Wednesday, February 22, 2012

Economy: Business Cycle Update

It has been awhile since I updated the Business Cycle outlook, so I think it is time for us to see how the global economy is performing as we slowly approach March. The last time I took the time to write about the global Business Cycle (Articles: Part I & Part II) in November of last year, I concluded the following:
"The global economy is still growing. That is a fact. And where there is growth, there is a rise in profit. That too, is also a fact. Therefore equities globally are still hanging in there.
...there are also some possible positive signs which show us Prices Paid Index that is falling could reduce margin pressure over the coming months and push global PMIs towards a recovery into the 1st quarter of 2012. This could really back foot perma bears as the equity market will do a mother of all short squeezes..."
Business Cycle
The quote section in the introduction, which was originally written in November 2011, pretty much outlined what happened into the first quarter of 2012. What we saw was a recovery in the global PMI indices, which resulted in a strong S&P 500 rally from 1150, towards 1360 today. So how is the global economy looking like right now?
When following the global business cycle, I tend to use variety of indicators, some of which are financial, some of which are leading and some of which are economic lagging. When we look at the chart above, we could assume the following:
  • At the same time, US equity earnings remain at record highs within the current business cycle. Same can be said with Profit Margins, shown in the chart above. It should always be a known fact to investors (not traders) that the best time to buy stocks is when margins are depressed and when earnings are down. Therefore, common sense states that investing in stocks right now, does not make a lot of sense when profit margins and earnings are at record highs. Obviously, this is not a timing indicator for traders, so I am not advocating a recession will begin tomorrow. I am actually quite optimistic for 2012,, but after that some serious problems could start to occur.
  • Exporters and manufacturers in both Germany and Japan are still decently confident that the current business cycle will keep expanding. Japanese Tankan survey indicates that conditions are slowly deteriorating, but things are not serious just yet. Their main problem is the strength in the Yen and the weak global demand. Quite to the contrary, German lfo survey of 7,000 CEOs running manufacturing companies, indicates that these business leaders still see further expansion in the current business cycle. Finally, manufacturers in United States are also regaining confidence that the business cycle will keep expanding, as the ISM continues to expand.
  • Major conundrum in the leading indicator space comes as Weekly Jobless Claims data keeps improving in the US, while the ECRI Leading Index is not signalling the recovery is as strong. As a matter of fact, S&P 500 has made intermediate peak in April 2010 and than a higher peak later in May 2011. Weekly Jobless Claims have confirmed this rise, while ECRI's intermediate peaks have been diverging with the stock market since April 2010 - a worrying sign that equities are just running higher on money printing. Which one is right and which one is wrong?
The economy and the stock market are two different animals. As stocks tends to lead the business cycle, a contrarian stance always needs to be taken on board when viewing economy. What I mean by this is that when the economy is under-performing, with worries of a recession like in August 2010 or September 2011, stocks should be bought. At the same time, when the economic data has outperformed, while profit margins and earnings remain at record highs, one should at least take a cautious stance as an investor (not a trader). This is definitely not the time to be deploying new capital on a large scale.
From the short to medium term perspective, we can see in the chart above thanks to Citigroup Economic Surprise Index, the stock market has definitely priced in majority of the improvements in economic data since the August of 2011. That could signal a potential for the data to surprise to the downside in coming weeks or months. Having said that, from the long term perspective, the expansion is still intact in the current business cycle and there are no signs of up-and-coming recession. Nevertheless, caution is still advised as record profit margins and record earnings will not continue forever in this secular equity bear market. On top of that, it is very worrying to see almost nobody is paying attention to Chinese hard landing at this point in time.

My advice is to enjoy the growth period for now and hold the bullish stance with the current trend, but be careful as the economy starts to deteriorate near the end of this year. I will come back throughout the year and monitor how the global Business cycle is progressing...