By Fedor Sannikov
The recent U.S. stock exchange rally set the record in
positively closed sessions and set us thinking whether current
economic indexes justify the investors' behavior and, more
importantly, what comes next? Let us consider the fundamental
market growth and earning fixation factors to conclude what can be
expected in the last 4 months of 2012.
Below, we will mainly talk about the American market. I will
also present our global stock markets movement correlation
estimates in breakdown to regional markets. Since the early 90's,
correlation tendencies, pointed out by Gerhard, Poon and Khillion
in their research works, show that by the end of the 20th century,
the correlation between global industries decreases while the
correlation between countries grows. At the same time, this does
not refer to the U.S. or China markets during the post-recession
period since 2009.
Global markets' annual and monthly performance correlation
estimates for 2001-2011 are shown below. The figures ranging from
0.85 to 1 are in yellow and from 0.7 to 0.85 are in grey in the
global regions annual performance correlation table. The earning
correlation figure for the majority of markets exceeds 0.8. In
other words, the figures are too high to be beneficial for
decreasing risks through standard deviation of performance in
long-term investments. The markets of China and Japan, Japan and
South Korea, Argentina and China have the lowest correlation
figures. The monthly performance correlations are lower which could
benefit position traders. The monthly performance correlations
between the stock markets of China and other countries remain the
The regional annual performance correlation:
(click to enlarge)
The regional monthly performance correlation:
(click to enlarge)
The author's research shows that under globalization and
blurring market borders, creating portfolios with correct choice of
industries becomes more relevant compared to the correct choice of
regional markets in order to manage international investment
The U.S. Bull Market and Its Causes
1. On the one hand, the latest months have brought abundant data
regarding problems in Europe, growth rate reduction in the American
and Chinese economies. On the other, such news do not shock
investors, they have become used to it, and these risks are
accounted for in the price of shares. During the last weeks, the
marker participants have been ignoring the negative news while
getting excited about the positive, which is a clear sign of a bull
market. For how long? It seems that the investors have prepared
themselves for the 2% U.S. GDP growth by the 2012 results, and if
this "optimistic" forecast proves to come true, there will hardly
be huge sales.
The real U.S. GDP growth:
2. Nonfarm payroll data for July (163,000 growth) exceeded
expectations, which inspired the investors especially on the
background of weak April-June 2012 data. The number of filed
unemployment applications prompts optimism as well (see the graph
below). In other words, the unemployment data is not depressing,
however Nonfarm payrolls is not the leading indicator.
By the end of July 2012, labor force in the U.S. was 155 million
people. Population growth and labor force at 1% per year in America
(without dropping the unemployment rate) means that the U.S.
economy should generate additional 1.55 million jobs per year or up
to 129 thousand jobs per month. In order to decrease the
unemployment rate the number of generated jobs should be
significantly higher. Since the beginning of the year, nonfarm
Payrolls average growth rate was 151 thousand per month. In order
to obtain a 2% and more annual GDP growth, the productivity growth
rate should suffice to cover the lack of labor force. In 2012, the
1% productivity growth rate shows that the lack of labor force is
covered by the productivity growth.
3. One of the main fundamental causes for the U.S. stock market
growth is the recovery of the real estate market. In the first half
of 2012, the average growth rate of building permits was 25.8%
compared to the same period last year. The average growth rate in
2011 was 1.2%.
The average Housing Starts growth rate was 27% since the
beginning of the year as compared to the same period last year. In
2011 this figure was 5.4%.
The average rate of new homes sales was 14.9% in the first half
year compared to the same period last year. The average growth rate
of the index was -3.45% in 2011.
The average growth rate of existing home sales was 3.5% in the
first half of 2012, while this figure was 3.6% in 2011.
Therefore, the housing market recovery inspires the market
participants. The investors believe that construction marker growth
would cause the growth of related industries and thus become of the
fundamental pillars for healthy economic recovery. Despite the fact
that the construction sector employment is only 5.5 million people
(which is only 3.6% of the total U.S. labor force), the
multiplication effect can become one of the driving forces for
further growth. At the same time, construction companies do not
rush to hire: the employment rate in the U.S. construction industry
has hardly changed since the beginning of 2010 and is far from the
7.5 million people during the pre-crisis period. U.S. construction
spending growth is shown on the graph below.
