July 8, 2015


Last month, I discussed how volatility was rising in the bond markets around the globe.  In the last few weeks, that volatility has spread to stock markets. 


The two primary global dynamics that the market is watching is the increasing probability that Greece may exit the European Union and more importantly, the crash going on in the Chinese stock markets.  The decline in China has accelerated to the point where their government is halting the trading in what Bloomberg identifies as 43% of their entire market.  Imagine halting the stocks in 43% of the companies that trade on the U.S. stock exchanges due to declining prices.


The Chinese have not identified when those companies will re-open for trading.  That means that holders of those stocks are stuck and don’t know when they will be able to get out and have no idea what the prices will be when they re-open.  Now, consider that investors were buying Chinese stocks with record amount of margin debt.  So, many of the holders of the stocks that have been halted own them with borrowed money.  As the overall Chinese market declines further, it triggers more margin calls.  Since investors can’t raise money by selling the stocks that are halted, they have to sell from the stocks that continue to trade.  That adds increased selling pressure for the overall market. 


As the Chinese market went parabolic early in the year, record amount of new trading accounts were opened meaning that more and more people in China were piling in at prices meaningfully above where prices are today.  This will likely create additional weakness in the Chinese economy and we are seeing that reflected by the drop in many commodity prices such as iron ore and copper. 




While we are seeing increased volatility around the globe, it is still relatively muted with the major indices in the U.S.  We have seen declines such as a day recently with the Dow dropping around 350 points but the S&P 500 is still down less than 5% from the highs, although both the Dow and the S&P 500 are negative for the year.  Probabilities for further declines are increasing.  Let’s look at a few charts.


The first chart is a chart of the S&P 500 for the last 7 months.




The blue line is the 50-day moving average and the red line is the 200-day moving average.  The market essentially bounced off the 200-day moving average at the end of January.  Then, the S&P 500 dropped down to the same support line at the end of June and tried to bounce like it did in late January.  It has retested it again a few more times in recent days.  Now, let’s look at a few more charts that suggest the odds are increasing that the market will likely break down through this support area and add to recent declines. 


Here is a chart of the advance-decline line which takes the number of stocks going up each day and subtracts the number of stocks going down and runs a cumulative number.  It is one measure of market breadth.  When the line is rising it indicates that there is broad participation among stocks to the upside which is a healthy sign.  When it is declining, it indicates that an increasing number of stocks are going down.  This indicator often leads the market in overall direction.  Here is this indicator over the same 7-month period.




If you compare this chart with the one of the S&P 500, you can see that the advance-decline line peaked in late April and then the S&P 500 peaked later toward the end of May.  This line continues to make lower lows and has not shown any signs yet of turning back up.


Next, let’s look at some of the more economically sensitive areas of the market.  First, here is the index of industrial companies.




This chart shows that the industrial index has broken through the 200-day moving average.  Now, let’s look at the materials index which are companies involved in basic materials used in the economy.




Here, we see a similar break of the 200-day moving average.  Next, let’s take a look at the transportation index which consists of companies that move goods in the economy.




While earlier weakness in the transports was blamed on the airlines, weakness is spreading to the truckers and logistics companies.  Next, let’s look at the emerging markets index which is no surprise that we see weakness here.




Lastly, let’s look at an all-world index which gives a picture of global markets.




The chart shows that, it too, has broken down through the 200-day moving average. 


The 200-day moving average is one technical trend line that market participants watch as it is an average price of the last 200 trading days.  It provides a relative metric to compare prices across indices.  When multiple key indices are breaking down below trend lines, it often suggests that risks are rising.


StockCharts regularly has technical updates.  One recent update included a chart of monthly prices for the Dow and an overlay of the monthly MACD indicator.  Without going into the details of how that indicator is created, it is a price oscillator that compares trend lines from moving averages.  Here is the chart.




This chart goes back to 2006.  The candlestick line is the Dow, and the red and black moving average lines represent the trend lines within the MACD indictor.  The bars on the chart represent the spread between the two trend lines.  When the market reached a major peak in late 2007, the MACD started to turn down in a significant way as indicated by the increasingly negative bars.  Then, when the market reached the lows in early 2009, the bars started to turn back up and have stayed above the zero line for most of the time since then, except for just a few months where it went slightly negative.  Now, if you look at the end of the chart, you can see that the MACD has rolled over and the bars are the most negative since right after the last major peak. 


