Tuesday, February 3, 2009

Where are we in The Economic Cycle?

Based on John Murphy's definitions lets take a look at the economic picture and see where were lie and what to look for when the recovery begins.

First up are four factors Murphy has defined for monitoring the economy:

As John Murphy states in his book "Intermarket Analysis"

Consumer Expectations are very important because consumer spending accounts for two-thirds of the economy.

Consumer sentiment first bottomed in June 2008 then staged a modest bounce; it subsequently retreated to June lows in November and has only recently started to recover. It is in the process of "reviving", but likely won't classify as "rising" until it gets past 70. On past form this could take another 6 months.

What of Industrial Production?

Industrial Production (IP) is one of the most widely followed measures of economic activity. During a recession, with business and consumer spending on the decline, Industrial production is falling. When IP starts to rise, it is am early sign that the economy is recovering.

Little comfort in these figures. The 3-month trend is squarely down and the monthly data is riding below the average. When individual sectors are considered only Ultilities are growing, these having bottomed in August 2008. Consumer confidence leads IP so it could be 6-12 months before we see a meaningful recovery in IP. This will delay the recovery because by definition IP is still "falling".

Interest rates are relatively straightforward

A rapid rise in interest rates usually occurs in the late stages of economic recovery, which contributes to the eventual recession. Conversely, rapidly falling interest rates during a recession contribute to the eventual economic recovery.

Looking at the iShares Lehman 20-yr+ Treasury ETF (TLT) a clear top in bong prices (bottom in yield) can be seen in December 2008. Tops rarely confirm in a 'V' fashion so a second rally may kick off around $100 to take it close to $123, although the second rally may stall out around $118. Interest rates look to be "bottoming" but this process will probably take longer than people expect given the Fed has no more leeway to lower rates any further than it has.

As for the Yield Curve

During an economic recovery, the yield curve has a tendency to flatten out. This means that short-term rates are rising faster than long-term rates and the spread between the two flattens. The crucial point comes when short-term rates exceed long-term rates. It is a dangerous situation called an inverted yield curve and is usually an early sign of an economic contraction

The current Yield Curve looks decidely 'normal' and fits with the definition of a Recession.

From these four factors it would appear the next recovery will lead with Consumer confidence pushing above 70, followed by an uptick in IP. Interest rates are already in a favourable environment for a recovery (along with depressed commodity prices).

Value buyers may want to sniff around Industrial (XLI) and Basic Material (IYM) stocks in anticipation of a recovery. The action of Institutional buying will reflect in the charts with flat-lined moving averages and a major capitulation low holding (last November?) as support.

For the Basic Materials group I have made a YourCall for a move to $61.59 wth a stop at $30.49 within the year. It's a tall order but it is nicely set for a decent 2009.

Consumer data sourced from Reuters.
Industrial Production from the Fed.
Yield Curve from Stockharts.

Dr. Declan Fallon, Senior Market Technician, Zignals.com the free stock alerts, market alerts, and stock charts website