Volatile financial markets like those witnessed last week leave all investors, bulls and bears, uneasy about the world. The crosscurrents influencing U.S. equities are in many ways unlike anything we have ever seen. In situations like these, we always like to go back to the most important things in our arsenal of research … the things that are anticipatory of the economic outlook. Interestingly, series like the Monetary Flow Index or the relative performance of early cyclicals remain incredibly upbeat about the road ahead and see the four percent pullback in the S&P 500 as exactly that … a pullback.

In recent years, the most accurate series for forecasting U.S. LEIs have been inflation related. These charts remain very bullish at this time as the continued drop in inflation argues for more upside ahead for leading indicators. This also puts the crisis in Europe in a different light; indeed, the decline in commodity prices and the strength in the U.S. dollar witnessed in the wake of the recent turmoil in Europe are welcome news for U.S. consumers. Indeed, U.S. consumer confidence was able to rise to a new cycle high in April despite everything taking place in Europe. As we see it, there is a silver lining to all this and the U.S. consumer for now is the beneficiary. The following pages highlight the influence of Europe on U.S. markets … covering both benefits and disadvantages and, most importantly, key series to monitor. As always, feedback is most appreciated.

Volatile financial markets like those witnessed last week leave all investors, bulls and bears, uneasy about the world. The crosscurrents influencing U.S. equities are in many ways unlike anything we have ever seen. In situations like these, we always like to go back to the most important things in our arsenal of research … the things that are anticipatory of the economic outlook. Interestingly, series like the Monetary Flow Index or the relative performance of early cyclicals remain incredibly upbeat about the road ahead and see the four percent pullback in the S&P 500 as exactly that … a pullback.

In recent years, the most accurate series for forecasting U.S. LEIs have been inflation related. These charts remain very bullish at this time as the continued drop in inflation argues for more upside ahead for leading indicators. This also puts the crisis in Europe in a different light; indeed, the decline in commodity prices and the strength in the U.S. dollar witnessed in the wake of the recent turmoil in Europe are welcome news for U.S. consumers. Indeed, U.S. consumer confidence was able to rise to a new cycle high in April despite everything taking place in Europe. As we see it, there is a silver lining to all this and the U.S. consumer for now is the beneficiary. The following pages highlight the influence of Europe on U.S. markets … covering both benefits and disadvantages and, most importantly, key series to monitor. As always, feedback is most appreciated.

We remain bullish here and our reasons are fairly straightforward. On the U.S. front our outlook requires leading indicators of the economy to continue to move higher. Most series we look at that are anticipatory of U.S. LEIs argue that this remains the likeliest path in the coming quarters. Since LEIs bottomed back in the fall, the coincident data points of economic activity are also set to look much better. We would expect upside surprises to series like retail sales, employment and industrial production (see this AMs Small Business Confidence Survey that rose to a 14-month high). Another part of the story is a broadening of the recovery to Asia where we are seeing constructive data points. Indeed, the decline in inflation in China and the leadership of early cyclicals in both Korea and Australia’s markets are bullish signs. Note that the Chinese market was one of the best performers in April and seemed fairly impervious to events in the rest of the world.

It’s clear that developments across the pond have impacted U.S. equities. It is also fairly clear that some components of the risk trade changed as early as February when Spain issues began to flare up. There are a few things that are very important in this debate. First off, Europe’s problems are already heavily priced in. Can Europe’s issues be bigger than what investors have already discounted? Of course. Still, there are some bright spots. The most important one is that correlations across European equity markets have declined significantly in recent weeks. This means that  we now see days where Spanish and Italian equities move lower while the DAX manages to rise and vice versa. This is likely the result of LTRO doing its job in setting up a ring fence around core Europe. This essentially diminishes the influence of peripheral Europe on the rest of the world. We do not see the European issues being a deal breaker for US equities at this stage … these things will matter much more when LEIs are headed lower (likely later this year or early next). For now, we continue to expect a new cycle high in U.S. equities. Time will tell … as always.

