August 7, 2015


In my last commentary, I discussed how volatility was increasing in a number of areas of the market.  The major indices have not broken down yet and this has masked the building weakness under the surface of the market.  Let’s continue our review from last month with updates on the current condition of the financial markets.


To start, let’s look at another indicator that reflects how the broader range of stocks is performing.  The 200-day moving average is often used as a longer-term trend line for the price of a stock.  It is a simple average of the price of the stock over the last 200 trading days.  It is just one trend line that can be used to get a sense of whether the stock is in a longer-term move higher or whether it is starting to trend lower.  The chart below shows the percentage of stocks trading above this longer-term trend line for the NYSE, a very broad composite of stocks.




The above chart shows the percentage of NYSE stocks trading above their 200-day moving average with the red line and the S&P 500 with the dark line.  The red line shows that about 65% of stocks were trading above their long-term trend line back in late April and then the percentage started to decline.  The S&P 500 peaked about a month later and has been in a volatile range sideways since.  Over the past few months more and more stocks have been breaking down below their trend lines and the divergence between the performance of most stocks and the major indices has been growing.  This gap between the two lines is likely to close in the next month or two and suggests that further weakness is ahead.




From a fundamental perspective, earnings growth has outperformed top line revenue growth for some time now.  Trend economic growth as reflected by GDP has persisted around the 2% range, which impacts revenue growth.  Two dynamics have inflated earnings growth at a higher rate than usual.  One is that profit margins rose to all-time highs over the past few years and have yet to revert back to the long-term average.  Typically, as long as capitalism is working this is one economic variable that is very mean reverting, which Jeremy Grantham has repeatedly discussed.  Second, the extreme monetary policy has encouraged excessive issuance of debt to fund stock buybacks instead of investing in capital projects and this inflates earnings per share in the near-term.  These two dynamics have been going on for the past few years and may run its course before long as far as extracting as much earnings per share possible out of the tepid top line revenue growth.




It is interesting to note that the Atlanta Fed has an economic forecasting model that has been more accurate than most in the recent period for predicting near-term GDP growth.  The Federal Reserve Board should probably pay a little more attention to it.  So, their latest forecast for 3rd quarter real GDP growth was just released at a whopping 1%.  Here is a chart which shows the consensus forecast by economists on Wall Street compared to the Atlanta Fed forecast.



This chart shows that the consensus is currently over 2% more than the Atlanta Fed which highlights rising probabilities of disappointment for the markets and continued weak top line revenue growth.




Next, let’s take a look at an index of base metals which includes copper, aluminum and zinc.  One reason for looking at the prices of base metals is that these are heavily used in the economy and can give at least an indication of global growth. 




This chart above shows a dramatic decline in the prices of base metals.  China has been the marginal buyer of these types of commodities so it is definitely being impacted by the slowdown there.  However, if the other economies around the world were growing at a healthy rate, it would help stabilize pricing.  This suggests that the global economy continues to weaken and the likelihood of upcoming economic disappointment.




The decline in commodity pricing, the slowdown in China and the rising U.S. dollar is also pressuring emerging markets.  One area to monitor as a clue to the direction of the emerging market stocks are their currencies.  John Murphy of StockCharts recently highlighted two charts on this topic.  Let’s take a look. 


The chart below shows a basket of emerging market currencies in green and the emerging market index in red.




The chart shows that the currencies and the stock markets tend to correlate together.  In the last year, the currencies have begun to weaken more dramatically and have recently diverged from the stocks.  The currencies are suggesting that a break down in emerging market stocks may be coming.  The next chart shows a longer-term view of emerging market stocks.




This chart shows that the emerging market stocks sitting right above the red trend line and the currencies suggest that this trend line may be broken soon.




Now, let’s tie this in with the primary focus of the market right now, and that is whether or not the Fed is going to raise rates a quarter of a point off the zero bound in September.  As I have said many times, the Fed should never have taken rates to zero and should not have started up their printing press as these actions distort market prices, encourage the misallocation of capital and eventually leads to more pain for the economy and investors.  They have maintained this extreme monetary policy for so long that they are backed into a box. 


So, the Fed seems intent on getting off the zero bound no matter what in September.  I continue to believe that either they will not raise rates this year or if they do, the market will later view it as a policy mistake.  They will likely get cold feet and decide to hold off, but if they do raise in September, imagine what market participants will say if the Atlanta Fed model comes true for the 3rd quarter.  If they raise and subsequently, 3rd quarter GDP comes in anywhere near 1%, the pundits on CNBC will flip as will markets.  Going down the policy path that Bernanke created has unfortunately made the markets much more linked to future policy decisions than we have historically seen.


It is going to get interesting as we move through the next three months.  Market internals are weakening, the economy continues to slow, commodities continue to decline, and other signs of stress are appearing such as in emerging markets.  And, the Fed seems intent on raising rates.  Risk is rising and August through October has often been unkind to markets.  Make sure your seatbelts are fastened as the ride may start to get bumpy.


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.