Two roads diverged in a wood.  Robert Frost took the one less traveled by and that made all the difference.  Come to think of it, though, he never said if the difference was good or bad.  We like happy endings, so we'll accept the poetical inference that things worked out okay. 

Even so, we are left to wonder if Frost would embrace the same daring approach today to traverse the wood of the stock market where two roads are diverging.

One road is the well-worn path of the liquidity trade while the other is the less traveled path of weakening economic trends.

In our September 24 article, Leading Economic Index Reflects Risk, we called attention to the economic warning signals flashing in the Leading Economic Indicators Index.  Today, we are going to look at some market indicators with a leading edge -- indicators that are looking rough around the edges, some more so than others. 

Specifically, we'll be looking at copper and oil, along with semiconductor and transportation stocks.   

A QE3 Rally Before QE3

Between June 1 and September 13, the S&P 500 surged 14.2%.  The summer months were imbued with a bullish spirit that reveled in an expectation of further policy accommodation from the world's central banks.  The Federal Reserve and the European Central Bank were the focal points in that respect and they did not disappoint.

All boats essentially rose with the QE3 expectation tide.  That is demonstrated in the chart below for our contingent of leading indicators.   

Reading Between the Lines

Transports are a leading indicator because the movement of goods and/or people by ships, trains, trucks, and airplanes is integral to economic growth.  Judging by the notable underperformance of the transports during the summer rally, there appeared to be an awareness that QE3 may not be the economic fix everyone hopes it can be.

Rising crude oil prices, along with earnings warnings from the likes of Norfolk Southern (NSC) and FedEx (FDX), acted as weights on the transports, which frankly have been underperforming all year.

The best-performing indicator in our grouping was crude oil.  Prices rose 18.1% from June 1 to September 13 (the day of the QE3 announcement).

At first blush, the surge in crude prices would go hand-in-hand with an outlook for increased demand, which is something one would expect to see with stronger economic activity; however, oil prices were underpinned primarily by geopolitical risk tied to the rising tension between Iran and Israel as well as a weaker dollar that fed speculative buying interest in the dollar-based commodity.

The uptick in oil prices then was not all it seemed to be as a proxy for economic-related demand.  The same could be said for copper, which has a large number of uses in industrial applications but whose rising price did not fit with reports of slowing economic activity around the globe.

Finally, semiconductors, which are also needed in many products beyond just computers, had a great run beginning in late July.  That rally coincided with a huge run in Apple (AAPL) and it occurred despite a number of warnings out of the semiconductor space that included warnings from industry leaders Intel (INTC) and Applied Materials (AMAT).

The Fed Answers the Call

On September 13, the Federal Reserve gave the market what it was looking for in more ways than one. 

First, it announced QE3, saying it will buy $40 bln each month of agency mortgage-backed securities. Secondly, and most importantly, the Fed left that commitment open ended, saying it would undertake additional asset purchases and employ other tools if the labor market did not improve substantially.  This element is why QE3 has been euphemistically referred to as "QE Infinity."

For good measure, the Fed said it expects a highly accommodative stance to remain appropriate for a considerable time after the economic recovery strengthens and it also announced that it felt economic conditions would warrant exceptionally low levels of the federal funds rate target at least through mid-2015 versus prior guidance for at least through late-2014.

The stock market and so-called risk assets took off on the headlines.  The S&P 500 gained 1.6% on September 13 and added another 0.4% on September 14.  And then the rally ended.

The actual announcement of QE3 was the culmination of what the market had been anticipating for months.  Notwithstanding the two-day pop after the announcement, there hasn't been any sustainable follow through.

The market action has the semblance of being a classic case of buying the rumor and selling the news.  In fact, the S&P 500 is now trading 0.5% lower from where it closed on September 12 -- the day before the announcement.

A period of consolidation is understandable after a rally like the one witnessed between June 1 and September 13, but what stands out today is that each of the leading indicators named above has underperformed the market following the actual announcement of QE3.

What It All Means

We don't have the answer in this instance of what it all means -- not yet anyway.  It could simply be a case of profit taking after a big run or it could actually be a tacit signal that the market's confidence in the Fed to turn the economic and earnings tide in short order is waning.

Under the latter view, one should see copper and oil, as well as semiconductor and transportation stocks, lagging.  Conversely, they should be leading if market participants are anticipating a sustained pickup in economic activity.

More time is needed to assess which of these divergent positions will prevail.  It is too early to tell.  How the fiscal cliff debate plays out will matter greatly. 

Keep in mind though that the trend in these leading market indicators needs to be watched closely.  The path they follow could make all the difference -- good or bad -- for the market outlook.

--Patrick J. O'Hare, Briefing.com