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The most important question investors should be asking at this point isn't
whether the secular bull market which began in 2009 is over, but whether
continued equity market weakness in 2016 will lead to the unthinkable, namely
an economic recession. A recession in 2016 has been deemed
virtually impossible by most mainstream economists, so much so that all
discussion of this possibility has evaporated. And while most U.S.
economic data categories are still admittedly strong, the persistent weakness
under the surface of the equity market over the last several months demands
that the topic be reexamined.
One of the tenants of Charles Dow's conception of the stock market is that
the market's primary trend is a precursor of U.S. business conditions in the
aggregate. Dow maintained that a steady decline of the major
indices typically precedes trouble in the business economy by at least 6-9
months. And while there are a few instances when the economy was
able to withstand a bear market without entering recession, such cases are
the exception instead of the rule.
The stock market's problems can be traced primarily to weakness in
commodities, particularly crude oil. Commodity weakness has been a
result of diminished industrial demand in Asia and Europe as the leading
industrial countries are still suffering the effects of the misguided tight
money and austerity policies pursued by central banks and foreign governments
in recent years. As predicted, those austerity chickens have come
home to roost and they aren't in any hurry to leave the chicken
house. If our own experience in 2008 is any guide, it will likely
take the better part of 2016 for the stimulus measures enacted by the
People's Bank and the ECB to have any measurable impact, and that's assuming
both entities remain committed to an aggressively loose money policy.
So the bigger question is whether the U.S. economy has enough forward
momentum to withstand the impact of the global slowdown. The
effects of this slowdown are clearly being felt by equity investors, and that
should be a warning sign to economists that a consumer spending slowdown is a
real possibility in 2016. Most economists consistently downplay
Dow's theory that the stock market is a leading indicator, however, so any
slowdown in business this year will likely take most of them by
surprise. Moreover, most economic statistics that most economists
rely on for making forecasts are lagging indicators. This means
these numbers won't reveal a weakening domestic economy until it's too late
to take preventive measures.
The key "statistic" for measuring the condition of the U.S.
consumer should be the stock prices of the leading consumer retail, consumer
discretionary and business service and transportation
stocks. Examples would include FedEx (FDX), United Parcel Service
(UPS), Amazon (AMZN), WalMart (WMT), and Starbucks (SBUX). These
and other stocks are included in the New Economy Index (NEI), which I devised
in 2007 to measure the underlying strength or weakness in the U.S. consumer
economy. Here's what the NEI looks like as of Jan. 8.
 
Remarkably, NEI has managed to stay above its intermediate-term uptrend
line for months on end despite the continual erosion in the global
economy. This can be attributed to the increasing willingness of
consumers to make discretionary purchases, as well as their blithe unconcern
at the possible domestic impact of the global slowdown. NEI is
finally showing signs of weakening, however, and may be on the verge of
finally breaking its intermediate-term uptrend. If this happens it
will be the first indication in several years that the U.S. consumer is
beginning to lose confidence. I should mention that the only
consumer confidence that really counts is whether the consumer is actually
spending money, not the opinions he expresses to some pollster on the state
of the economy.
Behind the weakness is a drop in the dollar value of commodity prices,
which reflects the deflationary undercurrent still present in several
European and Asian nations. While deflation is no longer a major
threat to the U.S., the residual effects of the weak global economy are
beginning to erode corporate profits. This is one reason for the
internal weakness in the NYSE broad market in the last few
months. A critical precursor to an improvement in the equity
market then will be a reversal of the overseas economic weakness.
To that end, the European Central Bank (ECB) announced a year ago its
first round of quantitative easing (QE) with monthly purchases of EUR 60
billion worth of public bonds. The European QE is expected to last
until September 2016, with any extension dependent on the exigencies of the
euro zone economy. The goal of this stimulus measure on the part
off the ECB is to reverse the deflationary trend and hopefully replace it
with some inflation.
In the March 2015 issue of Business Credit, economists
for the euro zone economics team Euler Hermes S.A. forecast a "positive
but limited impact" for Europe's QE of 0.5 percentage points of GDP
growth and 0.3 percentage points on inflation through July
2016. That forecast, which many economists shared, looks to have
been a tad optimistic in light of recent developments. Although
the ECB stepped up its stimulus program in December, the latest data show
consumer prices have remained unchanged at an annual 0.2 percent, below
consensus expectations.
Euler Hermes rightly observed that the ECB lags far behind the U.S.
Federal Reserve and the Bank of England when it comes to rapidly responding
to deflationary threats. The Euler Hermes team also pointed out
that the "transmission mechanism of QE is less clear in the euro zone
because the private sector is less intertwined with financial markets than the
United States or the United Kingdom." Moreover, non-financial
corporations in Europe tend to finance between only 10-20 percent of their
debt in the market. Euro zone households have less equity market
holdings, preferring savings deposits or bonds; real estate holdings also
have less impact on consumption than in the U.S. With these
fundamental differences between the euro zone and the U.S., it's easy to see
that the success of Europe's QE program faces many obstacles.
The biggest hope or success of euro zone QE is, as Euler Hermes observed,
the "policy signaling effect" which would theoretically help to
increase business confidence and therefore raise inflation expectations and
loan demand. Unfortunately, however, the ECB was late "coming to the
QE party" which will make it more difficult to reverse the effects of
deflation. In Euler Hermes' words, "If the ECB was a credible
deflation-fighter, it would not need to print humongous amounts of money; the
mere announcement of a credible target would trigger a virtuous circle
leading to that target."
Perhaps the old saying "better late than never" applies to the
ECB's attempts at staving off deflation. But given the central
bank's poor track record, investors shouldn't get their hopes up too high
that success will be met anytime soon.
So if European QE won't be a major factor in reversing the global economic
malaise in 2016, what could possibly bring about an improvement?Confidence is
the keystone of a thriving economy, as any economist will testify.When
consumers, investors and business owners are confident in the strength and
stability of business conditions they express this confidence by spending
money, either to consume or to invest and expand business.The lack of
confidence in the long-term strength of the recovery is what has held back
U.S. economic growth in recent years.Every time it looked as if the economy
was ready to take off it was hindered from doing so by some foreign threat or
another.In 2015, uncertainty over the global outlook led to cost-cutting and
a complete lack of capital expenditures among S&P 500 companies.Revenue
growth and net income were also down for the year due to the strong dollar
and hard-hit oil sector.Thus confidence in the long-term outlook has been
sorely lacking.
Without confidence, the next best thing is outright fear.The type of
profound fear that was common in the years immediately after the credit
crisis hasn't been seen since the recovery gained traction in 2013 and
beyond.While confidence is far preferable to fear, at least fear can generate
the kind of action needed to stimulate the economy - much as was the case
with the Fed's QE program after the crisis.So without a return of confidence
in 2016, perhaps it will come down to how much fear is needed to generate
concerted and aggressive action by governments and central banks in the
coming months.
The U.S. Congress abdicated much of its authority to the Fed in the wake
of the credit crisis; Congress must reassert its authority in the nation's
fiscal affairs, however.Businesses and investors would find renewed
confidence in the economic outlook if taxes were lowered and regulatory
burdens were lifted.The current administration has done much damage to the
economy by way of increasing both, which has added to the uncertainty among
investors and has hindered capital investment.
Of the two major factors - confidence and fear - it would appear the safer
bet that fear, rather than confidence, will be the dominant force behind
efforts at reversing the damage caused by the global economic slowdown in
2016.
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