Financial Market Commentary

It’s the time of the year to reflect on the direction of the economy. For the past several years I have examined each individual component of The Conference Board’s Lagging, Coincident and Leading Economic Indicators and created my own diffusion index by ranking each indicator -1, 0 or +1. I have found that this method produces accurate forecasts of future economic conditions. In 2013 I predicted a continuation of sluggish growth ahead of virtually everyone else (link here), and in 2014 I reversed that call and predicted faster growth (link here), which also turned out to be correct. Thus far in 2014 GDP growth has been higher than any year since the 2008 financial crisis, which can be seen in the following graph.

I’ll break this year’s forecast into 3 parts. Part 1 will cover The Conference Board’s 7 Lagging Indicators, which help us look back and understand how economic activity evolved over the past 6-12 months (I will cover the Coincident and Leading Indicators later this week). I find that the Lagging Indicators are most useful for corroborating previous forecasts and identifying the main factors that contributed to growth in previous periods.

The following table shows my rankings for each lagging indicator. While no indicator is flashing a negative signal (corresponding to a score of -1), I scored most of them zero rather than +1, as the evidence strongly suggests that GDP growth in 2014 was dependent upon artificially low interest rates and further increases in consumer debt loads, which were already high.

Sluggish wage growth and an elevated services CPI (which tends to rise in the early stages of an economic slowdown) cast further doubt on whether 2015 can match or exceed the growth we’ve seen in 2014. The diffusion index scores of 29% and 32% (equally weighted and using The Conference Board’s weights, respectively) reflect my view that although economic growth was positive, economic momentum remains surprisingly tepid. The economy may have difficulty sustaining its recent performance all the way through 2015. A detailed analysis of each lagging indicator follows below.

The most heavily-weighted lagging indicator is the Average Prime Rate (weight = 0.2815), also shown with Total Commercial and Industrial Loans. The rate has never been lower, and commercial and industrial loans continue increasing, so this indicator merits a score of +1.

Next is the Ratio of Consumer Credit to Personal Income (weight = 0.2101), also shown with Personal Income Less Transfer Payments, which provides an additional perspective on sources of consumer spending power. It strikes me that the credit-to-income ratio is a “goldilocks” number, in that we don’t want it to be too high or too low. The ratio recently exceeded its 2003 high, which tells us that consumers feel it is necessary to manage ever-larger debt loads, despite the steady gains in Personal Income from non-Transfer Payment sources, as shown in the graph. I will therefore rate this indicator zero, as growing household debt loads are a potential source of financial instability — especially if interest rates were to rise.

The next Lagging Indicator is the Consumer Price Index for Services (weight = 0.1955). The Conference Board describes the interpretation of this indicator: “It is probable that . . .  service sector inflation tends to increase in the initial months of a recession and to decrease in the initial months of an expansion.” Recent increases in this indicator therefore bear watching — any further uptrend would be concerning, as increases in the index are associated with recessions (although not always with a lag). I will therefore rate this indicator zero.

Ratio of Inventory to Sales (weight = 0.1211). With the prevalence of just-in-time inventory management, this ratio has trended downwards for decades. Recently there are signs of a gradual buildup in inventories, however, so this indicator earns a score of zero.

Commercial and Industrial Loans (weight = 0.0970) are shown below. Consumer credit is rising almost asymptotically, while industrial loans are increasing at a saner rate. This pattern of rapidly increasing consumer credit suggests that economic growth and spending are dependent on increasing debt levels, so I will also have to rate this indicator zero.

Nominal and Real Unit Labor Costs (weight = 0.0587) are shown in the graph below. Sluggish job creation has helped businesses keep labor costs capped — good for business, bad for working class consumers. After deflating unit labor costs by the chained PCE, we see that the trend has been negative for 12 years — in other words, “labor costs” (wages and salaries to workers) have not kept up with the rate of inflation, which tells us why consumers have been increasing their debt loads. The “good for business, bad for working class consumers” story causes me to rate this indicator zero.

Median Duration of Unemployment (weight = 0.0361) is shown below, along with the Civilian Labor Force Participation Rate. Unemployment duration continues improving, down to a median 13 weeks (which is still elevated compared with previous business cycles). The decline in the labor force participation rate has slowed, but is not trending upward. I can coax a +1 out of this indicator, but I might be rounding up from +0.5 — the labor market simply is still a far cry from what it used to be in the U.S.

Taken together, the lagging indicators generally confirm that 2014 was a positive year for economic activity and GDP growth.  I have concerns regarding the sustainability of real GDP growth in the 3.5%-4.0% range, however, due mainly to the following factors:

• artificially low interest rates,
• increasing consumer debt,
• wage growth below the rate of inflation, and
• a rising services CPI.

My next installment in this year’s economic outlook will cover The Conference Board’s Coincident Economic Indicators.

Call me crazy, but there seems to be a lot of chatter devoted to convincing us that we’re not in a deflationary spiral. One of the main rationales behind QE was that quintupling the size of the Federal Reserve’s balance sheet was necessary to engineer a “healthy” rate of inflation of at least 1-2%. Let’s see what the numbers tell us (everything below is non-seasonally adjusted). If we believe that the core Consumer Price Index (CPI ex-food and energy) is the correct measure of inflation, then we’re inflating:

On the other hand, if we believe that the Producer Price Index for Commodities is the correct measure, the trend may be changing from inflation to deflation:

And, if we prefer to examine at the prices of key agricultural and physical commodities directly, without “hedonic adjustments” by government bureaucrats . . .

