The Most Important Economic Signal Since 2001
One of the most constantly repeated themes in the financial news media of late has been the slowdown of the U.S. economy. Fed chief Bernanke jumped on this theme in his latest remarks, stating that the economic softness is proceeding along the lines envisioned by the Fed (of course it is - the Fed created it!)
To take an example of how soft the economy was this year, a report from a few weeks ago showed that consumer borrowing fell in September by the largest amount since the recession of the early 1990s. The rate of change in the sales of single family housing fell by an amount similar to the recession of this same era in 2006. And auto sales was also hit by the economic slowdown this year.
All of this can be attributed to the Fed's tight money policy from the past two years as the Fed funds interest rate has risen steadily and money supply as measured by M2 and MZM has also declined on a rate of change basis. Bank credit also suffered a percentage change decline through the first three quarters of 2006.
Whenever consumer credit outstanding reaches a low level as it did earlier this fall it sends a clear signal to the Fed that it had better start pumping the money supply. The Fed has been pumping for the past few weeks and by early 2007 we should see an even greater infusion of liquidity back into the monetary system which in turn will resuscitate the consumer economy and further help the stock market. It will also help to stabilize the soft sections of the real estate market. The banks simply cannot afford to let the U.S. consumer fall by the wayside since the consumer economy is still a major engine for the absorption of Chinese imports and the financing of the global economy.
As one analyst has written, the world's economies are addicted to the U.S. consumer and the global economic expansion currently underway would come to a screeching halt without him. But even the U.S. with its long-term trend of being a net importer is starting to flex economic muscles in the export area. Economist Ed Yardeni points out that in September, U.S. exports and important were up 16.7% and 13.4% year over year, respectively. According to Yardeni, export growth was the highest since 1995. Indeed, the many similarities between 1995 and today, economically speaking, are quite startling. Don't forget that 1995 was the start of the economic super-boom that extended into the late '90s and was also the start of the acceleration phase of the stock bull market of the second half of that decade.
Despite the growing amount of positive economic signs, everywhere in the financial press we hear of analysts and newsletter writers asking, "Will the economic slowdown continue into 2007?" Many are concentrating on the U.S. economic numbers as they are released by the Commerce Department. Others - notably the Dow Theorists - are looking to the Dow Jones Transportation Average for clues. But one area they don't seem to be watching is the area of bank credit growth. This would give them an even bigger "heads-up" on future economic performance than almost any other chart or statistic they care to monitor. And what does the bank credit trend show us? The chart below is worth a thousand words.
The percentage change spike in the bank credit chart shown above was the largest one since late 2001 when the previous economic recession formally ended. This latest leap in bank credit from a percentage change annualized standpoint is one of the most important charts for providing clues as to what's ahead for the U.S. economic and financial outlook. The story it tells is an exceedingly bullish one and 2007 should see the positive results from the increasing liquidity. Money supply from many sources is increasing and this lets us know that the economic slowdown - which brought the U.S. to the brink of recession this year - will turn into economic improvement in 2007. It will also help to further stimulate the bull market in stock prices in the months ahead.
How else can we be sure that this improvement in monetary liquidity and the consumer economy will transpire in the upcoming months? Besides the fact that the 8-year liquidity cycle recently bottomed, it's also important to remember that the 10-year stock market cycle is still up until 2009 and this will create a strong underlying support and upside bias for the market in the next couple of years (temporary backslides notwithstanding). And as market strategist Donald Rowe points out in a recent Wall Street Digest, with $5 trillion in cash on the sidelines this is the most liquid stock market ever. With stocks moving higher in September, October and November in the face of overwhelming negative news and bearish investor sentiment it is interpreted as a signal that better things are coming in the months ahead. Remember, the stock market is the ultimate barometer for business conditions and with the persistent rally last month in what has historically been a bearish month, it should be interpreted as a "heads up" for an improving market and economic situation heading into 2007.
According to the historically reliable IBES Valuation Model for gauging fundamental valuation in U.S. shares, stocks are 33.7 percent undervalued and at an historic long-term low. This chart is strongly bullish for the stock market outlook ahead. So is the spread between the S&P 500 earnings yield (6.84%) the yield on 10-year Treasuries (4.53) as it favors owning stocks over bonds.
Investor sentiment also continues to show a decided favoritism toward fear and pessimism rather than excessive optimism. From a contrarian standpoint that's supportive of the bull market in stocks. The International Securities Exchange Sentiment Index, which measures calls versus puts, recently reflected the highest level of put buying/bearish bets on the stock market in its history. That extremely high level of pessimism will take time before it completely works off the bearish extreme and turns into extreme optimism at the next major market top. We've a long way to go before that happens.
Another reason for expecting the bull market to continue into 2007 is the bull market in Merrill Lynch. I agree with what one prominent analyst said about MER recently: in the old days the saying on Wall Street was "what's good for GM is good for America" in terms of the financial/economic outlook. But today it's more accurate to say tthat "what's good for Merrill Lynch is good for America." MER has been in a broad upward trend since the June bottom and hasn't looked back since.
The pattern traced out in MER's chart is reminiscent of what happened back in late 1994 to early '95. After peaking in the early part of '94, MER declined to its *internal* low in the spring before making its final price low in October of that year. By the beginning of 1995 MER was off the races and rallied for eight consecutive months before its first corrective pullback. The bull market in MER didn't peak until 1998. Historically, whenever MER rallies for at least five consecutive months from its most recent correction bottom it means the broad market trend will be up for several more months.
To reiterate our position, the sectors expected to outperform in the coming 3-6 months include technology in general with semiconductors and nanotechs in particular expecting to experience bull markets. Leadership is likely to shift from the Industrials to the technology sector when the next phase of the bull market gets underway in the weeks ahead. We'll be reviewing the most attractive technology stocks at the next confirmed buying juncture based on our internal and momentum indicators.