July Macro Update: Recession Risk Remains Low

Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least a year and in several instances as long as 2-3 years. On this basis, the current expansion will last well into 2018 at a minimum. Enlarge any image by clicking on it.

Weekly Market Summary

Summary:  SPX has gained every month in the first half of the year, and it is up 8 months in a row for just the fifth time in 26 years. Long streaks like these have consistently led to further gains in the following months. Likewise, strong gains to start the year - SPX gained 8% in the first half and NDX gained 16% - have most often led to further gains in the second half of the year. The bullish trend in equities is supported by continued advances in the macro economic data.

The crack that opened in NDX two weeks ago has widened further. The index has now fallen 5% and has broken below its 50-dma. The consistent historical pattern is for SPX to follow, lower. That hypothesis is further supported by bullish sentiment - at a 3-1/2 year high by at least one measure - and the exceedingly tight trading range in SPX over the past month which most often precedes an expansion in volatility.

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For the week, large cap stocks lost 0.5% while the Nasdaq-100 (NDX) lost nearly 3%. The volatility index, VIX, gained 11%.

Equities have finished a very strong first half of the year. US large caps gained +8% while NDX gained twice that (+16%). Both of these outperformed the consensus long, Europe (+5%). But the best performing region to start the year was emerging markets, which gained an astounding +18%. Enlarge any chart by clicking on it.

This Is What A Bubble Looks Like: Japan 1989 Edition

Summary: Take the US tech bubble of the 1990s, add the subsequent real estate bubble of the 2000s, multiply by two, and you have a good approximation of the events leading to Japan's stock market crash in 1990.

The Nikkei stock index rose more than 900% in the 15 years before it finally topped. It was a frenzy powered by a belief that Japan Inc. was on its way to taking over nearly every major industry worldwide. The stock market bubble was further fueled by a massive real estate bubble at least twice the size of the one the US experienced in the 2000s. Tokyo alone became more valuable than all the land in the US.  In short, it was the product of a tsunami of monumental and concurrent events that are unlike anything present in the US today.

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Long advances in the stock market bring out fears that the rise will end in a crash. A current meme is how the US market today is just like the one leading up to the 1987 crash. That same argument was made in 2013, 2014 and 2016, and failed each time. More on that in a recent post here.

Today's stock market is sometimes compared to Japan's main stock index, the Nikkei, in the years leading up to its brutal crash in 1990.

Some might recall the Nikkei's spectacular advance. The index rose 30% in 1989 alone, but this came after a long bull market. Over the last 5 years of that bull market, the Nikkei rose 3.4 times; over the last 15 years, it rose more than 10 times. The rise was relentless.

Weekly Market Summary

Summary:  Most of the US indices made new all-time highs this week. SPY is making 'higher highs' and 'higher lows' and is above all of its rising moving averages; this is the definition of an uptrend. Moreover, the cumulative advance-decline lines made new highs this week, indicating that breadth generally remains supportive. Net, there appears to be little reason to suspect the indices have reached an important top.

That said, NDX has opened a noteworthy crack in US equities. NDX has fallen 4.5% in the past week. In the past 7 years, falls of more than 4% in NDX have preceded falls in SPY of at least 3%. That doesn't sound like much, but it would be the largest drop so far in 2017. A key watch out now is whether NDX weakens further and breaks both its 50-d as well as its mid-May low; if so, then SPY is likely to follow with its first 5% correction since the US election. These are the consistent historical patterns. Moreover, by at least one measure, bullish sentiment is at a 3-1/2 year high.

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Our overall message continues to be that (a) trend persistence in equity prices, together with decent underlying macro data, is likely to lead US indices higher over the next several months and probably through year-end; and (b) an interim drawdown of at least 3-5%, sooner rather than later, seems to be odds-on.  A number of studies supporting this view were recently detailed here.

This week, SPY, DJIA, NYSE and RUT all closed at new all-time highs (ATH) on Tuesday. SPX has made 23 new ATHs this year. NDX, meanwhile, has closed above its 50-dma for more than 130 days in a row, the longest such streak since 1995 (from Bespoke). Both of these are clear indications of strong trend persistence. Enlarge any chart by clicking on it.

Fund Managers' Current Asset Allocation - June

Summary: Global equities have risen 5% in the past 3 months and nearly 20% in the past year, yet fund managers continue to hold significant amounts of cash, suggesting lingering doubts and fears. They have become more bullish towards equities, but not excessively so: less than half expect better profits and a better economy in the next 12 months.

Allocations to US equities dropped to their lowest level in 9 years in April and remain nearly this low in June: this is when US equities typically start to outperform. In contrast, weighting towards Europe and emerging markets have jumped to levels that suggest these regions are likely to underperform.

Fund managers remain stubbornly underweight global bonds. Current allocations have often marked a point where yields turn lower and bonds outperform equities.

For the first time in seven months, the dollar is no longer considered highly overvalued. Since November, the dollar has fallen 4%. A headwind to dollar appreciation has dissipated.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, managers are overweight equities and cash and very underweight bonds. Enlarge any image by clicking on it.

Within equities, the US is significantly underweight while Europe is significantly overweight. 

A pure contrarian would overweight US equities relative to Europe and emerging markets, and overweight global bonds relative to a 60-30-10 basket.