Weekly Wrap-up: EM-Ratio -- What, Me Worry?
The stock market freaked out a bit on Friday because nonfarm payrolls growth was negative, printing a disappointingly -4K on Friday (consensus around +100K). While it's true that one number does not a trend make, it struck me as important to look more deeply into the employment numbers to see if the market has something significant to worry about. And from what I see, it looks like there is.
This first chart shows the Civilian Employment-Population Ratio (EMRATIO, blue line) from the late '40s through Friday's numbers.
The chart also shows grey highlights wherever the National Bureau of Economic Research (NBER) has concluded that the economy was in a recession. (These numbers come out late, often after the recession has ended, which is why I speak about them in the past tense.)
What makes itself apparent to my eye is that any time the EMRATIO has fallen by as much as 0.5% from a local high it has fallen much further than that (usually 2-3%) and any time a fall of that magnitude has occurred there has been a recession.
The EMRATIO has now fallen about 0.6% since its peak in December 2006. So, if the "forces of nature" that have governed the economy continue to operate as they have over the past 50-60 years, it looks like we're in for a larger fall in the EMRATIO (2-3%) and for a recession.
Of course for our purposes we're interested in seeing the relationship between the EMRATIO and the stock market. And that relationship/correlation is extremely strong.
This next chart shows the EMRATIO in blue and the SPX on a log scale in red. The data plotted is monthly. And the correlation is a very strong +0.92 (where 1 is perfect, -1 is perfectly inverse, and 0 is no correlation).
If we were to plot the SPX on an arithmetic scale the correlation would be a still-strong, +0.80.
Now something I see on this chart is that, as per the aphorism, the stock market is indeed a leading indicator. You can see that in the '60s and '70s the SPX dipped before the EMRATIO fell and the SPX rallied before the EMRATIO had bottomed.
What's curious at the right side of the chart is that the stock market has been ignoring the dip in the EMRATIO since December. There is precedent for such market heedlessness back in the '80-'81 time frame (the more leftward of the 2 yellow highlights on the chart above) when the SPX (red line) rallied as the EMRATIO fell (blue line). But that blitheness was correct in '81-'82 when the SPX fell, bottoming in the summer of '82, ahead of the EMRATIO.
Now, maybe, as Fed Chairman Bernanke has suggested, there are secular forces at work that are causing the EMRATIO to deteriorate (e.g., the graying of the population and an increase in the length of time it takes to fully educate our students). But those forces have not changed so terribly much over the last 3-5 years, not nearly enough, at any rate, to account for the sharp swings seen in that time frame.
What we have is a nascent decline in the ratio of the people working to the people living in our society. And unless the Fed takes its foot of the brake (eases interest rates by a fairly significant amount) and takes a pre-emptive approach to monetary policy (pre-empting further fallout from the mortgage/housing markets' problems) the EMRATIO will continue to indicate a high likelihood that a recession is coming and the stock market will very probably begin to reflect that economic slowdown.
(Of course, then there's the issue of whether rate cuts will be of sufficient swiftness and size to make a significant difference...)
So, how does all of the above jibe with our view of the 4-yr cycle in the stock market?
This next chart plots the performance of the current cycle (black line) against the first 2 years of the 4-year cycle's average and median performance (red and blue lines respectively).
So far the -1 Standard Deviation (SD) line has contained the sell-downs during the current cycle. (Statistically speaking, about 68% of iterations of the cycle should fall inside the grey envelope.) So long as that -1SD line continues to contain the decline it's reasonable to maintain that we're still in a normal-ish correction. However, if that grey envelope breaks to the downside, then we may be forced to revise how we look at the current cycle.
If the Fed continues to keep short-term interest rates too high, then the potential for an '87-like stock-market dislocation exists.
However, if the Fed "does the right thing" then I suspect that the SPX will, after a volatile September-October period, manage to rally up toward the +30% level for the cycle, up around 1600 by year-end, roughly bisecting the performances of the '94-'98 cycle and the '86-'90 cycle.
The consensus for Forward 52-Wk Operating Earnings per Share (F52W EPS, blue line below) for the SPX now stands at $101.60. That's down $0.02 from last week's all-time high and is 10.4% above Trailing 52-Wk Operating EPS (T52W EPS, yellow line below), which is at $91.99, down $0.12 from the all-time high of 4 weeks ago.
The trends remain positive but there is some evidence of slowing: the yellow line is up 9.9% over its year-ago level (down from last April's Y/Y growth of 13.2%); the blue line is up 9.4% Y/Y compared to its 13.1% Y/Y rise as of last February.
On a sector-by-sector basis we see that there's some modest recent improvement in growth projections for Health Care and Information Technology.
Meanwhile there's deterioration in growth projections for Utilities, Consumer Discretionaries, Consumer Staples, and especially in the Financials.
Looking more closely at the Financials we can see that since July there has been a sharp decline in the consensus estimates for both 3Q07 and 4Q07 (pink and yellow lines below).
The results for 2Q07 (navy blue line) have really only declined in the most recent postings for that quarter.
The estimates for 2008 have fallen, but not quit as precipitously as the lines representing 2007's final 2 quarters.
YIELDS AND EQUITY RISK PREMIUM
The Forward Earnings Yield on the SPX is now 6.99% (F52W EPS / SPX Price). Meanwhile the yield on the 10-Yr Treasury is at 4.37%.
That's a 2.62% spread. And that spread (which is very wide relative to historical norms) is what we call the Equity Risk Premium (ERP). That's the amount of excess yield demanded by investors for assuming the risk of investing in the stock market relative to risk-free US Treasuries.
ERP is not quite as high as it was during the summer of 2002, but it's not too far away, either.
The very high ERP is normally associated with very good cyclical returns on the stock market (over the coming 2-2.5 years).
There has been a flight to quality since early July when ERP was down under 1.5%. That flight to quality has a) driven bond yields down (prices up), b) driven stock yields up (prices down), and C) steepened the inversion of the yield curve.
The inverted yield curve, along with the declining EMRATIO, is forecasting an economic slowdown. The Fed has some easing to do if it wants to avert some serious market dislocations that could exacerbate the slowdown and turn it into a major recession.
I continue to suspect that the Fed will ease policy significantly between now and the end of the year (50-75 basis points). But if they get all hawkish and fail to ease, then, as far as the stock market goes, caveat emptor.
Best regards and good trading!