One of the consequences of the real estate market recovery is
that the shares of home construction companies reveal multiple
higher-than-expected growths compared to the U.S. broad market
index. The graph below represents the comparison between the
iShares Dow Jones US Home Construction Index Fund performance and
the S&P index performance for the last 12 months.
4. The bottom line is that people's spending is defined by the
income, savings rate and financing are decisive for the U.S. GDP
growth. We can make a conclusion based on the graphs below that the
average real income growth rate in the first half of 2012 is
slightly below 2%. At the same time, the main source of spending -
the real disposable income - enjoys a 1% growth rate. This
signifies that the population's income grows at the rate of the
U.S. residents' increase. There is not income growth per capita
(i.e. no "the healthy" life quality increase).
The nominal (not accounting for the inflation) disposable income
of the U.S. population exceeds the nominal spending. The average
nominal income of the population was $985 billion per month in the
first half of 2012 while the average nominal spending was $919
The savings rate as a percentage from the real disposable income
has increased from 3.38% in December 2011 to 4.44% in June 2012.
The absolute growth was $137 billion.
We can make a conclusion based on the U.S. real disposable
income graph that the consumer credit growth rate was 4.8% in the
first half of 2012. The amount of credits increased by $69 billion
compared to December 2011. However small, this still is a source of
The population's income and spending figures reflect the past
but not the future and this growth is reflected in the prices of
shares as of the current date.
The U.S. personal consumption growth:
The U.S. personal income growth:
The U.S. real consumer spending growth:
The U.S. real disposable income growth:
5. Unfortunately, today the countries' monetary politics can
have more influence over the financial markets than the fundamental
state of economy. But this only concerns short and mid-term
perspective. A speculative cause for the developed markets growth
is the expectation that the FRS and the ECB will be able to give
their support through the quantitative easing programs when
required. In the U.S. more and more FOMC members express their
confidence in the necessity of further monetary stimulation.
The latest comments suggest that the FRS is ready to launch QE3
"fairly soon" if the state of the U.S. economy leaves much to be
desired. Such expectations allow approaching the risk of investing
into shares with more confidence. On the other hand, taking into
account almost 0% interest rates, it is doubtful that the QE will
have a tangible effect over the American economy. The expectations
of the market drug are accounted for in the prices of shares,
nevertheless the QE3 amount and the announcement of bond redemption
are able to support the stock rates in the short-term.
The Eurozone economy stimulating measures will be discussed at
the ECB Monetary Politics Committee meeting in September 2012. The
announcement of a new LTRO program is less probable compared to the
sovereign bonds redemption program. LTRO demands pledge assets from
banks: do they have enough mortgage assets? Securities Market
Program will come handy for refinancing Spain and Italy debts and
decreasing interest rates for them. Probably, the redemption will
begin in the beginning of autumn 2012, and the risks that the ECB
will end up containing even more trash assets increase. The growth
rate dynamics of the Eurozone residents securities among the ECB
assets is presented in the graph below.
The growth rate reduction in China and the decreasing general
inflation open new opportunities to the monetary authorities to
broaden the economy stimulating programs, meaning that the Chinese
stock market has a chance to perform positively in the second half
of 2012, taking into account its relative closeness. The State
investments and interest rates reduction did not revive the Chinese
economy in the beginning of 2012, while the commodities inflation
adds concerns to the government. Did the Chinese government need
growth altogether when it had announced the "soft" landing?
Investors do not rush to invest into risky emerging market assets.
Consequently, the Chinese Shanghai Composite index is renewing its
minimums while the American S&P - its maximums.
It is argumentative whether the FRS should implement the
quantitative easing on the background of the latest unemployment
and housing market reports, though the speculations over the topic
continue. Today, this FRS decision is not only economic but
political as well: who to support in the election race. Supporting
the market before the elections against fair housing market and
unemployment rates seems as obvious support of Barack Obama.
