Economic indicators and stock markets change their minds

What a difference a month makes. After worrying for much of April and early May that the global economy is headed for a downturn, recent data have pointed to a more benign outlook and stock markets have responded accordingly.

Early April saw US light sweet crude oil prices hitting a record of over US$58 a barrel, triggering fresh concerns of an oil-induced recession. This was followed by the report of unexpectedly weak growth in US retail sales in March, a fall in housing starts in March, higher inflation in March, a decline in the Conference Board's US leading index in March, a decline in consumer confidence index in April, a plunge in new orders for durable goods in March, and culminated with a first quarter GDP report dominated by the revelation of a downwardly revised growth rate of 3.1 percent, rising prices, rising inventories and slowing business investment.

Elsewhere, the data were as bad if not worse. Japan and Europe saw falls in industrial production in March, and leading indicators gave little confidence of improvements in economic outlook.

All these indicators had economists worried that what Federal Reserve chairman Alan Greenspan thought was a "soft patch" in the economy was turning into an outright downturn.

A survey of fund managers by Merrill Lynch in early May found that out of 339 managers questioned, 56 percent expected global growth to weaken slightly or a lot over the next 12 months, while only 23 percent expected a stronger world economy. And whereas in the previous month, fund managers in Asia had been relatively optimistic, they were now more negative.

Towards, the end of April, though, better news was already starting to seep through.

In the US, there was news that sales of new and existing homes and house prices rose in March. What was probably most significant in turning the tide in sentiment, however, was the very healthy increase in non-farm payroll reported for April. Retail sales also improved in April, inflation fears abated as price increases outside energy remained moderate in April and housing starts reversed the fall in March by turning up in April.

Meanwhile, in Japan, unemployment reportedly fell in March and unlike in the US, first quarter GDP turned out unexpectedly strong. And in Europe, inflation, especially core inflation, remained moderate in April.

Of course, the global economy is by no means out of the woods. The Conference Board's US leading index continued to fall in April while in Japan, the index of leading economic indicators was below 50 percent in March for a second month.

Nevertheless, the pessimism exhibited in April seems to have lifted somewhat, and this is probably best reflected in stock markets.

Around the middle of April, stock indices had made what at that time looked like decisive plunges below their 200-day moving averages -- for examples, see the charts below for the S&P 500, the Nasdaq and the Nikkei 225. This led many investors to make sell calls.



However, with the economic data becoming more benign going into May, the S&P 500 and the Nasdaq turned back up above their 200-day moving averages. Only the Nikkei 225 remains below its average.

Interestingly also, despite the weak economic data coming out of Europe in general and the UK in particular, the FTSE 100 has been resilient this year and never dropped below its 200-day moving average.

Historically, the 200-day moving average has had some usefulness in market timing. Buying stocks whenever the Dow Jones Industrial Average rises above its 200-day moving average and selling when it falls below would have enabled an investor to beat the market on a risk-adjusted basis, according to evidence provided in Prof Jeremy Siegel's book Stocks for the Long Run. Its main claim to fame, though -- as related by Siegel -- is that it would have enabled investors to get out of the market just before the 1987 crash.

However, followers who timed the S&P 500 and Nasdaq using the 200-day moving average would have been whiplashed by these markets over the April-May period. In fact, the charts above show that this would have happened quite frequently over the past year. Unfortunately, this is an unavoidable hazard with following this technique -- or at least with following this technique on its own. As Tomi Kilgore wrote in MarketWatch recently, "charts don't lie, but they can certainly change their minds".

So, too, for that matter, can fundamental economic indicators.

US employment growth underlines economy's resilience

After some poor economic numbers coming out around one to two weeks ago, the latest economic data seem to have allayed some concerns that the economy is heading for a downturn.

Last Friday saw the US Labor Department reporting that non-farm payroll employment for April increased by 274,000. And with upward revisions for February and March to 300,000 and 146,000 respectively, it was a good sign for the economy. The unemployment rate remained unchanged at 5.2 percent.

The previous day, the Labor Department had reported that productivity in the non-farm business sector had increased 2.6 percent in the first quarter, faster than the 2.1 percent in the previous quarter.

Together with the increases in personal income and spending by 0.5 percent and 0.6 percent respectively reported by the US Commerce Department at the end of the previous week and healthy increases in new and existing homes reported earlier in that week, these were the indicators that the US economic expansion remains relatively resilient.

Other data from the US over the past fortnight had not been so positive. Consumer confidence clearly deteriorated in April and if consumer spending falters, business investment may not pick up the slack. The Commerce Department's advance first quarter GDP report shows slowing business investment and rising inventories contributing to overall GDP growth slowing to 3.1 percent from 3.8 percent in the previous quarter.

