Out with a Bang!

Out with a bang!  Perhaps “out with a tweet” is a better headline, as markets capped the worst year for equities since 2008 with a rally sparked by a Trump tweet suggesting great progress in negotiations with China.  Though it was a nice way to end a turbulent year, it was not enough to erase the headlines: Worst December for the S&P500 and Dow Jones since the Great Depression and worst year for the indexes since 2008!  Yeah that seems pretty bad.  On the bright side, the S&P 500 ended the year down only -6.24% versus -38.49% in 2008.  For further cold comfort, in 1931, at the height of the Depression, the S&P500 fell -47.07%.  The Great Depression lasted from 1929 starting with the October market crash and lasted through 1939.  We are nowhere near that type of calamity (or 2008 for that matter), so while 2017’s losses are no cause for celebration, we need to take all of the headline comparisons with a grain of salt.  The simple fact remains that markets can’t always just go up and while it was indeed a difficult year for many investors, it should serve as a reminder that in order to be a successful investor, one must take a long term view and maintain diversified portfolios to minimize potential losses during tough times.  On Monday, the S&P 500 climbed +0.85%, the Dow Jones added +1.15%, the Russell 2000 index rose +0.29%, and the NASDAQ 100 advanced by +0.71%.  While all of the indexes, but the Russell, have advanced past their key lower Fibonacci resistance lines, they are all still in negative longer term trends with negative momentum.  All of the major indices remain risk off.  In the coming months, I will be spending more time detailing the behavior of the bond market as it is typically looked at as a leading indictor to the broader markets.  The primary reasons for this are that they are most sensitive to economic performance, they are directly related to interest rates, and they are predominantly traded by institutions managed by professional managers.  Although the adjective “professional” doesn’t always guarantee success, those managers typically have access to more data and spend all of their waking hours analyzing it.  Stocks on the other hand are more widely held and are far more subject to emotion and crowd psychology so it is more difficult to predict economic health by their behavior.  Bonds also closed the year with a rally with ten year yields ending the session at 2.68% around 28 basis points higher than the close of the prior year.  The 2/10 yield curve flattened slightly to 19 basis points after starting the year at 51 basis points, which is certainly a tell-tail sign about what bond traders are thinking.  The year ahead will certainly be one in which investors are searching for any advance signs of economic slowdown, which makes all of the daily economic releases I talk about that much more important. Today we will get the Markit PMI release which is expected to be at 53.9, flat from last month’s figure.  PMI stands for purchasing managers’ index and is always an important number in China (last night featured a less-than-good one) and will become an increasingly important one in the US in the year ahead.  Because it is Geek-out Wednesday I will go into a bit more depth on PMI.

PMI, or purchasing managers index, is produced by several sources and is considered a critical and fairly accurate leading economic indicator.  The indicator describes the health of the manufacturing and services sectors of the economy.  The index is compiled by surveying purchasing managers’ activity across 10 key areas as follows:  New customer orders, production levels, employments, supplier deliveries, inventories, customer inventories, prices, order backlogs, new export orders, and material imports.  Purchasing managers are asked whether their past month’s activity in these key areas increased, decreased, or stayed the same.  All of the respondents questions are then compiled into what is referred to as a diffusion index.  A diffusion index indicates how widespread, or diffused activity might exist.  In the case of PMI, it is calculated as follows:

PMI = (P2 * 0.5 ) + P1

Where:

P1 is the percentage of respondents that experience an increase in activity

P2 is the percentage of respondents that experience no change in activity

For example if 35% of respondents report that new customer orders have increased, 55% report no change, and 10% report a decrease, the index is calculated as follows:

(55% * 0.5) + 35% = 62.5%

An index level of 50 means that there has been no change in activity while a reading of 100 indicates that all respondents are experiencing growth.  A reading of 0 would mean that all respondents are experiencing a decrease in activity.  Additionally, the farther away the indictor is from 50 the more it is diffused.  So an index of 80% represents greater growth than 60%, as it is spread out amongst more respondents.  On the decrease side, a reading of 25% is a greater slowdown than an index of 40%.

The manufacturing PMI is finally calculated by creating an equally weighted average of all of the different query areas and a reading that is greater than 50 indicates an increased activity in the manufacturing sector and vice versa for readings less than 50.  What makes this number so important?  Manufacturing of goods is at the heart of an industrial economy and precedes all other activity in the economy as a whole.  A car must first be manufactured before a consumer can purchase it.  To take the auto example further, if a purchasing manager at Ford receives increased orders for automobiles, they would increase orders of parts from component manufacturers and hire more employees.  Component manufacturers who get the increased orders will themselves increase materials orders, employment, and production.  You can see how PMI can paint a fairly accurate picture of manufacturing activity.  The PMI’s importance actually extends beyond just a report as many purchasing managers use the releases to determine their own purchasing decisions factoring the number into their projections.  Several firms compile a PMI and the most prominent are the Markit Group and Institute for Supply Chain Management (ISM).  The Markit PMI, which will be released later this morning includes manufacturing and services while the ISM number (which is more closely followed) is limited to the manufacturing aggregate.  That ISM number will be released tomorrow and it is expected to come in at 57.6 versus last month’s 58.4. It is important to note, that while manufacturing activity is an important economic health indicator, manufacturing only represents about 20% of GDP which is dominated by services.  The ISM also releases a non-manifacturing PMI which better represents the services sector.  In emerging market economies such as China, where manufacturing dominates economic output, a manufacturing PMI number is a critical read on its economy.  Just last night WHILE YOU SLEPT the Chinese Caixen PMI showed a fall to 49.7 which is consistent with the “official” government release.  If you followed me this far, you will note that the reading represents a slowdown in economic activity.

Today, being the first day of a new year, will feature a further rebalancing activity that could not be completed last week.  Traders and institutional managers will begin to slowly nibble on new positions, which may help to lessen the volatility we experienced in the latter part of December. Traders will also head to the trading pits with a clean slate attitude, which will hopefully help improve investor sentiment which ended the year in trepidation.  It will take a lot more than attitude to turn the downward trending markets around however.  I am an optimist so I like to refer to the winter solstice, which occurred a few weeks back.  The solstice is the day of the year with the longest night.  That is to say that is the darkest day of the year.  The optimist in me notes that every day after the solstice features a longer day – every day gets lighter.  Please call me if you have any questions.

daily chartbook 2019-01-02