Archive for January, 2014

The Steadily-Improving Economic Outlook For 2014

It’s that time of the year — I can’t let the pundits pontificate without throwing my opinion into the ring. This post will take you on a tour of the individual components of The Conference Board’s leading and coincident indicators as described in Chapter 2 of my new book Applied Equity Analysis and Portfolio Management. The chapter describes how to analyze the level and trend of each indicator, synthesize your analyses into discrete scores of -1, 0, or +1, enter these values into the chapter spreadsheet (included with the book), and let the spreadsheet average your scores into a diffusion index for each set of Conference Board indicators. We’ll start with the leading indicators, which are depicted in the table below, along with the weights assigned by The Conference Board.


We’ll start with the Leading Indicators. The most heavily-weighted component is the Average Length of the Manufacturing Workweek (weight = 0.2781), shown below with total employment in the manufacturing sector. The length of the workweek has regained its pre-recession level, which is typically interpreted as a positive signal. Unfortunately, as also shown in the graph, this longer workweek is being enjoyed by 5 million fewer employees in the U.S. since the start of the 2008 recession. Although the length of the workweek is up, the dramatic contraction in manufacturing employment leads me to score this indicator zero, rather than a more optimistic +1.


The second leading indicator is the ISM’s New Manufacturing Orders Index (weight = 0.1651). The index has recently reversed its post-recession downtrend, bouncing strongly off its recent low of 50 (suggesting contraction). Notice how previous recessions have been preceded by similar downtrends. I will rate this indicator +1.


The University of Michigan’s Consumer Sentiment Index (weight = 0.1551) has also been in a slow, steady uptrend, which merits a score of +1. Notice how the indicator collapsed in late summer of 2011 before Bernanke went to Jackson Hole and vowed to leave the QE spigot on full blast for “as long as it takes.”


Interest Rate Spread Between the 10-year T-Note and the Fed Funds Rate (weight = 0.1069). This indicator is really a proxy for the slope of the yield curve. A steeply sloped yield curve indicates economic expansion, while a flat or inverted yield curve indicates slowdown or contraction. The curve has recently steepened, as longer-term rates have rebounded with the expectation of further tapering of the Fed’s QE program. This indicator also merits a score of +1.


Manufacturers’ New Orders for Consumer Goods (weight = 0.0811). Nominal and real Durable Goods Orders (deflated by the Personal Consumption Expenditure Index, or  PCE) are shown below. The indicator rebounds sharply following the last recession, with Durable Goods Orders displaying slow, steady growth back to their levels preceding each of the last 2 recessions. The positive signal conveyed by this indicator merits a score of +1.


The Conference Board’s proprietary Leading Credit Index is replaced by The Chicago Fed’s National Financial Conditions Index (weight = 0.0794). Lower levels indicate “looser” borrowing conditions. Access to credit remains easy, especially for this stage of an economic expansion, so I’ll rate this indicator +1.


Level of the S&P 500 (weight = 0.0381). The S&P 500 is on the verge of breaking out of its secular bear phase. As stock prices are supposed to lead economic conditions by 3-9 months, I will rate this indicator a cautious +1.


The reason for my caution over the level of US (and global) stocks is conveyed by the graphic below, which shows that Central Bank “activity” has fueled stock prices to a considerable degree. I remain concerned over what happens when more significant tapering occurs.


Manufacturers’ New Orders for Capital Goods (weight = 0.0356). Unlike the pattern observed in Durable Goods, the Capital Goods Orders index has yet to match its level from prior expansions. The trend is up, however, so I’ll rate this indicator zero.


Initial Unemployment Claims (weight = 0.0334). Unemployment claims continue trending lower. This indicator therefore rates a score of +1.


Building Permits for New Private Housing Units (weight = 0.0272). This indicator continues advancing, but only to levels associated with the depths of the 1982 and 1991 recessions. I will therefore rate the indicator zero.


The individual scores for each leading indicator and their weighted and unweighted averages (with possible lows and highs of -100% and +100%, respectively), are shown in the table below. The weighted diffusion index value of +70% is by far the strongest score since the most recent economic expansion began, indicating further acceleration of economic growth through the first half of 2014, and possibly longer.


The prospect of faster future growth was confirmed by a Q3 GDP growth rate of +4.0% (see below). The above analysis of the leading indicators corroborates that this may not be an outlier, but representative of our first year of growth exceeding +3.0% in almost a decade.


Next we’ll consider the Conference Board’s 4 Coincident Economic Indicators. This set of indicators measures the strength of current economic activity. Retail and Food Service Sales (substituting for The Conference Board’s Manufacturing and Trade Sales indicator (weight = 0.5318, shown below)), have risen steadily since the last recession, earning this indicator a score of +1.


Total Nonfarm Payrolls (weight = 0.2597). The US economy is producing jobs, with total employment finally achieving its level from the mid-2000s.


Taking a shorter-term look at payrolls and hiring confirms that the pace of new job creation remains sluggish. I will therefore rate the Total Nonfarm Payrolls indicator zero — the uptrend is positive, but the level of employment is not sufficient for a +1 score.


Personal Income Less Transfer Payments (weight = 0.1357). Personal income in the US is at an all-time high, which is definitely a positive. Examining the next graph below, however . . .


. . . I also compare Personal Income to Transfer Payments and Personal Consumption Expenditures. Notice how the upward trend in income and spending is strongly supported by an above-trend sruge in Transfer Payments (Social Security, Medicare, Welfare, etc.). Although I have strong concerns about future reductions in Transfer Payments and the effect on spending, I’ll rate this indicator a cautious +1.


Industrial Production (weight = 0.0728). Until last year, Industrial Production was the most heavily-weighted coincident indicator. The nominal series looks encouraging, but the inflation-adjusted series displays some convoluted behavior. Although the trend in the nominal series is upward, the lackluster behavior of the real series leads to a ranking of zero.


Merging the above -1, 0, or +1 ratings into a diffusion index provides a score of +50% if all indicators are equally-weighted, and +67% if we use the Conference Board weights. The implication is that growth and economic activity have accelerated in the current period.


A few more charts to wrap up. Unless “this time it’s different,” historically bullish sentiment is usually a negative sign for equities — the latest reading of bulls over bears makes me a little nervous:


We also live in a society that abhors discussion of long-term structural problems, like the tens of trillions in underfunded Social Security and Medicare liabilities — we’ll never be able to pay half the “promises” baby boomers are counting on:

Medicare-Social-SecurityIt might not be the disparity between rich vs. poor that incites the revolution:

US-Household-Income-Since-1960Perhaps it will be the one-time wealth tax that keeps being discussed — the exhibit below is from a recent IMF report. Just because it worked in Cyprus, I wouldn’t count on it working in the US . . .


Of course, much of our short-term prosperity is fueled by the US sinking deeper into debt every day:


Corporate profits as a percent of GDP are at an all-time high, while wages and salaries as a percent of GDP are at an all-time low:


And much of those profits are increasingly concentrated in the financial sector — even with significant household deleveraging (ah, the power of those hidden fees . . . ).


Overall, there has been a significant pickup in economic activity in the second half of 2013. If the Fed treads lightly with its QE tapering, a real GDP growth rate of +3.0% in 2014 is definitely possible. Longer term, however, income disparity, federal deficits and debt loads, hopelessly underfunded entitlement programs and an increasingly “financialized” US economy present significant concerns — concerns that US and global stocks seem content to ignore — until they can’t. For the short term, however, US stocks are likely to rally at the slightest provocation, and the outlook for growth and job creation in 2014 looks more promising than it has in any calendar year since the financial crisis.

Categories: Market Commentary