Chart 3. VIX 2011 YTD
Next a quick rundown of fundamentals. In Chart 4 you can see a history of the Kansas City Financial Stress Index (KSFSI) and the Chicago Fed National Activity Index (CFNAI). While both are in “bad” territory (Positive financial stress and negative activity index) they are not quite at the levels that have predated the last two recessions.
Chart 4 KSFSI,CFNAI and U.S. Recessions
However, when we zoom in, in Chart 5 you can see that the two indicators are heading in different directions in terms of indicating an improving economy. While the Chicago Activity index rose over the last month, so did the financial stress index. The theory behind the two indexes is that economic activity will be pulled lower if financials stress continues to increase.
Chart 5 KSFSI and CFNAI January 1, 2011 – September 30 2011
On this note, I have to throw in one slightly troubling chart. While earlier I noted that the absolute drop in JNK could be the result of rising level of interest rates. However, in Chart 6, we see that the bond market was not as enthralled with the Europe Solution as the stock market. The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt (“T-bills”). In Chart 7 you can see that the spread continued to rise through the market rally of the last week. The implication is that banks are even less reluctant to lend to each other now, then they were a week ago. This is not a good omen for future releases of the KSFSI.
Chart 6 TED Spread
But not to end on a sour note, I’ll finish with the prior graph of the CFNAI and KSFSI, but this time throwing in GDP in Chart 8. This is the source of my renewed optimism. GDP is at the highest level it has ever been.
Chart 7 CFNAI,KSFSI, and GDP
And yet, as we see in the final Chart 9, SPY is still well below prior peaks in both 2000 and 2007. In fact we are at levels first seen in 1999.
Chart 8 SPY Monthly from 1996 to present
Putting it All Together
Not surprisingly the Europe Solution is being scrutinized and the analysis is not as positive as the initial reaction. There are certainly some big holes. Seriously, who is going to step forward and “voluntarily” accept a 50% haircut on Greek bonds? And while there is to be a trillion Euros available to recapitalize European banks, where exactly will it come from, and at what price? At this point the stock market is only a couple percent positive on the year and trading at a modest 13 times earnings. Not where you’d expect a “euphoric” market to be.
But what this appears to have accomplished is to buy significant time. Time for Europe to put its financial house in order. And as long as we can see some sort of begrudging movement, it leaves room for the U.S. to move up (or down) based on our own fundamentals
With the important 200 SMA breached to the upside for SPY, our modified trading signal will have us wait a few days to see if it holds. If so I will move our ETF Growth Cycle Portfolio into higher beta ETF’s to take advantage of the seasonality cycle that favors the November to May period. Our dividend portfolios have been fully invested since around the time JNK crossed above its 30 day moving average. For new accounts in cash, I will be scouring our targeted dividend stocks for stocks that have not fully recovered from last quarter’s sell off. Even if ( and it is a big if), Europe is out of the way for now, a muddle through economy still looks probable. I like the idea of generating return through dividend yields.