3. The 48-month ROC of Real Stock Prices

Chart 5 compares inflation adjusted equities to their 48-month ROC, or more specifically to the 12-month MA of that momentum time span. The concept is that stocks move in a regular cyclic rhythm around the 4-year business cycle. Using a 48-month time span therefore helps to filter out most intermediate market setbacks until the cycle has had a chance to run its course. The red arrows tell us when the MA (red plot) reverses to the downside after the ROC itself has moved above the +65% overbought zone. These situations have a tendency to reflect the most extreme moves in crowd psychology, when prices are at their most vulnerable. Seven such signals have been triggered since 1890. All but the one in 2013 were followed by bear markets. In two cases (1929 and 2000) the market tops proved to be secular in nature. The brown arrows merely flag regular reversals by the MA i.e. those not associated with extreme ROC readings. In total there have been 24 signals, only three of which proved to be false. The recent drop in the MA again warns of equity market vulnerability.

Chart 5 Deflated US Equities versus a 48-month ROC (Source Reuters)

4. Industry Group Diffusion

Finally, Chart 6, shows us that long-term industry group momentum has also triggered a sell signal. This series monitors a basket of S&P industry groups that are above their 40-month MA’s. The resulting calculation is quite jagged, so the data have been smoothed with a 30-month MA. Sell signals are triggered when it experiences a negative 4-month MA crossover (the red dashed line) from above the equilibrium level. The solid vertical red lines indicate valid, and dashed ones false signals. July’s marginal sell signal has now turned into a more decisive one and is a further indication that owning equities is very risky at the present time.

Chart 6 The S&P Composite versus Industry Group Momentum (Source Reuters/S&P)

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Equities and the Economy

The market’s relationship to changes in the level of economic activity is of paramount importance. In almost all cases, equities rally during a recovery, and sell-off during recession. One notable exception developed in the late 1920’s when equities rallied during a recession. Another developed in 2002, when prices declined in the face of a recovery. That disconnect was likely caused by the unwinding of the tech bubble. Generally speaking, the more severe is the economic contraction, the nastier the bear market. For example, in 1966 the growth rate of the economy slowed but a recession was avoided. The market escaped with a shallow 10-month decline. Compare that to the sharp economic contractions, say in 1974 and 2008, which experienced devastating bear markets.

The moral of the story is that it is very unlikely that a sustainable and deep market decline will take place unless the economy experiences a severe recession. The problem is that the lead time between market peaks and the onset of a recession has varied from none in 1929 to 12-months in 1956. Indeed, lead times of 7-9-months are not at all uncommon, which means that a bear market can be well underway before it is realized that a recession has begun. Almost no one is currently forecasting a recession, because pretty well all of the widely followed leading indicators are continuing to point north, but then, economists as a group have never been very good at identifying such turning points.

Chart 7 highlights previous recessionary periods in red and flags their onset with the vertical lines. The one green and two red arrows highlight the three secular trends in equities since the 1960’s. The two secular bears were associated with a range bound indicator reflecting structural problems. This compares to a rising trend during the 1982-2000 secular bull.

From a cyclical aspect, you can see that both the momentum of the ECRI Weekly Economic Indicator and capacity utilization have both fallen to levels consistent with recessionary conditions. The ECRI WLEI itself has ruptured its 2009-2015 recovery trendline. The ellipses show periods when one or the other momentum series has fallen into negative territory, but the economy has avoided recession. Currently both series have slipped into negative territory. All other previous situations of this nature have been associated with a recession.

Chart 7 ECRI Weekly Economic Indicator and Two Momentum Series

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Chart 8 compares the S&P to three economic indicators, our own Pring Turner Leading Indicator, the University of Michigan Consumer Sentiment and a composite indicator combining the ISM Manufacturing PMI with its service industry counterpart. The Pring Turner series has led each recession since 1953, but is not yet showing weakness. Nevertheless it is very close to its recovery trendline. It would not take much to result in a penetration. Michigan Consumer Sentiment, another leading indicator, is currently right at its breakdown point. Finally the ISM manufacturing/service “combo” indicator is also in a finely balanced state. This chart is certainly not forecasting a recession, but it is evident that these indicators are in a fairly precarious position. Slight weakness from current levels could tip the balance in a negative way in which event things could unravel fairly quickly, certainly within the common 7-9-months lead time between market peaks and the onset of a recession.
Chart 8 S&P Composite versus Three Economic Indicators (Reuters/ISM)

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Conclusion

Evidence continues to point to an extension of the secular bear market in inflation adjusted equities, both in the US and the rest of the world. That does not necessarily mean that the 2009 lows will be taken out but sufficient primary trend technical indicators have turned negative to conclude that investors should adopt a very defensive position. Current readings of most leading economic indicators argue for at least a slowdown but at the moment, fall short of signaling a recession. If that began to change the probability of a severe bear market would be greatly enhanced.

This article was written by Martin Pring, the Investment Strategist to the AdvisorShares Pring Turner Business Cycle ETF (DBIZ).