TSX TrendWatch Weekly

The Canadian equities markets continue to frustrate us by not becoming more definitive in direction. This week I’ll deliver a mixed bag of leading indicators for both the markets and the economy. I can’t say that there is any sort of consensus among them, but they’ll give you something to think about while you’re lazing beside the pool working on your tan.

First, last week’s mundane results.

WEEKLY REVIEW… The S&P/TSX Composite Index essentially didn’t move at all last week (0.0%), while the S&P/TSX Venture Index declined a modest -0.7%.

Once again the major US indexes fared worse. The Dow declined -1.0%. The S&P500 was off -1.2%. Nasdaq -0.8%.

There really isn’t anything significant to say about the 10 major sector indexes, but it may be worth noting the the S&P/TSX specialty indexes focussing on mining were -2% to -4% lower over the week. Both gold and silver bullion declined about -1.5%.

With little price action last week we’re still at a stand-off with the trend values… 48% with positive trends, 52% negative. The median trend value is 0.0%… you can’t get more neutral than that!

The conservative investor should wait for better odds, while the more adventurous might say “hey, I’ll take my chances, and look at the better performers among the positive stocks”. Your choice.

LEADING INDICATORS… Some would argue that it’s impossible to have a leading indicator of either economic or stock price performance, because no one can predict the future with any level of certainty. There are too many unexpected events that can throw off the most thorough analyses.

All the same, some longer term measures have been fairly reliable… by which we mean more often right than wrong when viewed from many years of data.

Unfortunately, those that are right 51% of the time are not clearly differentiated from those that are accurate 60-80% of the time. And, there is always the contentious issue of just what constitutes “being right”.

With those caveats, and the even more significant caveat that “the economy does not predict the stock market, the stock market anticipates the economy”, here’s what I’ve been looking at lately.

Economy

The latest debate seems to revolve around whether the US is going back into recession, and, if so, will it drag down other countries in the process.

• One popular economic indicator is the Economic Cycle Research Institute’s Weekly Leading Indicator. The index has been in a downward trend since April and is close to a 49 week low. However, “expert” opinions on this vary widely… from a 65% chance of a “double-dip” recession being imminent, to the observation by another guru that the accuracy of the WLI is in the neighbourhood of just 25%. Keep in mind also that the ECRI data are based on US data and that the methodology (i.e. index components and how they are combined) are impossible to find (in my experience anyway), perhaps because they are proprietary.
• The Statistics Canada Composite Leading Index rose by +1.0% in June, after +1.1% gains in April and May. In fact there have been consistent monthly increases all year. There are ten components that make up the index, and just the Housing Index is showing signs of having topped out in April. Since Housing is just one of ten unweighted components, this is not a major cause of concern at this time. In short we have nothing to worry about from this index.
• An even better economic predictor by far (in my view) is the yield curve. Normally, short-term interest rates are lower than long term interest rates, because those investing in the longer term are taking on more risk and should be rewarded accordingly with higher yields. It’s quite easy to look up the yield numbers for, say, 13 week T-Bills right out to 2, 5, 10 and 30 year Treasury Bonds and these usually form an upward sloping line when plotted on a chart. When the slope of that line reverses and short term money gets more expensive than long term money, a recession almost always follows within 6-12 months (7 times out of the last 7 recessions). As of last Friday the difference between the 10 year bond and 3 month T-Bills was about 2.75%… well up on the positive side. No sign of another impending recession there.

Stocks

The state of the economy is not something to be ignored, because if you don’t have a job or a home, you probably won’t have a lot of money to invest in stocks. Since stock prices rise when there are more buyers than sellers, the state of the economy will have some influence on the markets. That influence, however, is much smaller than most people realize. While we were in the worst depths of this most recent recession we had the best bull market in history in terms of price appreciation in the shortest amount of time. Whether that bull market is over is what we’re trying to figure out now.

The point is that stock prices are most heavily influenced by future expectations of stock prices… not by what the economy or corporate profits look like today. For that reason I believe that leading indicators for the economy are pretty much irrelevant if you’re trying to anticipate future stock prices. I’m far more inclined to look at what the “smart money” is doing, and to some extent the demand for the goods and services that publicly-traded companies provide.

My rationale is simple… when a few investors with huge amounts of money move into or out of stocks at once, prices rise or fall. Then, huge numbers of investors with smaller amounts of money follow… reinforcing the trend. Similarly, when a few Fortune 500 companies open up the purse strings and buy huge amounts of goods and services, the profit potential of their suppliers will rise and that’s good for the “E” in their P/E ratios… driving up the “P” in turn, as stocks become undervalued (i.e. cheap).

• I like to look at the State Street Investor Confidence Index (SSICI) for the “smart money” angle. State Street bases its index on actual money flows from large institutional investors worldwide to and from riskier assets like stocks to safer income assets like bonds. The SSICI has rebounded in June after substantial declines in April and May. We’re hoping to see further appreciation in the next report (July 27). Other confidence indexes are generally based on opinion polls and surveys… hence much less reliable.
• Although forward earnings estimates are a widely accepted leading indicator, there is remarkably little evidence that accumulating all those consensus estimates for a broad range of stocks predicts actual forward stock earnings… which in turn are supposed to guide stock prices. The correlation between earnings estimates and actual earnings growth, according to Bill Hester, a fund manager at Hussman Funds, is 0.28… meaning that less that 1% of the variation in actual earnings growth can be accounted for by forward earnings estimates. That’s totally useless!
• There are various purchasing managers’ indexes (PMI’s) that tap into demand for goods and services… which in turn should increase profitability for the suppliers (and in turn fuel stock price gains). The Hussman research suggests that such indexes are much more strongly correlated with earnings growth (with about a six month lag). What’s problematic is that forward earnings estimates right now are rising, while PMI figures are falling off. If PMIs are a better predictor, there’s a reason for caution at this point. Those who’d like to follow PMI data more closely should look at the Institute for Supply Management’s Manufacturing Index for the US and the Ivey PMI for Canada.

So, there you have some big picture items to consider while you decide where and when to invest next. We’ll continue to monitor these indexes, but, more importantly, will wait for better odds before investing substantial capital. We’ll want our %-up index (charted above) to get back into 60%+ territory for more than a week or two.

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