However, today there is no certainty as to the victory of either
candidate, which is why it would be politically correct of the FRS
to abstain from any actions until the results of the elections. If,
based on preliminary polls Romney's victory is apparent the FRS
will be inclined to stimulate the economy.
6. Historically, the years of elections in the USA remunerated
those who invested into shares, the summer of the electoral year is
considered especially positive. 2012 was not an exception. If we
look back, September and October offered sales to the market with
further increase and Christmas rally by the end of the year. I
expect the stock market to likely perform positively by the 2012
results if Mitt Romney wins the elections.
7. The corporate reporting season also inspire optimism to
market participants. The majority of S&P index companies'
performances exceeded market expectations in the Q2 of 2012. Above
that, in the current economic situation the U.S. market appears as
the most attractive from the risk/earnings perspective. The
American market has traditionally been considered the safe heaven
during stormy times in the Global economy.
Now let's move on to the figures that suggest the coming cooling
of the American market.
Bear Signals: Are Sales Inevitable?
1. The Philadelphia Fed Survey, a business conditions index, the
leading industrial production dynamics indicator is on the negative
side. The Empire State Manufacturing Index reflecting the business
conditions forecast for the New York producers also stepped on the
negative side in August 2012. Chicago PMI, the leading index of
productive and non-productive activity in Chicago, has had a
downward trend since the beginning of 2012.
The ISM Manufacturing, a production conditions index, does not
only have a downward trend but has closely approached the 50 points
limit. When this figure is between 43 and 50 it suggests negative
production rates (but not negative rates for economy as a whole).
The figure below 43 stands for the beginning of recession in the
economy. At the same time, economists joke that the ISM
Manufacturing Index has forecasted more recessions than there
actually were. A separate graph below shows the comparison of the
ISM Manufacturing Index dynamics to that of the S&P.
2. The durable goods orders growth rate, the leading indicator
of productivity and capital investments, has had a negative trend
since the beginning of 2012 (16.11% in December 2011, 7.53% in June
2012). According to Morgan Stanley, 40% of the companies have
postponed investing in their development until better times.
The growth rate of the U.S. factory orders, the leading
indicator of general production activity, is also decreasing from
11.5% in December 2011 to 2.47% in June 2012.
The business inventory growth rate, the leading indicator of
future sales, has dropped from 7.69% in December 2011 to 5.02% in
June 2012. I expect low business investment activity until the
results of the U.S. Presidential election have been announced.
3. The sentiment of service industries index has also been
downgrading since the beginning of 2012 (56.8 in January; 25.6 in
June 2012), although the U. S. ISM Non-Manufacturing Index remains
on the positive side.
The current consumer sentiment is lower than the spring peaks
although showing signs of liveliness in June 2012:
4. In Q2 2012, the current profits of the majority of S&P
index companies exceeded expectations. But the profit should be
"healthy" proven by the revenue and cash-flow growth. About 60% of
the broad U.S. index companies did not meet the revenue growth
expectations and are highly conservative in regards to the coming
trimesters' forecasts. The cost reduction effect tends to come to
an end while sales growth is the long-term source of profit. The
graph below suggests the idea that the American corporate profit
margin has currently reached its local maximum.
5. "Fiscal Cliff" is another political show gaining popularity
in the USA. Compared to the last year's notion of the State debt
ceiling it will probably be rotated in the media until the end of
the year. The "show" will go on until the end of elections, after
which the Congressmen will make a Christmas present to the people
and proud of having fulfilled their duties, will retire to
celebrate the New Year. If this will not be the case, the
Congressional Budget Office presents frightening for the American
economy recessional figures which the politicians will hardly agree
to. RBK gives the U.S. Congressional Budget Office data: "the
fiscal tightening equivalent to almost 4% of the country's GDP will
be the most severe since 1969 when the country required funds to
finance the Vietnam War. Back then it had led to a recession.
