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We Have Nothing to Fear but a Lack of Fear Itself

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    March 5, 2015

    The S&P 500 had its first monthly close above 2100 in February, the Dow closed over 18,000, and the NASDAQ currently rests a mere 3% below its 2000 bubble peak of 5132.52. Why is the stock market heading higher when incoming economic data is surprising to the downside? The Citigroup Economic Surprise Index (CESI) for various global regions shows data for the U.S. currently rests at the lowest levels seen in nearly three years while the European CESI is near a two-year high.

    citi econ regions
    Source: Bloomberg

    What is surprising is the resiliency of the U.S. market in the face of such a sharp decline in positive economic surprises. Declines of the current magnitude have often marked the big corrections we’ve seen during the bull market.

    u.s. citi econ
    Source: Bloomberg

    There are obviously some other factors at play that are supporting the markets. Perhaps chief among them is the coming launch of the European Central Bank’s (ECB) quantitative easing program (QE) this month with the slated goal of expanding its balance sheet by 60B Euros a month. Beyond the obvious support coming from the ECB there are other liquidity supports that appear to be at play as well.

    The big scare in late-2014 was the deterioration in the junk bond market in the U.S. with energy weighing quite heavily. However, since December we’ve seen some healing in the space and the recent sharp improvement in February between the junk bond and US Treasury spread coincided with the move higher in the S&P 500.

    junk bond spreads
    Source: Bloomberg

    Another way of looking at the corporate bond market are credit default swap (CDS) indices for investment grade (blue line below) and junk bonds (red line below), which have been improving since the middle of January and confirmed the market rally we saw last month.

    junk bond cds
    Source: Bloomberg

    The Yen-carry trade also looks to be aiding the markets as the Yen is challenging new lows to the USD and, given its correlation to the markets, another leg lower in the Yen could spark a stock market rally ahead.

    yen carry trade
    Source: Bloomberg

    Another liquidity spigot that is currently flowing strongly is the growth in commercial bank credit. The recent 13-week annualized growth rate is nearing double-digit territory and almost matching the highest growth rate seen in the last five years. While the Fed may be slowing down its balance sheet, commercial banks are doing just the opposite and picking up the Fed’s slack.

    bank credit
    Source: Bloomberg

    While several liquidity spigots are flowing and helping to levitate the stock market, there is one area of monetary liquidity that is moving in the opposite direction and that is margin credit. Typically most bear markets, recessions (shaded red bars below), and sharp corrections are associated with a contraction in margin credit and we are currently showing the strongest decline in margin credit growth since late 2011 to early 2012. This is a worrisome development that bears watching and we’ll have to see what the February margin numbers look like.

    NYSE margin
    Source: Bloomberg

    We Have Nothing to Fear but a Lack of Fear Itself

    While there appears to be several liquidity supports that are pushing stocks higher, bullish sentiment is approaching worrisome levels. The National Association of Active Investment Managers (NAAIM) Exposure Index represents the average exposure to US stocks reported by active managers and is shown in the middle panel in the figure below. The current reading of 99.23 is at the upper extreme seen over the last decade and the spread between the percent bulls and bears for the American Association of Individual Investors (AAII, bottom panel) is also elevated.

    Source: Bloomberg

    Some market-based sentiment indicators I use also suggests some complacency has slipped into the market as the equity put/call ratio is near its lower bounds that are often seen with short-term market tops. Additionally, the decline in the Volatility Index (VIX) rate of change is also near its lower bound that is typical of near-term market peaks and suggests some caution in the near-term.

    equity putcall
    Source: Bloomberg

    If we do get a market pullback I wouldn’t expect it to be prolonged or deep given we are likely to see growth reaccelerate in the coming months and the recent string of negative economic surprises in the U.S. CESI should trough. The relative performance of consumer discretionary to the energy sector suggests we should see an acceleration in the U.S. ISM Manufacturing PMI in the coming months and in conjunction with an improving global economy (see here) a sustained move lower in stocks appears unlikely.

    ism early late
    Source: Bloomberg


    Currently the U.S. economy is showing the largest string of negative economic surprises while our European friends across the Atlantic are showing the strongest string of positive economic data. Typically we’ve seen U.S. equities struggle when economic data comes in on the negative side and yet markets are hitting new all-time highs.

    It appears that various liquidity spigots are trumping near-term economic weakness and supporting the markets. We have European QE which is slated to begin this month and then we also have healing undergoing in the junk bond market as well as a yen-carry trade which looks ready to begin another leg of devaluation. While the ECB is ramping up its printing presses the U.S. Fed has ended QE but commercial banks are picking up the slack as credit growth is nearing double-digit rates and offsetting the deceleration of the Fed.

    Tempering these liquidity supports is the contraction in margin credit which turned negative in January on an annual basis for the first time since July of 2012. Given the stock market tends to suffer sharp corrections when margin credit turns negative, margin numbers for February should be monitored closely for either a continued withdrawal of liquidity or a bottom alongside the recovery in the junk bond market.

    Should margin credit in February show a further decline into contractionary territory the markets will be on shaky ground and prone to a pullback which would not be surprising given the general level of optimism and complacency prevalent in the markets. If stocks do stumble in the days and weeks ahead I wouldn’t expect much downside momentum given U.S. and global growth are, in my opinion, likely to reaccelerate in the months ahead.

    Images: via Flickr (licence attribution)

    About The Author – Chris Puplava, Financial Sense Online

    Chris graduated magna cum laude with a B.S. in Biochemistry from California Polytechnic State University, San Luis Obispo. He joined PFS Group in 2005 and is currently pursuing the designation of Chartered Financial Analyst. His professional designations include FINRA Series 7 and Series 66 Uniform Combined State Law Exam. He manages PFS Group’s Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account. Chris also contributes articles and Market Observations to Financial Sense and co-authors In the Know—a weekly communication for Jim Puplava’s clients only—with other members of the trading staff. Chris enjoys the outdoors.


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