Beware the Economist who is seeking guidance from the stock market as to the state of the economy. These creatures make lousy economists and worse money managers.
That’s a lesson I learned a long time ago, and its one that Michael Panzner reminded me of again today. Panzner is a trader and author (he wrote the book: “The New Laws of the Stock Market Jungle” which is in my queu, waiting to be read). What started this line of thinking was an interesting question Panzner sent out Friday morning: What to make of the “Flattening Yield Curve & Fed Tightening Cycle?”
It seems that GKST‘s Brian Wesbury put the Hookah down long enough to pen a Wall Street Journal op-ed, “What’s an Analyst to Do?” Wesbury’s piece is somewhat disengenuous; A quick sample reveals one of the analytical flaws I see all too often lately from dismal scientists: “Since Aug. 12, the Dow is up 2% and the Nasdaq is up 8%, signaling a positive view of the economy.” (emphasis added)
It is the height of folly to pull out a single 30 day period of market activity and declare that it reveals the basis of an economic anything.
Looking at the performance of the markets year-to-date shows not only how financially costly such an exercise can be, but how totally dubious a proposition this is. As this chart below clearly reveals, the markets have hardly been signalling Wesbury’s “positive view of the economy.” In fact, that same argument could have been made at least 3 times so far in 2004; Unfortunately, the markets also signalled the converse view of the economy at least 3 times in ’04.
The most recent reversal (which started the week of September 14) would be the 4th negative signal; Especially if it gathers any more downside momentum, a distinct possibility. In reality, these short term jags are indiciative of nothing — they are typically knee jerk reactions to sentiment and overbought/oversold scillators. More significant, however, is the market’s overall bias since the beginning of 2004: Its been mostly negative, as the down channel clearly reveals to anyone who can read a chart (that includes economists, too).
click for larger chart
Source: Stockcharts.com, BLR
Panzner makes note of Wesbury’s theory that
“recent moves in the long end of the yield curve do not reflect the bond market’s anticipation of an economic slowdown. In his opinion, other factors negate this argument, and he seems to offer an alternative view that the decline in long-term rates is mainly due to “carry trade” arbitrage stemming from a monetary policy that remains “excessively accomodative.”
Essentially, Wesbury confronts two possibilities: Either the Fed is being too accomodative, or the economy is (horror!) slowing. Wesbury decides that its not the economy, stupid, and instead both the Bond and the Federal Reserve are wrong.
Well, perhaps. But as Panzner correctly observes:
“If one looks back at data over the past two decades (see nearby chart), it seems that whenever the Federal Reserve has embarked on a tightening cycle and the yield curve has flattened — which is the situation we have now — it has presaged a downturn in economic activity, as reflected in the Institute for Supply Management Manufacturing Index. I have used this measure because it has had a pretty good correlation with swings in year-over-year Gross Domestic Product data during the period.”
I much prefer quantitiative analysis — its far more persuasive to me — than an unsupported theoretical argument . . .
Panzner concludes: “While the possibility remains open that Mr. Wesbury may be correct, a wide range of profit-warnings and anecdotal reports suggest it is more likely a case of deja vu all over again. If so, the economy — and equity prices — may slip lower in the months ahead.”
That’s not far off from my own expectations: I’m looking for more a bounce off of 1100 SPX, followed by downward pressure culminating in an October bottom (that may lead to a new rally peaking in February March time period, but that’s just a guess).
Update: September 27, 2004 8:15
The WSJ’s Steve Liesman considers a third conclusion: Both. The Economy is slowing, and the Fed may be at the end of its rate hiking cycle because of it.
Graphic courtesy of Michael Panzner, Rabo Securities
What’s an Analyst to Do?
By BRIAN S. WESBURY
WSJ, September 24, 2004; Page A14
Does Slide in Bond Yields Signal the Sky Is Falling?
WSJ, September 24, 2004