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International Market by Martin Pring’s InterMarket Review (February 2015)

Our Stock Barometer remains on its buy signal, but barely so at a 50% reading (49% would turn it bearish). Further deterioration could come with a break by the S&P Composite below its 12- month MA, which in February is estimated to be in the 1980/90 neighborhood. One usually reliable component, the yield on 3-month commercial paper, is somewhat problematic for the current cycle. This series goes bearish for the Barometer when it crosses above its 12-month MA. The intention is to signal the first step in the tightening process. However, with rates so low it is uncertain whether a current rate of .155 compared to the average .135 is really as bearish as it normally would be. Our position is that we will be inclined to go with the bearish signal if the Barometer does go bearish and is joined by several other reliable long-term indicators.

Longer-term Indicators

Chart 10 features one of these indicators. It is derived from the ratio between the S&P Composite and M2. A rising ratio is bullish since it indicates that stocks are responding positively to an expansion in the money supply and vice versa. The series we are monitoring is a smoothing of its 48-month ROC (the thick red line in the bottom panel). Bear signals are triggered when it peaks from a moderately overstretched level or higher. Occasionally, a false negative is triggered, as was the case at the end of 2013, but by and large the majority of the signals are valid. We see a very fine balance in the current situation with the indicator at a relatively high reading and starting to keel over to the downside.

Chart 11 introduces commodity momentum into the formula. Our stock/commodity model works on the theory that unstable commodity prices are bearish for equities. It moves into a negative mode when one of two conditions is in place. The first is when the 10-month ROC of both the deflated S&P and the CRB Spot Raw Industrials are below zero; i.e., stocks have started to react negatively to falling commodity prices. Alternatively, the system goes bearish when the differential between the 8-month ROC of commodities and equities favors commodities by a number greater than 20%. In other words, when commodity prices become unusually unstable on the upside and equities are failing to respond in a positive manner, equities usually succumb with a decline. Commodities are currently in a negative mode, but the 10-month ROC for equities is still positive. That means the model is bullish and will remain so, unless the inflation adjusted S&P falls below its level 10-month average. Since the CPI is pretty stable at the moment that would probably mean a drop in the nominal S&P. For the record, the 10-month comparisons stand at 1885, 1923 and 1960 in February, March and April, respectively.

Last month we compared the rate of return on equities to the interest rate on government bonds by comparing the Shiller P/E to the yield on 30-year governments. It showed stocks to be at a record level of over valuation against bonds. Chart 12 uses the same approach, but substitutes Moody's Corporate BAA yield. The red arrows indicate when the ratio reverses through the overstretched 4.6 level or reverses just below it. There have been 9 such signals since 1929 and only two (flagged by the dashed arrows) have failed. This relationship is in record territory at this time and still advancing. It is clearly demonstrating that the elastic is getting fully stretched and in danger of snapping at any time, but since it is still rising, a sell signal has not yet been generated.

The two brown dashed horizontal lines show that the 1929 and 1966 secular peaks became important pivotal points that turned back many subsequent rallies and reactions. The fact that the deflated S&P has returned to the 2000 peak could be highly significant for price action in 2015 as it should represent important resistance.

Equities and the Economy

In almost all cases the stock market discounts future economic developments. Two notable exceptions developed in 1927 when the market refused to buckle to a recession and 2002 when it ignored the initial stages of a recovery by selling off. It is generally a good idea to have the economy on your side when forecasting equity prices. At the moment, the vast majority of leading indicators are pointing to fair weather ahead, as is the consensus of economists. The recent employment report has also encouraged commentators to become more confident and this has generated a 6-year high in the University of Michigan Consumer Confidence indicator.

Even so, the data are starting to reveal some weakness in certain indicators that have offered fairly reliable omens in the past. At the end of a cycle it is normal for commodities and interest rates to rally as the system tightens. This sucks out purchasing power from consumers and subsequently causes the overall economy to roll over. Something unusual has started to happen in the current cycle as eight years of overbuilding in the commodity arena, combined with a slowing demand from China, the world's largest consumer, has resulted in commodity prices peaking ahead of their normal business cycle sequence.

