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The Stock Market Rally... To Nowhere

Submitted by Lance Roberts via STA Wealth Management,

Has Consumer Confidence Peaked?

The latest reading of consumer confidence (103 for September) was a bit of head-scratcher. With the market in the midst of a 10% correction, layoffs rising, job, wage growth stalling, and China on the verge of implosion, how could confidence rise? 

While the media, and the Federal Reserve, focus on lifting asset prices to spur consumer confidence, as I discussed previously, such actions have relatively little impact on the vast majority of American's currently. However, there is a very high correlation between actual economic activity and consumer's confidence as shown in the chart below.

This should not be a surprise since consumers drive roughly 70% of economic growth. When the economy slows down enough to curtail consumer actions, confidence will once again drop. 

For investors, however, the question of the relationship between confidence and market behavior is more important. The chart below shows consumer confidence as compared to the S&P 500 index.

Sharp contractions in confidence have historically been coincident with sharp declines in the market and the onset of economic recessions. Currently, the decline in the market has not resulted, yet, in a decline in confidence as only a small portion of the economic makeup has been affected by the drop. Furthermore, the drop in the markets has not been dramatic or sustained long enough to break the "hope" of a continued "bull market."

However, if we look at the annual rate of change in the S&P 500 as compared to confidence, a potential warning signal emerges. 

Declines in the rate of change of the financial markets have generally preceded more marked declines in confidence as well as economic activity. Due to the rapid onset of the recession and market decline in 2008, the declines in both measures were more coincident.  

Currently, the annual rate of change in market performance has been declining since the beginning of 2014 when the Federal Reserve began extracting excess liquidity from the financial markets. This suggests that the current levitation of confidence will likely be transient unless market performance begins to reaccelerate. 

While there is indeed a correlation between rising asset prices and consumer confidence, the relationship between confidence and economic activity is significantly more important. With the recent decline in asset prices, a slowdown in economic activity in the quarters ahead will likely have a bigger impact on confidence than currently anticipated. 

GDP Forecasts Remain Weak

The Federal Reserve Bank of Atlanta publishes a weekly, "real-time" look at the economy in their GDPNow economic forecast model. As shown below, the model, currently forecasts a significantly weaker 3rd quarter GDP than even the most bearish current consensus estimate.

This is important because it confirms the Chicago Fed National Activity Index (CFNAI) which, as I have discussed in the past, is the single most important, and overlooked, economic number. To wit:

"And of all the indicators I've tested, the CFNAI has the best track record of forecasting future GDP. Since 1980 the CFNAI has explained roughly 40% of the variation in the following quarter's GDP, an extremely high proportion for a single indicator.


To assess that predictive capability I have created a second 4-panel chart with the four CFNAI subcomponents compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. For comparative purposes I used the annual percentage change for each of the four components."

"The correlation between the CFNAI subcomponents and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy."

Importantly, as with the GDPNow indicator, the CFNAI is showing that the economy is running weaker than headlines have suggested.

Despite Central Bank interventions, suppressed interest rates, and a surging stock market, the economy has failed to gain any significant traction. This is an anomaly that we can also see in the CFNAI data.

If we break the CFNAI down into a "supply" and "demand" model we see a very interesting, and telling, picture emerge.

As shown the supply side of the index has historically had an extremely high correlation to the demand side. That ended with the financial crisis. Since then the supply components have far outpaced the actual underlying demand in the economy. This goes a long way to explaning the ongoing weakness in economic growth as the lack of aggregate demand continues to weigh on labor and wage growth. 

Until demand rises to a level strong enough to absorb the existing supply, economic growth will continue to "muddle" along. 

Stock Market Rally To....Nowhere?

This past Tuesday, I discussed the potential for a short-term rally in the market stating:

 "As you can see, the markets did retest the late August lows, and when combined with the very oversold conditions, led to a frantic 'short covering' rally back to previous resistance. It is worth noting that the recent market action is very similar to that of the August decline and initial rebound as well."

Importantly, while the market has rallied back to its previous resistance levels, it has also become extremely overbought once again as well. This suggests that a bulk of the rally from the lows is complete, and investors should continue to "fade rallies" until a more bullish trend resumes.

However, for that more "bullish" outlook to take root, the market will need to rise above 2060 currently. The problem will be the strong level of resistance provided by the two long-term moving averages that have only crossed during more severe market corrections. 

With a large number of technical indicators currently suggesting that the easiest path for prices is downward, investors should remain cautious of overly aggressive exposure in the short-term. If the market is still confined within a more "bearish" trend, the current rally, like the ones that preceded it, will be a "rally to nowhere."

Just something to think about.