Five ways to take the markets’ temperature

The growth scare of late 2018 feels like a long time ago and the flap over inverted yield curves of summer 2019 also seems to be quickly fading from the financial markets’ collective memory: yields of 1.58% on US 2-Year Treasuries and 1.84% on the 10-year paper mean the US curve is as steep now as it was in June 2018.

That said, a 36 basis-point gap hardly signifies a truly ‘steep’ yield curve, given that the average premium yield from US 10-year paper over the 2-year since 1980 is exactly 100 basis points (or one full percentage point).

As such, the bond market does not appear to be entirely convinced that the US – or global – economy is as strong as advisers and clients might like to think. It may therefore be worth revisiting the quintet of indicators upon which this column regularly relies to gauge a combination of both the economy and the financial markets’ appetite for risk.

Regular readers (or attendees at AJ Bell Investcentre events) will remember that these are:

  • the copper price;

  • transportation stocks;

  • small-cap stocks;

  • semiconductor stocks; and

  • bank stocks.

  • The bad news is that transport and small-cap stocks continue to lag behind the headline indices, which is not always a great sign.

    The good news is that all five indicators are going up, with copper, transport, banking and small-cap shares all showing improved momentum since the autumn and the chip stocks simply sizzling all year through.

    “Current trends suggest the latest stock market rally may still have legs, although advisers and clients know better than to let their guard down, given legendary stock trader Jesse Livermore’s pithy comment that “Stock markets ride the escalator up and take the elevator down”.”


    This suggests that the current rally may still have legs, although advisers and clients know better than to let their guard down, given legendary stock trader Jesse Livermore’s pithy comment that “Stock markets ride the escalator up and take the elevator down”. Hopefully these indicators will prove their worth before we all hear the ‘ping’ as the lift doors shut tight (which presumably it will, one day).

    Five points

    1. Copper. ‘Dr Copper’ is so called because the industrial metal’s malleable, ductile and conductive properties mean its wide use makes it a good guide to global economic health. For most of 2019, the metal looked pretty poorly but a rally began in autumn and has continued ever since.

    Dr Copper is looking brighter as we head into 2020

    Source: Refinitiv data

    2. Transportation stocks. Richard Russell’s Dow Theory argues that if the Dow Jones Transportation index is thriving, then the better-known Dow Jones Industrials index should flourish too.

    The logic here is that is can only be good news if the share prices of the firms moving goods around the world by road, rail, sea or air are doing well. If something is sold, it has to be shipped.

    By default, the opposite holds true. Weak transport stocks could mean inventories are piling up on shelves and forecourts, to herald production cuts and a potential downturn in industrial activity, economic output, corporate earnings and potentially stock market valuations.

    “It is therefore of some concern that the Dow Jones Transportation index is lagging behind the Dow Jones Industrials benchmark [… o]ver the past year, [… h]owever, more encouragingly, the Transports have outpaced the Industrials since October.”


    It is therefore of some concern that the Dow Jones Transportation index is lagging behind the Dow Jones Industrials benchmark rather than leading it. Over the past year, the Transports are up by 20% and the Industrials by 24%. However, more encouragingly, the Transports have outpaced the Industrials since October, so advisers and clients may be inclined to think such concerns are just a case of splitting hairs, since a 20% rise over a year can hardly be described as a weak showing.

    Transportation stocks are trying to pick up the pace again

    Source: Refinitiv data

    3. Small-caps stocks. Small-caps serve two purposes in this survey. First, they act as an economic indicator as they tend to be more reliant in their domestic arena rather than global trade flows. Second, they are a good measure of financial markets’ risk appetite.

    Rather like the Transports, the small caps have lagged over the past year but they have begun to gather steam since the autumn, when the US Federal Reserve began to pump liquidity into the American interbank funding (repo) markets. This is a fair sign that animal spirits are running strongly, but it will be interesting to see what happens as and when the Fed starts to withdraw that liquidity.

    Small-cap stocks are making big strides again

    Source: Refinitiv data

    4. Silicon chip stocks. Rather like the small-cap names, the semiconductor stocks are a measure of both economic activity and risk appetite. Silicon chips are everywhere – from our smart devices to our cars to industrial robots and smart meters – so they are a fair guide to economic activity. In addition, chip stocks are loved by momentum traders as they tend to thrive amid earnings forecast upgrades and falter when estimates are falling.

    The chip stocks peaked some six to nine months earlier than the major headline indices at the peak of the bull markets in 2000 and 2007, so any marked weakness here could be a bad sign. However, over the last year, the Philadelphia Semiconductor index is up by 63% against 31% for the S&P 500, so this indicator looks the strongest of the lot for now.

    “Over the last year, the Philadelphia Semiconductor index is up by 63% against 31% for the S&P 500, so this indicator looks the strongest of the lot for now.”


    Silicon chip stocks are still cooking on gas

    Source: Refinitiv data

    5. Bank stocks. This takes us back to the yield curve. A flattening or inverted curve can be a warning that a downturn or recession is coming. Banks thrive off a steep yield curve and struggle when the curve is flat or inverted. The steeper the curve, the fatter their net interest margins tend to be, so the current environment is very difficult for them, as their lagging share prices suggest.

    Banking stocks were the weak link in the bull narrative in 2019…

    Source: Refinitiv data

    Using the S&P Global 1200 indices, the banks are up 16%, while the headline index is up 26%, and the performance would have been a lot worse still had the US banks not performed so strongly. The banks have started to show some life since the autumn, too, though whether this is just the result of cheap Fed support via the repo market remains to be seen.

    “The banks have started to show some life since the autumn, too, though whether this is just the result of cheap Fed support via the repo market remains to be seen.”


    … and their performance would have been a lot worse had the US lenders not done well

    Source: Refinitiv data

    Conclusion

    On the face of it, Dr Copper and four equity market indicators suggest that the prevailing narrative at the moment is a return to global growth, thanks to ultra-loose monetary policy and a loosening of fiscal policy by governments, with inflation to just the ‘right’ degree in tow – enough to suggest the economy is fine but not so much that central banks feel obliged to raise interest rates.

    The bond market still feels less convinced, with fears of debt-inspired deflation lingering, while the gold price seems to be limbering up for stagflation or even (too much) inflation.

    These asset classes still seem concerned about the risk of ‘policy error’ on behalf of central banks (too tight or too loose) and 2019’s pivot from cutting to raising the cost of borrowing suggests the monetary authorities are far from certain they are on the right track.

    As such, advisers and clients still need to be prepared for multiple possible outcomes, building diversified portfolios that suit their long-term target returns, time horizons and appetites for risk and enable them to face the future with the same equanimity as the stoic philosopher Seneca, who once wrote: “I do not know what is going to happen but I do know what is capable of happening – and none of this will rise to any protestation on my part. I am ready for everything.”

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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