Manufacturing appears to be wobbly. Although new orders for manufactured goods surprised on the upside by increasing 0.1 percent in March, new orders for manufactured durable goods in March decreased 2.3 percent, with non-defense capital goods orders excluding aircraft -- often used as a measure of business spending -- in particular falling 4.0 percent. The purchasing managers' index compiled by the Institute of Supply Management fell to 53.3 in April from 55.2 in March.

Indeed, manufacturing is slowing on a worldwide basis. The Global Manufacturing PMI -- a composite index produced by JPMorgan and NTC -- fell to 51.9 in April from 52.9 in March. The output sub-index fell to 53.5 in April from 54.2 in March while the new orders sub-index fell to 52.4 in April from 54.1 in March.

The sample of national PMIs below shows only Japan and Australia recording improvements. Europe is clearly slowing -- possibly contracting -- with PMIs falling below 50, as is the case with Singapore. Even China appears to be slowing.

	March	April	Change
US	55.2	53.3	-
Eurozone	50.4	49.2	-
Japan	52.7	53.3	+
UK	51.6	49.5	-
China	55.2	54.4	-
Australia	52.6	52.9	+
Singapore	50.8	49.7	-

Commenting on the survey, David Hensley, director of Global Economics Coordination at JPMorgan, said: "April PMI data indicated that growth of global manufacturing output and new orders downshifted following a period of broad consolidation. The Output PMI is currently consistent with below-trend growth of global IP of around 2.5% saar."

Despite the poor PMI numbers, not all manufacturing-related data from Europe last week were bad; Germany did report a 2.2 percent rise in factory orders in March, after a 2.0 percent decline in February. However, Bloomberg quoted Rainer Guntermann, an economist at Dresdner Kleinwort Wasserstein, as saying that "the leading indicators suggest the second quarter will be very weak again".

Britain has other problems besides manufacturing. The Confederation of British Industry's April survey showed that retail sales fell at their sharpest pace since July 1992, while the Department of Trade and Industry reported that the number of people going bankrupt in England and Wales hit a record high in the first three months of 2005.

Amid these reports, the Federal Reserve continued with its tightening programme, hiking its target federal funds rate by 25 basis points to 3 percent. Other central banks -- specifically the Bank of Japan, the Reserve Bank of Australia and the European Central Bank -- have elected not to make any significant moves on monetary policy, indicating perhaps some ambivalence about the direction of the global economy and inflation.

Some economists, though, remain relatively optimistic. In an interview with SmartMoney reported on 5 May, Lakshman Achuthan, managing director at the Economic Cycle Research Institute (ECRI), said:

We view the weakness in manufacturing, or GDP or employment numbers...as part of a slowdown that has been going on for a year. That's in contrast to those who view it as a new slowdown. We think it's the end of the slowdown... [Leading indicators] seem to have made their lows months ago. Now they're rising, which we translate into a forecast of a firmer economy in the second half of 2005 as opposed to an economy that's below trend or experiences a vicious cycle of downturn.

Achuthan mentioned three indicators that the economy is not headed for a sharp downturn in the near future: interest rates remain relatively low, the housing market remains strong and businesses remain profitable. As for inflation, he thinks that globalisation and the Federal Reserve's interest rate hikes should keep it at bay.

He even has some things to say about the outlook for the stock market:

ECRI does not forecast prices... What I can say is that most, if not all, major bear markets are associated or related to recessions in the economy. And we're not forecasting a recession... The farthest we look is a year. And the stock market typically leads the economy by maybe half of that. So that would suggest that we don't have huge downward risk of a big drop in the market.

Good news for stock investors? Perhaps. But as Achuthan points out, the ECRI is not in the business of forecasting the stock market. Take its stock market prognosis with a pinch of salt.

The elusive consensus

The past week's economic news can probably be better described as bad rather than good. However, whether this is just a soft patch or whether it is pointing towards further deterioration in the economy remains a matter of much debate among economists, and investors and investment analysts appear to be as divided as economists.

While the past week has seen some sprinkling of positive news on the economic front, it is probably fair to say that the negative news has dominated, even from the usually-resilient United States economy.

The week started off encouragingly, with Monday's report of a rise in existing home sales in the US in March being followed the next day by a report of a surge in new homes sales in March to record levels. Wednesday, however, saw a 2.8 percent plunge in reported durable goods orders in March, the biggest drop since September 2002. This was followed on Thursday by news that first quarter US GDP growth was 3.1 percent, substantially down from 3.8 percent in the fourth quarter. Higher inflation, rising inventories and slowing business investment were the highlights of the GDP report.

