LPL: 10 signs of another spring slide

The following is excerpted from LPL Financial’s market commentary research for the week of March 26. To read the full commentary, click here.

In both 2010 and 2011 an early run-up in the stock market, similar to this year, pushed stocks up about 10% for the year by mid-April. On April 23, 2010 and April 29, 2011, the S&P 500 made peaks that were followed by 16 – 19% losses that were not recouped for more than five months. While late April is still four weeks away, judging by what indicators seemed to precede the declines in 2010 and 2011, we have identified 10 indicators to watch over the next four weeks.

The 10 indicators include:

1. Fed stimulus – In each of the past two years, Federal Reserve (Fed) stimulus programs known as QE1 and QE2 came to an end in the spring or summer and stocks began to slide until the next program was announced. The current program known as Operation Twist was announced on September 12, 2011 and is scheduled to conclude at the end of June. The stock market may again begin to slide until another program such as QE3, the scope of which was recently hinted at by the Fed, is announced.

2. Economic surprises – The Citigroup Economic Surprise index measures how economic data in the United States fared compared to economists’ expectations. A rising line indicates that the data is consistently exceeding expectations. A falling line suggests expectations have become too high. The index moved to what has historically marked the peaks in optimism about a month or two before the peaks in the stock market in 2010 and 2011. This year, it appears the index may have already started to retreat from a peak since early February; if this index again leads by two months the slide may soon begin.

3. Consumer confidence – In 2010 and 2011, early in the year the daily tracking of consumer confidence measured by Rasmussen rose to highs last seen on September 5, 2008, just before the stock market collapse as the financial crisis erupted. The peak in optimism gave way to a sell-off as buying faded. Investor net purchases of domestic equity mutual funds began to plunge and turned sharply negative in the following months. This measure of confidence is once again close to the highs seen in early 2010 and 2011; we will be watching for a turn lower in the index that would indicate the start of an erosion of confidence.

4. Earnings revisions – The first couple of weeks of the first quarter earnings season (April 2010 and April 2011) drove earnings estimates higher in both 2010 and 2011. Earnings estimates for S&P 500 companies over the next year rose a greater-than-average 3 – 5% over the first couple of weeks of reports. But as the second half of the earnings season got underway in May 2010 and May 2011, guidance disappointed analysts and investors as the pace of upward revisions declined sharply. This year, we will be watching to see how much earnings expectations rise as the initial reports come in and if they begin to taper off sharply.

5. Yield curve – In general, the greater the difference, or spread, between the yield on the 2-year and the 10-year U.S. Treasury notes, the more growth the market is pricing into the economy. This yield spread, sometimes called the yield curve because of how steep or flat it looks when the yield for each maturity is plotted on a chart, peaked in February of both years at 2.9%. Then the curve started to flatten, suggesting a gradually increasing concern about the economy. This year the market is pricing a more modest outlook for growth, but we will be watching to see if the recent slight decline in the spread (currently about 190 basis points) begins to decline.

6. Oil prices – In 2010 and 2011, oil prices rose about $15 – 20 from around the start of February, two months before the stock market began to decline. This year oil prices have climbed back to the levels around $105 – 110 that they reached in April of last year. However, they have risen only about $10 since around the start of February 2012. A further surge in oil prices would make this indicator more worrisome.

7. The LPL Financial Current Conditions Index (CCI) – In 2010 and 2011, our index of 10 real-time economic and market conditions peaked around the 240 – 250 level in April and began to fall by over 50 points. This year, the CCI recently reached 249 and has started to weaken and currently stands at 232.

8. The VIX – In each of the past two years the VIX, an options-based measure of the forecast for volatility in the stock market, fell to a relatively low 15 in April. This suggested that investors may have become complacent and risked being surprised by a negative event or data. This year, the VIX has recently declined once again to 15 in the past two weeks.

9. Initial jobless claims – It was evident that initial filings for unemployment benefits had halted their improvement by early April 2010, and beginning in early April 2011, they deteriorated sharply. So far, in 2012 initial jobless claims continue to improve at a solid pace, but it may yet be too early, and so we will be watching for any weakening as April gets underway.

10. Inflation expectations – The University of Michigan consumer survey reflected a rise in inflation expectations in March and April of the past two years. In fact, in 2011, the one-year inflation outlook rose to 4.6% in both March and April. This year, inflation expectations have also jumped higher so far in March, reaching 4%. While this list may seem incomplete, it is notable that many of the most widely watched indicators of economic activity such as manufacturing (the Institute for Supply Management Purchasing Managers Index known as the PMI or the ISM), job growth, and retail sales, among others, did not deteriorate ahead of the market decline, but along with it. It is not that they are not important; it is just that they did not serve as useful warnings of the slide to come, while the above indicators did.

So far, about half of the 10 indicators point to a repeat of the spring slide this year, while the other half do not. We will continue to monitor these closely in the coming weeks.

Jeffrey Kleintop is the chief market strategist for LPL Financial.