Wells Fargo warned today that the U.S. could be entering a recession and the equity market took the news badly.
While numerous analysts have been warning of an impending recession, the market has ignored their claims and rallied to within 2% of the all time highs. The news out today carried a lot more weight because there was data to back it up.
First, the Fastenal CFO, Daniel Florness, warned "The industrial environment is already in a recession. I do not care what anybody says, because nobody knows the market better than we do." Fastenal (Nasdaq:FAST) sells wholesale industrial and construction supplies like bolts, nuts, screws, etc, which are used in manufactured products in the U.S. and internationally. They should know if manufacturing is slowing because demand for components is slowing.
Secondly, the Railway Supply Institute (Rsiweb.org) said third quarter railcar orders declined -83% to hit their lowest level in 27 years.
Third, FBR reported that orders for class A trucks declined -45% in October. In addition, BB&T reported that production of railcars, trucks and trailers would likely fall -20% to -35% in 2016 according to preliminary estimates.
That brings us to the Wells Fargo warning. After the order data was released the bank said over the last 45 years ANYTIME orders for machinery and transportation equipment declined, as is happening today, a recession followed. The bank said the risk of a recession was accelerating as we head into 2016.
We have other indicators that agree with the warning from Wells Fargo. Copper prices hit a six-year low this week. Copper is known as "Dr Copper" because of its ability to predict a downturn in the economy. Copper is used in almost every piece of electrical equipment made today. In addition, there is roughly 400 pounds of copper in every new home and thousands of pounds in new buildings. New cars have more than 55 pounds of copper. With copper demand plunging it suggests the demand is falling dramatically. Some of the decline is related to the strong dollar but the majority of the drop is related to demand.
Crude oil prices are also crashing. In the big picture, this is due to excess production. However, we have too much production because demand has not kept pace with prior cycles. Typically, a sharp drop in oil prices from an imbalance in supply and demand will immediately create a sharp spike in demand. While demand is rising, the pace is slower than in prior recoveries. This has pushed crude prices to a post financial crisis low.
The drop in oil prices has created a windfall for the U.S. consumer. The current national average for gasoline prices is $2.20 but 28 states have prices under $2.00. This has given the average driver an extra $700 to spend over the last year. However, they are not spending that money at the malls.
In the recent earnings cycle, the majority of brick and mortar retailers reported weak sales and lowered their outlook for the coming holiday season.
Consumers are struggling to pay the bills. Over the last 8 years, the average worker's pay has declined about $3,500 while their expenses for healthcare have gone up dramatically. With insurance deductibles rising from $500 a month on the average policy to several thousand in the current environment, consumers are running out of money. Any minor sickness that requires a visit to the hospital produces a bill that takes months to pay.
More than 94 million people are out of the workforce with the real employment rate (U6) at 9.8% (15.484 million) rather than the 5.0% (7.9 million) commonly reported in the press. The economic reporters were all excited last week then the number of people employed part time because they could not find a full time job fell -269,000 to 5.8 million.
It was reported today that more young people are living with their family than any time since 1940. Over 36.4% of young women ages 18-34 are living with parents with 42.8% of young men doing the same. They are not doing it because they like living at home. They are living there because they cannot support themselves on their own.
Are we really headed for another recession? The average time for a business cycle is 5.5 years. This rebound cycle started in June 2009 and is over six years old and most analysts expected it to continue through 2016 and then run its course. However, growth has been anemic and is on track for only about 1.7% in 2015. This anemic growth came after the Federal Reserve poured $4.5 trillion of stimulus into the economy and kept interest rates at zero for the last 7 years.
The Fed wants to begin hiking rates in 2015 because they know the business cycle is about to roll over and they need some room to maneuver when the next recession begins. They want to get 3-4 hikes into the system before the end of 2016 but they may not have that ability if the recession appears sooner than expected.
The equity market is finally paying attention to the weak economics and the weak earnings. The S&P ($SPX) rolled over after six weeks of gains and today it crashed through the support of the 200-day average at 2,064. This is a critical event because fund managers watch the 200-day as an indicator of market direction. The simple explanation is when the S&P is above the 200-day they tend to buy stocks. When the S&P falls under the 200-day they tend to sell stocks.
The recession scenario I described above will not likely occur until 2016. That means fund managers and investors are free to trade the historical trend until the calendar turns over and the new year begins.
November is the start of the best two and six month periods of the year. Typically, the first week is bullish and is the strongest week of the fourth quarter. The second week is typically negative as fund managers remove the window dressing they added at the end of October. The end of October is their fiscal year end and they want to be fully invested in winners for those end of year statements. As long as the market continues higher in November, they keep those positions in place. Once the market starts to falter, they dump those extra positions to raise cash in case there is a buying opportunity ahead. We are seeing that "window undressing" this week.
As option traders, we like to buy bottoms and sell tops. The break below the 200-day average suggests there could be further weakness ahead. However, fund managers are either barely breaking even or are negative for the year and they will want to buy stocks once a bottom appears. They need to earn some money before 2015 is over or they could be out of a job. Typically, the Russell 2000 small caps are the fund favorites as we head into the end of the year.
Rarely do the markets fail to rally in Nov/Dec. Even in times of stress, the calendar seems to rescue victory from the jaws of defeat. In this case, I would look to buy a call option on the Russell 2000 ETF (ARCX:IWM) and hold it until just before Christmas.
The Russell ETF has support at $113.00 and that would be a logical point to make an entry. If the IWM declines to the vicinity of $113, I would buy the January $115 call option, currently about $3. If the Russell just returns to the highs from last week at $119, you could double your money. If it moved higher ahead of the Christmas holidays at say $125 you could triple your money.
If the IWM does not decline further and begins to rebound, I would buy the January $119 call with an IWM trade over today's high at $116.50.
Bear in mind that the decline on Thursday could have been event driven and a one-day wonder and the IWM may not return to $113. Sometimes investors have a very short memory and today's disaster headline can be replaced by tomorrow's bullish headline. You should always be aware there is no guarantee that any support level will hold. Never invest money you cannot afford to lose.
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