This indicator, just like other technical indicators is not something to rely on by itself but offers another clue as you put the overall big picture into perspective. 




Now, let’s shift gears to highlight another perspective on the economy.  Here is a brief commentary from ECRI [Economic Cycle Research Institute] which suggests what we may see from the economy from a longer-term perspective.  I have discussed this dynamic before but this commentary sheds additional light on the topic.


“Recoveries have been weakening due to declines in growth in output per hour (i.e., productivity), growth in hours worked, or both.  Taken together, they add up to real GDP growth. It’s just simple math.”




“For the past four years, productivity growth (green line) has averaged just over ½% per year (red line), leading Fed Vice Chairman Stanley Fischer to lament that it ‘has stayed way, way down.’  Given the latest data, one could say that the U.S. is in a ‘productivity recession,’ having seen the largest back-to-back quarterly productivity declines in 22 years.”


“It’s often assumed that productivity growth will rebound to its post-World War II average – around 2¼% per year (gold line).  But you know what they say about assumptions.  To quote Fischer again, ‘productivity is extremely difficult to predict,’ and ‘will perhaps eventually return’ to its earlier pace.  In other words, there’s no clear reason why that will happen anytime soon.  Indeed, since the end of 2013, productivity growth has averaged minus 0.7% a year.”


“Potential labor force growth (blue line) should reflect the long-term trend in growth in hours worked.  But the Congressional Budget Office says it will stay at ½% per year at least for the next decade.  This is pretty much set in stone, given the demographics.”


“Adding up the likely trend growth of these two measures – ½% for productivity plus ½% for hours worked – gives us just 1% longer-term real GDP growth.”


“So, unless there’s good reason to believe that productivity growth will revive, trend GDP growth may very well stay stuck in the 1% range for years to come.  If so, growth slowdowns could much more easily push growth below zero, leaving very little room for error.  Is the Fed ready?”


This perspective by ECRI suggests that economic growth will remain muted if productivity does not rebound in a notable way since demographics indicate that the long-term trend in the growth in hours worked is likely stuck at ½% per year.  Since the last recession in 2008, capital spending has been relatively weak as companies use capital to buy back stock rather than invest in capital equipment.  This is based partly on their outlook for return on capital and the uncertainty throughout the economy.  The weak capital spending will likely continue to keep productivity relatively weak. 


This leads to a quick comment on the Fed.  Given all the uncertainty around the globe such as with Greece and China and the increasing volatility in financial markets, I continue to think the Fed will not raise rates this year.  Couple the volatility with continued muted economic growth and they will rationalize to remain on the zero bound.  They want to make one quarter point hike just to get off zero, but they will likely be too afraid to move. 




As I close this month, I want to highlight another growing issue in the economy that is a result of this ultra-easy Fed policy.  It is in the car market.  Here is a highlight from Bloomberg; “Demand for automobile debt in the U.S. is enabling lenders to make longer loans to people with spotty credit, stoking concern that car shoppers are being lulled into debt loads they won’t be able to sustain.  Of the subprime vehicle loans bundled into securities, 73 percent now exceed five years, up from 64 percent during the first three months of 2014, according to data from Citigroup Inc.  Loans as long as seven years are increasingly being put into more bonds as auto-finance companies and Wall Street banks sell the securities at the fastest pace since 2007.” 


Sound familiar to the housing market in 2006?  All the buyer cares about is the monthly payment, and zero rate Fed policy coupled with extending the term allows you maintain “affordability.”  All the banks and auto-finance companies care about are the origination fees and Wall Street gets the securitization fees in the process.  And, investors relax their guard and rationalize buying the loans in the search for yield.  A similar dynamic is in place as the housing market; now we get to see just how far it will go!  Once again, we see a Fed policy that encourages debt, creates moral hazard, fosters an unhealthy appetite for risk by savers, and enables the enablers to scalp fees in the process of origination/securitization.  When this blows up, the bailouts will come once again and will make the “cash for clunkers” program back in the last recession look like nothing.


Let’s close for this month.  Volatility is growing in the financial markets around the globe.  Risk is rising as evidenced by a number of charts that I discussed.  Between now and the end of October is traditionally the more volatile time of the year.  And, we are just entering earnings season which should highlight continued muted economic growth.  But have no fear; we still have the Federal Reserve to protect us, right?



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.