and by extension, earnings and equities may be headed.

To summarize, worrying concerns are aplenty:

Click on the charts for our Dashboard sites which contain more information on these and other indicators.

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Our latest Sentiment Report presents a mixed picture:

• Investors are less bullish or neutral
• Near-term GDP and earnings forecasts are up but longer-term are down
• US confidence is higher, European is lower

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The last decade witnessed a now familiar trend of cash-rich developing countries pouring their savings into US fixed income as a safe way to park their reserves. This savings glut hypothesis is held partly responsible for inflating the housing bubble in the US by pressuring long-term yields lower and helping along the process of securitization of risky assets into apparently risk-free securities.

More recently, FX reserve growth has slowed as EM currencies have appreciated and demand from the developing world, itself under deleveraging pressure, proven less than robust.

However, perhaps counterintuitive, as FX reserve growth has slowed, yields have actually fallen. Foreign buying, of course is not the only driver of yields – uncertainty about the recovery as well as QE have been major factors.

However, if and when the economy stabilizes and the Fed puts an end to the purchases, yields may be pressured higher.

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The chart that is making us nervous is Labor Income less Spending. In a nutshell, households earning less relative to spending means current levels of spending aren’t sustainable in the absence of higher incomes or lower savings. While higher labor unit costs are a welcome sign, lower savings is not.

And it is not at all clear what higher labor costs will do to equity markets. On the one hand, the economy could use more spending – however the markets may not look kindly on lower margins. The margin picture proxied below by EPS / Sales at the moment is looking ok.

However, warning signs are on the horizon from the small-business survey.

In the worst scenario, higher labor unit costs dampen margins but not boost spending as consumers will still be busy deleveraging. This could be a double knock on the market.

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Today, we check up on another section of the Equity Dashboard report – Risk Appetite.

Torrid returns in equities over the last few months have raised questions of whether the market has gotten ahead of itself. We look at three of our risk-appetite indicators below.

X-Asset Return: calculates intercept of 6m returns of risky and risk-free assets vs volatility – a high reading means riskiest assets have performed the best.

Market Pricing: calculates standard deviation of credit spreads, S&P volatility and Libor spread over bills – a high reading indicates a risk-on environment.

Equity Positioning: calculates investor flows into cyclicals/defensives, hi-beta/lo-beta, large-cap/small-cap and em/developed markets – a high reading indicates a more bullish stance.

Perhaps surprisingly, 2 of 3 indicators are still flashing a bullish signal. Even the mildly bearish indicator is actually more neutral than indicated and shows a negative forward returns due to a non-linear forward return bucketing issue which demands more investigation.

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Positioning indicators provide one of the several dimensions to our views on various asset classes (the others being valuation and technicals). These metrics are valuable as, over the short-term, large rebalancings and unwinds of crowded trades can often swamp all other factors.

In tracking treasury yields, we have found it valuable to look at duration-weighted positions of speculative investors in Treasury futures – the chart below shows that changes in treasury yield are reasonably correlated to investor positions.

The chart tells us that not only do investors tend to follow momentum but that extremes in positioning are often followed by a reversal of yields.

Finally, it would be amiss to ignore the large dislocation between current positioning vs. yields. While speculative investors have become a lot shorter bonds, yields have not sold off as much as expected. We should find out soon enough which side is wrong.

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