The beneficial effects on commodity consuming countries are well-known, but sharply falling commodity prices adversely affect capital spending as well. In the US, that could mean a reduction in job creation as the shale boom comes to an end. The bottom line is that these deflationary forces could reduce the lead time of many economic indicators this time around. That's why we need to pay close attention to those that have already started to deteriorate.

In that respect, the ECRI Weekly Leading Indicator has already crossed below its 12-month MA and 6-year recovery up trendline (Chart 13). The vertical lines represent the onset of recessions, which are highlighted in red. Relating these lines to the trend deviation indicator in the bottom panel shows that zero crossovers have consistently signaled recessions, with the exception of one false negative in 2011. The indicator was poised to cross its zero reference line again at the end of January. Crossing zero would not guarantee a recession by any means, but the current position of the indicator and its consistent track record tells us that it is not impossible for the consensus view to be wrong as a recession develops sooner, rather than later.

We see a similar setup in Chart 14, which features our Growth Indicator, another leading composite momentum measure of the economy. The vertical lines reflect negative zero crossovers. Note that pretty well all of them were followed or preceded a stock market correction of some kind. The current reading is very slightly in negative territory.

A final economic indicator that has consistently signaled recessions is our Pring Turner Leading Indicator (PTLI). This series, shown in Chart 15, has led every recession but one since 1955, but did call a "fake" contraction in 1966. Recessions are signaled when its trend deviation series in the bottom panel crosses below zero. For the last couple of years this series has been in a trading range comfortably above the zero line. In the past when ranging action such as this has been resolved on the downside, a process of deterioration preceding a recession has been signaled. Its ability to remain above the lower boundary of the trading range demonstrates this process is not yet underway and is one of the reasons why, right now, we are not prepared to read too much into the ECRI LEI weakness.

Intermediate Indicators

Chart 16 shows the current technical structure does not come without some negative warnings as we see the number of inverted bearish newsletter writers (source Investorsintelligence. com) at an extended level. Please note that the data have been inverted to correspond with price movements. Unfortunately, this is not a precise timing device. In the past though, it has been possible to construct meaningful trendlines whose violations have followed market declines of some kind. As a result, we are watching the 2012/14 up trendline quite closely to see when it experiences a downward penetration. The signal would come with a rise in bearish newsletters to the 18% level.

The Hamilton Bolton weekly A/D line (Chart 17) has been a great market indicator over the years, mostly offering up valid positive and negative divergences with the S&P. Previous divergences are highlighted by the red and green arrows. Since the middle of last year the A/D line has been weakening as the S&P has been strengthening. This, of course, is just a warning that the underlying structure is weakening, but actual confirmation requires the S&P to break trend. That would happen with a Friday close below the bull market trendline around 2000. In the meantime we are watching to see whether the potential head and shoulders top in the A/D line turns into an actual one.

One indicator that has fairly consistently warned of trouble is our Intermediate Health series, shown in the bottom window of Chart 18. Intermediate Health monitors a basket of S&P Industry Groups with a rising intermediate KST and usually turns ahead of the intermediate KST for the S&P Composite. In the current situation though, the S&P KST peaked first. With both series declining, we have some strong signals though this may result in widespread market weakness.

Inter-Asset Ratios

Two inter-asset ratios recently broke against equities. The first is the Stock/Bond ratio, displayed in Chart 19, which completed a head and shoulders top. It is being supported by three declining KST's suggesting bonds will continue to out-perform stocks for some months to come.

Chart 20, shows that stocks have also tentatively broken down against gold. This relationship is also being supported by universal KST action.

These two breaks say nothing about the direction of the absolute price action of stocks, although when they are out performed by bonds and gold it is usually a bearish factor.

Sector Watch

Charts 21 and 22 overlay the long-term KST for sectors that do well in the early (defensive) and late (earnings driven) part of a bull market. Looking at Chart 21, we see a rising KST for utilities, health care, REITS and consumer staples. Late cycle strength is concentrated in the gold share and technology sectors as shown in Chart 22. You will notice this is where the bulk of our industry group/sector recommendations on page 3 have been recently focused.

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