The U.S. markets are right back where they were a month or so ago after nearly making it to a new cycle high. This volatility, and the change in investor sentiment that accompanies it, is unlike anything we have witnessed in years. It is a strange development to see the S&P 500 off a little over three percent from its cycle highs and investor sentiment sitting near cycle lows! Maybe the events of the past few years have scarred investors so badly that being bullish around volatility has become a thing of the past? The likelier culprit in our opinion is the large decline in the number of companies providing guidance in recent years.

Company guidance to investors was always a beacon to focus on in times of volatility. Things like the French elections or problems at Spanish banks did not have to be major events for equities because there was always something to turn to for a view of the future. The world is different today as only a fraction of companies now provide guidance compared to ten years ago. This leaves investors without a beacon and thus much more sensitive to economic data points or newspaper headlines. Ultimately, it makes for a more volatile backdrop. Combine this with a world more vulnerable to external influences (i.e., inflation) and we have a market reality that is very different than the world we operated in a decade ago. The following report explains this phenomenon in greater detail and discusses the likeliest road ahead in coming quarters. Look out for part 2 of this report tomorrow.

The level of the WTLEI declined slightly in the first week of May. For the month of April, while the S&P 500 fell less than 1%, leading indicators were skewed to the downside with 8 of the 11 PMIs reported thus far ticking down. This week will be a quiet one for leading indicators as the first regional PMI to report for the month of May (the Empire Fed) will do so next Tuesday at 8:30 AM. Stay tuned.

Last week’s weakness in the WTLEI was driven mainly by a decline in sentiment. While investors’ risk appetite increased somewhat, growth expectations and consumer sentiment were the biggest drags on the index. Economic data came in mixed, but slightly down while the Market component countered some of the weakness exhibited by the other components.

In March, we noted that we were likely near the end of the P/E expansion (i.e., macro only) phase of the cycle and earnings expectations would need to improve for the market to continue rising. The Financials sector has provided the most upside surprise to bottoms-up analyst estimates on both the top and bottom lines in the current earnings season. In turn, analysts have rushed to raise their estimates to keep up with improving trends in fundamentals. While there are a host of factors that have propelled Financials’ fundamentals higher, the most influential one is the improvement in economic prospects, especially as it pertains to the consumer and housing sectors.

Having a macro understanding of the major influences of sector performance is paramount. For example, having a strong view on the outlook for the emerging economies and the likely path of commodity prices has been key for timing the turns in the relative performance of the Discretionary sector, especially over the past decade. Similarly, the action in homebuilding and the activity in stock prices have been leading indicators for the Financials space ever since we began giving away no-doc mortgages. To that point, seeing Homebuilding stocks besting the S&P by 27% YTD and in the #1 position of all industry groups is a great sign of comfort to us with respect to Financials and the overall economy.  Moreover, Consumer Discretionary stocks are at all-time highs. Is the consumer really down and out!?! We continue to believe this recovery is sustainable and the majority of our current and, more importantly, forward-looking indicators agree.

Two of this morning’s headlines really caught our attention: 1) “European Shares Climb On Spanish Growth Data”; and 2) “Euro-Zone Inflation Slows As Oil Gains Weaken.” While markets have since weakened from the announcement, it is notable that the Spain GDP report was better than all 20 economists surveyed by Bloomberg. While the negative GDP report now puts Spain on the list of countries in recession, the market has already taken its preemptive 20% bear-market correction, so this news is hardly news. What matters for stocks is what the media will be reporting in three or six months from now.

Market prognosticators love to complicate things … and admittedly, a few of our forecasting tools can seem esoteric to some. That said, over the years we have found that keeping it simple is more often than not the way to go. The chart above is quite simple. Plotting the news trends from Bloomberg on the words “Easing” (with a 9 month lead) and “Recovery” suggests that over the next three quarters, the media will mention “Recovery” a whole lot more. We made a similar chart last year using the words “inflation” and “slowdown” that worked just the same. Today, we are seeing easing across the global economy on both the policy and lower inflation front. These are the classic remedies that can help to stabilize and sustain economic growth. We believe easing is helping to stabilize growth in Europe today and sustain the recovery in the United States as well. Due to the past years’ Q2/Q3 sell-offs, the “Sell In May And Go Away” mantra is louder this year. Before you shout Mayday, read our 10 reasons to sit tight.