Financial Market Commentary

I have always been intrigued with investors’ reliance on the Conference Board’s Leading Economic Indicators (LEI), despite the fact that few can thoughtfully interpret (or even identify) the most heavily-weighted components (the first 4 account for almost 80% of the LEI’s behavior). In a recent Forbes article, Ken Fisher (a.k.a. the advisor with a strong track record of crying “bull” at the worst possible moment) informs us:

. . . another recession now would be unprecedented when you consider the historical evidence. We have never had a recession after the traditional leading economic indicator (LEI) index has been high and rising for five months . . .

Sounds like an invitation to take a closer look. Let’s examine the most heavily-weighted component of the LEI (weighted 35%), the growth rate of the M2 Money Supply. The inflation-adjusted series is graphed along with Real Business and Consumer Loans:

Paradoxically, the main justification for the aggressive expansion of the US Money Supply has been to spur lending during a period of market-mandated de-leveraging, which has always struck me as odd. As the graph shows, the Total Consumer Loans series continues trending downward, while the Total Business Loans series has risen slightly in 2011. Overall, however, there has been little positive impact on borrowing, mainly confined to the business side.

All is not lost, of course — the economy could still receive a boost if consumers were simply spending all that loose money, as measured by the velocity (or turnover) of the M2 Money Stock. The chart below depicts nominal M2 and the Velocity of M2:

The news from the Velocity series is hardly encouraging — the Velocity of Money has been in a downtrend since 2000, and is lower than it’s been at any time during the last recession. While the most heavily-weighted LEI component has been rising in recent years, this rise is solely due to artificial intervention by the Fed. No positive market response to all this loose money is evident in borrowing or spending.

Let’s take a look at the second most heavily-weighted LEI component, the Average Length of the Manufacturing Workweek, weighted around 26%. This series is depicted in the graph below. The Average Length of the Construction Workweek is also shown:

Both series are flashing positive signals. The Manufacturing Workweek is even slightly longer than it was pre-recession. Of course, focusing on the number of hours worked by those who remain employed allows for a positive interpretation that conveniently overlooks the information conveyed by the next graph, which shows Total Employment in Manufacturing and Construction:

Call me crazy, but I can’t understand how the fact that 3 million fewer manufacturing employees and 2 million fewer construction employees are working the same number of hours forecasts economic growth. Stabilization around a lower level of economic activity would be a more accurate interpretation. Moreover, these 2 variables account for over 60% of the entire LEI.

We’re on a roll now, so let’s take a look at the third most heavily-weighted LEI component (10%), the spread between the yield on the 10-year T-note and the Fed Funds Rate, shown in the graph below:

This series is really a proxy for the slope of the yield curve, where an upward-sloping curve implies economic expansion, and a flattening or inverting of the curve implies slowdown or contraction. Two key points here. First, the graph shows that the curve has been flattening throughout 2011, accurately foretelling the slowing economy in which we find ourselves. Second, as pointed out in a thoughtful article by Chris Turner via Advisor Perspectives, domestic and global Central Bank intervention has made it impossible to know (or even guess) what market-determined interest rates would or should be anymore.

Thus far we’ve accounted for 70% of the magical, mystical LEI index, and on this more granular level, it’s difficult to see the unequivocally positive information that is so apparent to bulls like Ken Fisher.

Still not convinced? Okay — let’s take a look at indicator number four, Manufacturer’s New Orders for Consumer Goods, weighted almost 8% in the LEI index. If we consider the change in the nominal series, the signal appears positive:

The series displays an impressive rebound since its recessionary plunge. Maybe there is some good news here; after all, consumers have been spending as of late, and Black Friday expectations are high. Before we get too excited, however, let’s take a look at the same series adjusted for inflation:

Ah, inflation, that silent thief, working its nefarious black magic over long horizons . . . the series is far less exciting when viewed in real terms. Non-Defense Durable Goods Orders are almost back up to their 2002 post-recessionary lows. With a little luck, we might soon be back where we were . . . 10 years ago.

Having accounted for almost 80% of the LEI, I rest my case. Ken Fisher’s exhortations notwithstanding, the LEI appears to be flashing positive signals because, like most averages, it obscures those always-devilish details. The economy has slowed and continues to slow. Unless businesses lay off even more workers to further boost profits, or stock valuations simply continue to ignore fundamental information, stocks may face considerable headwinds in 2012.