Bernie Schaeffer
My Complaints About Complacency
2/22/2005 7:04 AM ET
schaeffersresearch.com
Over the past several weeks, the equity market has pulled itself higher from its proverbial bootstraps, erasing most of the losses suffered during January and, in the case of some major market indices, moseying into positive territory for 2005. While this sign of strength is nothing to sneeze at, and has provided the bulls (and even the adaptable bears such as myself) some solid long opportunities, I still think the market is presently in a vulnerable situation. And the primary culprit for this vulnerability lies in the hands of the bullishly configured populace of economists. The overwhelming complacency, or dare I say optimism, particularly with regard to the U.S. economy, has distinct bearish implications.
Exhibit 1: Leading Indicators Are Lagging
Leading indicators are indicators that change before the economy sees the effect. Examples of leading indicators include unemployment insurance claims, building permits, money supply, stock prices, and inventory changes. The Federal Reserve keeps a keen eye on these figures as it weighs its interest-rate decisions. Lagging indicators change after a shift in the overall economy is felt. Examples include business spending, the unemployment rate, bank loans, and labor costs. Finally, coincident indicators move in direct correlation with the overall economic trend. The Conference Board offers a monthly indexed reading measuring the trends in these three groupings of indicators.
In January, the index of leading indicators dropped by 0.3 percent, while lagging indicators pressed 0.3 percent higher. This was the sixth time in eight months that leading indicators pulled lower. But analysts were quick to rush to the economy's defense, saying the pullback in leading indicators should not be a harbinger of slowing economic growth (isn't that exactly what it does mean?).
Exhibit 2: Volatility: How Low Can it Go?
In December, the CBOE Market Volatility Index (VIX -11.18) dropped to 11.14, its lowest reading since December 1995, and some honestly thought this level would stick for a while in the record books as a notable nadir. The "fear barometer" did hold above this level in January, as the market reversed course, but the VIX was quick to return to its downtrending ways this month, notching a reading of 10.90 the first week of February. While the market has embarked on a recent recovery of late, the 1.7-percent February gain in the S&P 500 Index (SPX - 1,201.59) hardly seems adequate justification for a nine-plus-year low on the VIX. For additional thoughts on the state of the market's volatility readings (and my projection as to when a market top might occur), please refer to this commentary from February 8.
Exhibit 3: "E" Is Even More Adoration for Earnings
In 2004, earnings for SPX companies grew by about 19 percent. As I pointed out in my 2005 Market Forecast, this impressive earnings growth did little to bolster the market's strength, so growth of about half this much (roughly the mean estimate from brokerage firms) probably won't have a great effect either. Adding to this dangerous mix is a sudden increase in earnings expectations. Just last week, a widely followed research house raised its first-quarter earnings growth estimates from 8.7 percent to 13.4 percent. Down the road paved with high expectations lies a pitfall of disappointment.
Exhibit 4: No Yields Like Low Yields
As of Friday's close, the current yield on a two-year U.S. Treasury note had risen to 3.43 percent, while the 10-year bond yield had declined to 4.26 (see the charts below). A narrowing trend (such as that seen of late) between short and long-term rates tends to forecast slowing economic growth. When the yield curve inverts, the potential for recession rears its ugly head. When (as now) long-term rates refuse to increase in the face of rising short rates (which occurs with a reasonable degree of frequency despite Greenspan's befuddlement with this state of affairs), the financial markets are predicting that rising rates will slow the economy, potentially leading to a recession and lower (rather than higher) interest rates.
The overwhelming view on Wall Street was articulated simply in a February 15 Financial Times article that stated: "The low yields on longer-dated bonds are being taken not as a hint of economic weakness but as a sign of confidence that inflation pressures are well contained for the foreseeable future." This article also concluded that any concerns over slowing growth are a "tough sell" for most economists.
As we have witnessed a serious flattening in the yield curve over the last year, I find such complacency among economists as strikingly similar to the "look the other way" consensus that emerged when the yield curve actually inverted in early 2000. The long bond's yield headed south, while short bonds saw their respective yields hold pat (or even edge slightly higher). Economists were similarly speedy to dismiss the implications of the trend, saying the phenomenon had all to do with Treasury supply issues, and nothing to due with the country's economic health. Well, that "health" quickly deteriorated in late 2000 and into 2001, as the stock market endured its first real bear market in more than 15 years.
As this was less than five years ago, you'd think analysts and economists would be a little more wary with their words, and a little more cognizant of the signs of a potential slowdown. But there seems to be a bit of an epidemic of short-term memory up and down Wall Street, as the consensus opinion, from Alan Greenspan himself down to the lowliest assistant broker, is a rosy one. Combine this with increased earnings projections and historically low volatility index readings (which imply complacency among speculative investors), and the market looks awfully susceptible to weakness from my vantage point.
Bernie Schaeffer |