Friday did see news of personal income and spending continuing their ascent in March -- by 0.5 percent and 0.6 percent respectively. However, a rise in the personal consumption expenditures price index by 0.5 percent negated much of the increases, while the saving rate continues to fall.

Forward indicators are also worrisome. The Conference Board's consumer confidence index for April fell to 97.7 from 103.0 in March, while the University of Michigan's measure of consumer sentiment in April fell to 87.7 from 92.6 in March. Manufacturing outlook moderated, with the National Association of Purchasing Management-Chicago's index slipping in April to 65.6 from 69.2.

It was little better in the rest of the world.

In Germany, the Ifo business climate index fell to 93.3, the third drop in a row, from 94.0 in March. A consortium of German think-tanks, in a report last week, cut its forecast for German growth this year from 1.5 percent to 0.7 percent, while the German government cut its forecast to 1.0 percent from 1.6 percent previously.

In Japan, household spending and jobs both fell in March compared to February, although the economy saw some reprieve in its often-disappointing core consumer price trend, which rose 0.3 percent in March. Japan's industrial production fell unexpectedly by 0.3 percent in March, but the NTC Research/Nomura/JMMA Purchasing Managers Index (PMI) rose to 53.3 in April, its highest reading in seven months.

Despite the generally deteriorating data, there is no consensus on the outlook. Many economists, including Federal Reserve chairman Alan Greenspan, think that the US economy is experiencing a soft patch, implying a re-acceleration in the near future. Others are less sanguine.

In a Bloomberg commentary on 29 April, Caroline Baum -- citing John Silvia, chief economist at Wachovia Corp, who said that the "soft patch" is "a non-starter as a concept" -- expressed skepticism of a re-acceleration. "The business cycle is maturing," she wrote. "The economy doesn't slow down and re-accelerate on its own... Rather, something exogenous needs to happen to cause the economy to reaccelerate."

Morgan Stanley's Richard Berner is more hopeful. In a commentary on 29 April in the Global Economic Forum, he wrote that falls in gasoline and other energy prices may "unmask pent-up demand for capital spending and hiring again".

Berner is also sanguine about the rise in inventories reported in the GDP report. He wrote: "With our industry analysts reporting that end-market corporate demand for personal computers, machinery, and industrial equipment appears to have strengthened in April, it seems likely that any inventory correction will be extremely short-lived."

However, John Hussman of the Hussman Funds, in a 25 April note, looks at the wider context and warns against expecting too much from capital investment: "There is very little in the way of new large-scale technologies that would pace a capital spending boom... we've observed a number of periods of booming investment and growth-pacing technological innovation over the past century. This isn't one of them by a long-shot."

If the economic news can be characterised as bad, it is probably safe to say that much of it has been anticipated by investors.

In his MarketWatch column on 28 April, Mark Hulbert wrote that the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average stock market exposure among short-term market timing newsletters tracked by the Hulbert Financial Digest, stood at negative 24.4 percent. This means that the average short-term market timer is short the stock market. According to Hulbert: "There has been only one other period since the bear market began in March 2000 in which the HSNSI was any lower. And that was last week, when it dipped to negative 30.6%."

Hulbert also pointed out that according to Investors Intelligence, 44.0 percent of newsletters they monitor are bullish and 29.7 percent are bearish. This is a relatively small margin between bullish and bearish newsletters, implying a relatively bearish outlook, but Hulbert also adds: "Because the average bearish percentage in rising markets is 35%, [editor Michael] Burke suspects there may still be too much optimism among investment advisors."

And Hulbert points out in his column the next day that among the top five short-term market timing newsletters he monitors, "three...are bullish, one is more or less neutral, and the fifth is bearish. That overall works out to a bullish consensus."

So the lack of consensus among economists is mirrored by investors.

And according to SmartMoney, some of the usually-bearish analysts that it regularly follows have also been ambivalent of late.

Bank of America Securities' Thomas McManus reportedly wrote in an 18 April note that while "we still recommend below-average equity exposure...near-term risks may be overstated". And in a 29 April note, he wrote that it is "past time for us to begin the process of sifting through the carnage to look for bargains".

In a note on 15 April, Merrill Lynch's Richard Bernstein reportedly wrote that "the yield curve has become flatter than normal" but "[i]mportantly, the curve is not inverted", indicating that a recession is not imminent.

This is a highly ambivalent market. Investors with a contrarian instinct will have to dig a little harder to find any misconceived consensus to bet against.