Investment Contrarians

Latest Economic Data Enough to Keep the Stock Market Moving Higher?

By for Investment Contrarians |

300113_IC_cekerevacOne of the stock market’s most perplexing moves for both professional and retail investors is when the market, best represented by the S&P 500, moves in a direction that might be contrary to current conditions regarding economic growth.

This is one of the most difficult concepts to understand; that the S&P 500 does not represent current economic growth conditions, but what the market believes is highly probable for the future.

We have recently witnessed a substantial move upward in the S&P 500, yet only recently have we seen some positive signs that economic growth may be slightly improving. I stress “slightly,” because no one really expects economic growth for 2013 to be massive.

While jobs growth has been relatively weak, there have been some signs that suggest economic growth is resuming. However, with much of the data, there can be quite a lot of noise that can distort the underlying strength or weakness of economic growth.

One example of a data set that does point to renewed economic growth, though the fundamentals may not be quite as strong, is the recent HSBC Flash China Manufacturing Purchasing Managers’ Index (PMI), compiled by Markit Economics. In January, the China Manufacturing PMI came in at 51.9—a two-year high, up from 51.5 in December. The January China Manufacturing Output Index was 52.2—a 22-month high, up from 51.9 in December. (Source: “HSBC Flash China Manufacturing PMI™: Operating conditions improve at the quickest pace in two years,” Markit Economics web site, January 24, 2013.)

Initially, this seems to signal that economic growth in China is starting to resume, which would be bullish for the S&P 500. I also feel this information has greater legitimacy, as it is not conducted by the Chinese government, whose data can be questionable. However, a statement that worries me regarding just how strong the underlying economic growth really is comes from this remark by Hongbin Qu, Chief Economist, China and Co-Head of Asian Economic Research at HSBC: “Despite the still tepid external demand, the domestic-driven restocking process is likely to add steam to China’s ongoing recovery in the coming months.” (Source: Ibid.)

To me, this indicates that the optimism was due, in large part, to businesses rebuilding their inventory levels, not growth in end-user demand. This is similar to a retailer stocking up prior to the holidays, hoping for a strong season. It would be quite different if the index was rising due to strong demand from the end-user.

This is the type of economic growth data that might initially propel the S&P 500 higher, as investors project out 12 to 16 months; however, if sales do not pick up globally, we could be left with a glut of inventory in China.

Another recent data set worth mentioning is the Markit Flash Eurozone PMI, which was also positive, coming in at 48.2 for January versus 47.2 in December. The January reading was a 10-month high. All parts of the eurozone PMI index showed positive signs, including the services and manufacturing areas. While the PMI was below 50, signaling contraction in the eurozone’s economy, the move upward to 10-month highs gave some indication that economic growth was just around the corner. (Source: “Markit Flash Eurozone PMI™: Eurozone downturn eases as PMI hits ten-month high,” Markit Economics web site, January 24, 2013.)

While I don’t doubt the legitimacy of these new data, I do worry that sentiment might have moved too far ahead of reality. Most humans are optimistic by nature. We all want to believe that economic growth is just around the corner. Especially in Europe, the recent quiet in the credit markets has led many to believe that the worst is over.

Nobody can predict the future, but what we can do is look at probabilities and market sentiment. With the recent move upward in the S&P 500, while there are some signs that economic growth is destabilizing, we are not in a booming economy. Considering how high the S&P 500 has moved, it is quite possible that the market has priced in a great deal of good news already.

S&P 500 Large Cap Index Chart

Chart courtesy of www.StockCharts.com

The S&P 500 is now near the upper end of its trading range. The relative strength index (RSI) is showing a slightly overbought condition, which does not necessarily mean that the market will have to go down; however, it is starting to become overpriced.

Investors always want to get ahead of the curve. Many who have profited from the substantial increase in the S&P 500 will now need to see substantial economic growth to justify current valuations. Does this mean that the S&P 500 needs to fall immediately? Of course not; however, this does mean that economic growth numbers need to be substantially stronger over the next couple of months or we will see investors begin to take profits, which will lead to a lower level in the S&P 500.

I would never recommend calling a top or bottom in a market. I would, however, certainly urge caution for new funds being allocated into the S&P 500 at current valuations. The stock market is certainly pricing in an increase in economic growth. And while we have seen some positive signs, we don’t know yet if this is sustainable.

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