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Market Distortions

We are all well aware how central banks have distorted markets. Old relationships no longer hold true because of these interventions. For example, markets use to rise on increasing volume and good breadth lending believability to a price move, but now they just go up regardless of market internals. This is just one simple sign that things have changed. Yesterday, I pointed out another with the Rydex data. The paucity of buy signals as price has lifted use to be a sign of a market top now it is the "new normal". These are just some of the new dynamics in this liquidity induced environment.

There are many others I am sure, but I have been mulling over another very important signal that has been rendered useless in this environment. This is the Economic Cycle Research Institute's Weekly Leading Growth Index (WLI). The WLI is considered a leading indicator of the economy, and the WLI has signaled recession twice in the past 2 years. Of course, we know how well that has worked out. Figure 1 is a weekly chart of the SP500 with the WLI (growth) in the lower panel. The red labeled price bars are those times when the WLI (growth) is less than a reading of -2.4. According to Doug Short at d.short.com, "a significant decline in the WLI has been a leading indicator for six of the seven recessions since the 1960s. It lagged one recession (1981-1982) by nine weeks. The WLI did turned negative 17 times when no recession followed, but 14 of those declines were only slightly negative (-0.1 to -2.4) and most of them reversed after relatively brief periods." So my recession threshold is -2.4 and this is indicated by the red line in figure 1.

Figure 1. SP500/ weekly
S&P 500 Weekly Chart
Larger Image

Back in quarter 3, 2010 Lakshman Achuthan, the Co-founder of ECRI, stated that the US economy was not going into a recession despite the low reading from the WLI (growth). Of course, we all know that Q3, 2010 was when the Federal Reserve announced QE2. Now I doubt Achutan had knowledge of QE2, but clearly this infusion of liquidity did avert a recession and turned the leading indicators higher. Curiously, the market didn't top out until the WLI was safely above zero, and the QE2/ POMO operations dried up.

Now fast forward 6 short months to quarter 3, 2011. The WLI (growth) is back below -2.4 (the price bars are red on figure 1), and ECRI's Achuthan has put out the following announcement: "Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession. And there's nothing that policy makers can do to head it off. ECRI's recession call isn't based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down -- before the Arab Spring and Japanese earthquake -- to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not "soft landings." And two months later in December, Achuthan reaffirmed his recession call in this video from Bloomberg. Of course, Q3, 2011 was the start of the Fed's Operation Twist, and the ECB has also expanded its balance sheet significantly since that time. All this has created a market that can't fail or isn't allowed fail.

So far it appears that Achutan's statement about policy makers ability to avert a recession is wrong. The Fed averted a recession in 2010 and it appears their coordinated interventions with the European Central Bank are having the same effect here in 2011 and 2012. Central bankers have opened the monetary spigots when the WLI (growth) was consistent with recession, and the markets bottomed. I suspect that the WLI (growth) remains a robust metric, and a good leading indicator of the economy. However, central bank interventions have led to distortions in the markets and economy that their indicators are unable to pick up.

If the WLI (growth) turns positive, I am curious if the Fed will take its foot off the monetary pedal. When QE 2 ended, the markets fell apart. I suspect some of the talk concerning another round of QE despite the "improving" economy targets this very dynamic. No reason to have that happen again. Right?


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