According to the CBO, in 2013 the result will be the same. The
GDP will be cut by 0.5%, moreover the economy will drop by almost
3% in the first half year. In a year's time, about 2 million
Americans will lose their jobs; therefore the unemployment will
increase from the current 8.2% to 9.1%. Based on the CBO estimates,
if the Congressmen refuse the fiscal cliff and agree only to
minimal cost reduction, the U.S. economy will grow by 1.7% and the
unemployment will decrease to 8% next year". Ben Bernanke has
already warned everybody that in case of a fiscal cliff the
consequences will be dramatic and the FRS will be helpless. The
existing uncertainty adds to the market participant's worries, even
though such events cannot be called decisive to forecast the market
6. The European problems remain though the market has already
got "accustomed" to the recession in Europe. The people continue
reducing consumption due to various reasons. In the Old World
countries, the debt rate per capita is high and the consumption
growth is improbable under the stable or dropping real estate
prices in the region. The governmental spending reduction means
further cut in consumption in Europe, as opposed to America, which
mentioned the budget reduction only at the political debates. In
reality, we will hardly witness the U.S. state budget deficit of
less than $1 trillion in the next 3 years. The exports from China
decrease on the background of recession in Europe and the global
economy slowing down. This has already influenced the raw material
prices as well as those of cyclic and mineral companies.
According to Ru Newspaper, "Athens may lack cash by October
without another portion of IMF money and the EU. In such case
Athens will be forced to print its own money and Greece will leave
the Eurozone. This scenario is not considered as catastrophic by
many. Some time ago the Government of Finland confirmed that they
have a plan in case of the Eurozone collapses. The Greek economy
represents 2% of the Eurozone economy, however opting out of the
Eurozone will be a dangerous precedent".
7. The S&P technical index has reached resistance at
slightly above 1400 points level. In order to fix the current
levels and move on, the macroeconomic statistics should satisfy the
optimistic investors' expectations. Moreover, the growth trading
volumes are extremely low in August 2012 compared to the average
level for the last 50 days.
8. VIX (Chicago Board Options Exchange Market Volatility Index)
has reached its minimum in the last 5 years.
9. Everything is relative. Is the U.S. stock exchange expensive
now? Yes, based on the P/E Schiller's ratio. This ratio also known
as Cyclically Adjusted P/E Ratio represents the correlation of the
S&P index companies capitalization to the inflation adjust
average profit of the index companies for the last 10 years.
10. In conclusion, I would like to present several comparative
technical graphs. A healthy stock market index growth means that
the less risk-concerned investors will remunerate the small-cap
companies. But since the beginning of the year, the S&P500
performance have been more than that of the iShares Russell 2000
Even the transportation industry (Dow Jones Transportation
Average) closely connected to the economy movement in general lags
behind the broad market index.
A sight into the future is the ground for making investment
decisions. Long-term stock market growth is possible under the
healthy corporate profits growth proven by the sales and cash flow
growth. The leading indicators such as building permits, business
and consumers sentiments and new orders rate become primary
important from that prospective. Today the leading indicators do
not offer a clear-cut picture of the future, while the investors
tend to value the U.S. real estate market recovery and the expected
monetary stimulation more.
At the same time, we have reasons to believe that healthy
corporate profit growth in the nearest trimesters is less probable
due to weak business sales growth forecasts. The market has reached
an important resistance level by the end of August. Moreover, the
investors will tend to sales due to the uncertainty before the
elections in November. The possibility of monetary stimulating
measures is accounted for in the current market price, although
stimulation in Europe and America can support the marker before the
U.S. Presidential elections.
I expect sales on the American stock exchange market based on
the September and October 2012 results. Further market movement
will in many ways be defined by the result of the elections. If
Mitt Romney becomes the President the stock market will probably
show significant growth by the 2012 results with possible Christmas
rally. If Barack Obama is elected, higher market volatility with
potential downward movement is probable. At the same time, if
Barack Obama is elected President the shares of drug producers and
stationed services providers (hospitals) will be in favor in the
context of the coming healthcare reform.
If the Congress lingers with voting over the fiscal cliff until
the end of 2012, the investors' nervousness may prevent the
Christmas rally in case either candidate gets elected President. In
case of improbable but dramatic for the market events such as
Greece leaving the Eurozone, one should expect higher market
volatility with high downward movement potential.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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