Over the course of the last two months the markets have had a lot of volatility and yet have essentially gone nowhere. While surveying the markets I see a host of indicators, indexes, commodities, credit spreads that are at a cross roads of sorts in which bullish or bearish resolution to prior trends should result in short order. The resolution of these trends will likely lead to a sizable move in the markets with the eventual direction unknown at this point. So buckle up and stay flexible as both the bulls and the bears are playing a game of tug-of-war, and so far both appear evenly matched.
LEIs vs. Earnings Season
What may be explaining the tug-of-war between the bears and the bulls are the different messages being sent by the leading economic indicators (LEIs) and corporate earnings. The LEIs have clearly rolled over and are suggestive of further market weakness ahead as shown below when viewing the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI).
Source: Standard & Poor's, ECRI
While the LEIs are forecasting weaker economic growth ahead that is suggestive of a weaker stock market, earnings season is upon us and a continued bullish earnings season is helping to keep the bears at bay. The second quarter earnings-per-share (EPS) distribution is still definitively skewed towards positive growth territory, as is the EPS percent surprise distribution.
Source: Bloomberg
While earnings and sales growth have come in strong so far this season after 76 of the 500 S&P 500 companies have reported, what is also visible and lines up with the decline in the LEIs is a clear deceleration in the growth trend. A peak in EPS growth was seen two quarters ago (Q409) which isn’t hard to fathom given the Armageddon-like conditions in Q408 (easy year-over-year comps), while the sales growth trend peaked last quarter.
Source: Bloomberg
So far strong earnings have kept the market afloat but it will be forward guidance coming from companies that will be of utmost importance since a decline in LEIs AND weak earnings growth would be quite the bearish cocktail.
Crossroads
As stated out the outset of this article, there are a lot of markets that appear to be at a crossroads in which a bullish or bearish resolution may be at hand. A few key markets and indicators are presented that should be monitored closely ahead. If the markets are headed higher in the near term I would look for bullish confirmations in the indicators below, and just the opposite if the markets are headed lower. With so much volatility in the markets one should not rely on any one market/indicator, but rather use a host of data to confirm the market’s next trend rather than jumping the gun and getting whipsawed.
And speaking of volatility, one of the key indicators I am monitoring right now is the Volatility Index (VIX). The VIX bottomed just as the market peaked in April and has put in a series of lower highs since its May peak, but has yet to break support below .50 or its 200 day moving average (200d MA, red). If the market is to move higher, look for the VIX to break below its 200d MA and below support at roughly .50. If the market is to head lower, look for the VIX to breakout above its declining trend line and above the 50 day moving average (50d MA, blue line).
Source: StockCharts.com
If the VIX breaks out that would not only be sending a negative message for the stock market but also the economy as the VIX has shown a negative correlation to the ISM indexes (VIX shown inverted below). A breakout in the VIX would be suggestive of further economic weakness ahead as it would be implying weaker ISM numbers are on the table for July’s reports.
Source: Moody’s Economy
Another area of the financial markets I’m keeping an eye on is currencies. One great tool as a gauge for global deleveraging or risk taking has been the Euro/Yen exchange Rate (XR). Just prior to the fall 2008 melt down the Euro/Yen XR was showing considerable weakness and gave an early warning before markets subsequently collapsed. Likewise, the XR bottomed in the fall of 2008 and failed to form a new low in early 2009 when global markets formed new lows, showing bullish divergence. The XR broke a six month trading range to the downside in January, warning of a coming correction, and its break of its 50d MA in April was also warning of a market correction.
Source: StockCharts.com
The XR broke below the 2008 and 2009 lows in May and has since been trying to break above 1.13 ever since, with each rejection at resistance coinciding with short term market peaks. The XR recently was rejected at resistance and appears to be heading south again after also failing to break above the 50d MA. If the bulls are to gain control of this market I would expect to see the Euro/Yen XR break above its 50d MA and 1.13. Until it does I would say the bears have the upper hand as major support (2008 and 2009 lows) has been broken and is now major resistance.
Source: StockCharts.com
A more diversified currency gauge I monitor is my Commodity Currency Carry Index (CCC Index) that measures the strength of high-yielding currencies versus low yielding currencies. What appears to be taking shape is the formation of a megaphone topping pattern. If this index breaks out to the downside I would expect widespread global deleveraging to occur as it would likely be indicating a global economic slowdown as commodity currencies are highly correlated to global economic growth. If the economic recovery growth story remains in tact I would expect my CCC Index to not breakdown but rally above its 50d and 200d MAs.
Source: Bloomberg
And speaking of global economic growth, the world’s economic growth miracle has been mired in a bear market ever since it peaked last summer. There is a clear declining trend channel and the Shanghai recently bounced off the lower trend line and may be forming a bottom. Whether this is “THE” or just “A” bottom is yet to be determined, but a move above the 50d MA (blue line) would certainly be an intermediate bullish development. A strong rally in the Shanghai would likely be viewed as a bullish factor for future global economic growth, so it should be a great watch point for determining the stock markets next move.
Source: StockCharts.com
In summary, both the bulls and the bears are fighting head to head and there appears to be no clear winner at this point. The LEIs suggest the bears will eventually win out but earnings season suggests the bulls aren’t going to lie down without a fight. To prevent getting whipsawed all over the place with the market noise, I would suggest monitoring the indicators mentioned above as a checklist for determining whether the next major move in the markets will be awarded to the bulls or the bears.
