Head of Research
The Super Investor
8 am 26 August 2020
Who is right, Wall St or Main St?
It is often heard these days that Wall Street is out of step with Main Street. Millions of Americans have been laid off and yet the main US stock market indices are at or near record highs. Unprecedented amounts of monetary and fiscal stimulus have propelled the market higher, but is there something else going on as well?
The share market is forward-looking, so is it telling us that an economic recovery is around the corner? Maybe, but to confirm it we need another objective, forward-looking indicator. Fortunately, one exists in the form of The Conference Board Leading Economic Index (LEI) for the US. And it has been rising for the last three months in a row.
The LEI is a composite of ten variables that lead the business cycle by 6 to 12 months. The business cycle is represented in the chart by the Conference Board’s own Coincident Economic Index (CEI), a composite of high-frequency economic data that are coincident with GDP. The shaded areas in the chart show past official US recession periods.
The LEI has historically turned downward before a recession and upward before an expansion. Three consecutive monthly declines in the LEI is normally considered a bad sign for the share market and the economy, and vice versa. The LEI has generally proved capable of predicting recessions and recoveries over the past 50 years.
US Leading Economic Index
The ten components of the US LEI are: 1) Average weekly hours for the manufacturing sector; 2) Average weekly initial claims for unemployment insurance; 3) Manufacturers’ new orders for consumer goods and materials; 4) ISM Index of New Orders; 5) Manufacturers’ new orders for non-defense capital goods excluding aircraft; 6) Building permits for new private housing units; 7) S&P 500 index; 8) Leading Credit Index; 9) Interest rate spread, defined as 10-year Treasury bond yield less Federal Funds rate; and 10) Average consumer expectations for business conditions.
The latest readings for the US LEI are a 1.4% increase in July to 104.4 (2016 = 100), following a 3.0% increase in June and a 3.1% increase in May.
The Coincident Economic Index for the US has also been rising for the last three months, which is earlier than usual relative to the LEI. It has no doubt been boosted by government assistance payments and the current situation is anything but usual. The outlook for the global COVID-19 pandemic is still highly uncertain. Hopes for a vaccine grow by the day but how effective and widely available any vaccine will be is still unclear. It is too soon to say we are out of the woods.
Commenting on the latest LEI result, the Conference Board’s Director of Business Cycles & Growth Research said, “The US LEI increased for the third consecutive month in July, albeit at a slower pace than the sharp increases in the previous two months. Despite the recent gains in the LEI, which remain fairly broad-based, the initial post-pandemic recovery appears to be losing steam. The LEI suggests that the pace of economic growth will weaken substantially during the final months of 2020.”
Wall Street is being selective
Perhaps a clearer picture of what is going on within the share market is provided by the Advance/Decline Line, which is an indicator of market breadth. It is calculated by taking the difference between the number of advancing and declining stocks, and then adding the result to the previous value. It rises when advances exceed declines and falls when declines exceed advances.
It is often a good idea to compare the AD Line with the performance of the actual index. Ideally, the AD Line should confirm an index’s advance or decline with similar movements. The Nasdaq Composite Index and its AD Line can be seen in the chart below. They look quite different.
Nasdaq Composite Index & Advance/Decline Line
The market is being quite selective about which stocks are being rewarded and which ones are not. Tech heavyweights with dominant market positions, such as the so called FAANG stocks, have been leading US equity markets higher.
Something similar is happening for the S&P/ASX 200 Index. There has been a pronounced bifurcation of the market between companies than have benefited from the COVID-19 pandemic and those that have been harmed, in some cases severely so.
Beneficiaries include consumer staples and hardware retailers, online retailers, cloud-based technology companies, certain healthcare companies, miners competing with Brazil, and gold producers. Those harmed include airlines and travel companies, office property owners, hospitality and live entertainment companies, employment advertisers, and education services companies dependent on overseas students.
ASX 200 Index & Advance/Decline Line
It is important to remember that markets discount long-term cash flows, not just cash flows for this year and next. For some of the companies being harmed by the pandemic, it is difficult to establish what the new baseline normal will look like for them coming out the other side. That is why at this stage it is safer to continue backing the companies less at risk of earnings downgrades in this still uncertain environment.
But there will come a time when it is worth looking again at quality companies in smashed sectors. A good example would be the online travel booking company Webjet (WEB).
Head of Research
Disclosure: The author does NOT own WEB shares.
Neither The Super Investor nor the author has received [or will receive] any benefit whatsoever from any party at all for the publication of this article.
Disclaimer: This report is produced for the general information of investors without any regard for any individual person’s needs or objectives. Indeed, this content may not be appropriate for you. Reliance on the information or data is at your own risk. Be sure to seek specific advice from your personal adviser before taking any action.
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