. . . we see that oil, copper, soybeans, wheat and corn prices are all deflating, with average declines of -29% over the past 2 years.

Which is not to say that QE has been completely unsuccessful in creating some inflation:

If you’re not concerned, you’re either not paying attention — or you’re a money manager. Bill Gross may be a strange individual, but he’s got a pretty good track record — see Bloomberg’s coverage of Gross’s deflationary forecast and Rich Miller’s more recent outlook for Europe. I would recommend preparing for additional sudden volatility outbursts, at least as bad as what we experienced during October 2014’s short-lived “correction.”

In this article I will analyze the 10 individual components of The Conference Board’s leading economic indicators as described in Chapter 2 of my new book Applied Equity Analysis and Portfolio Management. The chapter describes how to score each indicator +1, 0, or -1 based on their level and trend, and use the spreadsheets included with the book to average these scores into a diffusion index for each set of Conference Board indicators (Leading, Coincident and Lagging). All the graphs and data series shown below are included in the book. For readers on the fast track, this article will conclude that, despite generally positive readings on most of the official Conference Board indicators, the U.S. is likely to remain in a slow-but-steady expansionary phase for the next 3-9 months, with little chance that economic activity will accelerate further.

The 10 leading indicators are depicted in the table below, along with the weights assigned by The Conference Board.

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 is higher than it has been at any time since 1982, which The Conference Board interprets as unequivocally positive. 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 2001 recession. Although the length of the workweek is up, the 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 from 2010-2012, bouncing strongly off its 2012 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.” There is a bit of a concern that current survey scores in the mid-80s have been historically associated with recessionary lows in previous business cycles.

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 usually forecasts economic expansion, while a flat or inverted yield curve indicates slowdown or contraction. The curve has recently flattened slightly, despite expectations that the Fed’s QE program is now over (which should have resulted in higher, rather than lower, long-term interest rates). This indicator also merits a score of +1, as the spread remains sufficiently positive.

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 its level preceding each of the last 2 recessions. The positive signal conveyed by this indicator merits a score of +1.

The Chicago Fed’s National Financial Conditions Index will be used as a substitute for The Conference Board’s proprietary Leading Credit Index (only available by subscription, 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 has “broken 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, as Sept-Oct volatility is still playing out in markets, and some market pundits still calling for an all-out crash (see John Hussman, for example).

Manufacturers’ New Orders for Capital Goods (weight = 0.0356). Unlike the pattern observed in Durable Goods, the Real (inflation-adjusted) 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. The dearth of capital expenditure by U.S. firms, vs. their rabid appetite for share buybacks, remains a concern, however. It’s difficult to reconcile that the economy can be expanding when Capital Expenditures have grown more slowly than the rate of inflation for the past 14 years.

Initial Unemployment Claims (weight = 0.0334). Unemployment claims continue trending lower, and have achieved levels associated with previous economic expansions. 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 +60% is the second strongest score since the most recent economic expansion began, indicating continued acceleration of economic growth through early 2015, and possibly longer.

I will complete this post by taking a look at additional indicators that are not officially part of The Conference Board’s series. The prospect of faster future growth was confirmed by a 2013 Q3 GDP growth rate of +4.0% (see below), although subsequent growth has slowed once again.

Below is a table taken from The Conference Board’s public website on October 28, 2014. Despite the recent pickup in GDP growth, they are forecasting only 2.1% real growth for all of 2014, and 2.6% for 2015 — too slow to get the job done. Similarly, the sluggish rate of consumer spending is expected to continue through 2015. Perhaps most fantastical is the prediction of stronger growth in CAPEX spending for 2014 — despite today’s report by Bloomberg that both durable goods and capital goods orders have been contracting in recent months.

Gas Prices. Continuing with a quick look at other “unofficial” indicators, gas prices have eased off a bit thanks to the decline in oil prices, which should put a spring in the step of the U.S. consumer, especially heading into the holiday retail season.

Unemployment and Underemployment. Although an unemployment rate of 5.9% is a beautiful thing to behold, the U6 underemployment rate is the highest its been in 20 years — and that’s after 5 straight years of declining!

Financial Profits and Household Debt. Other trends that concern me include the record levels of financial profits as a percentage of GDP, and the continued high level of household debt, despite 5 years of modest deleveraging. An overleveraged consumer is likely to be a cautious consumer.

Corporate Profits and Wages & Salaries. I am also concerned when corporate profits increase at the expense of wages and salaries, as an underpaid employee is also likely to be a cautious consumer.

Nonfarm Payrolls vs. New Hires. Finally, notice the divergence between the rate at which Nonfarm Payrolls increase, vs. the more tepid pace of New Hires. The explanation? A timid, underpaid employee facing a national underemployment rate of 12% is less likely to leave a job they dislike to seek better employment opportunities. The increase in Nonfarm Payrolls is therefore due as much to a lower rate of voluntary termination as it is due to actual job creation.

Conclusion: The U.S. remains in an economic expansion, with no real indication of a pronounced slowdown on the horizon. Unfortunately, there is little indication that economic conditions will accelerate, either. Given Japan’s return to recession and Europe’s pronounced slowdown (and shaky bank stress tests), the U.S. will probably remain in this slow but steady expansionary phase for another 3-9 months.

The usually-reliable crystal ball of sector analysis suggests no more than tepid enthusiasm for stocks thus far in 2014. Although growth stocks have finally surged ahead of value stocks:

The individual leading sectors remained tilted towards the defensive, with only Information Technology matching the performance of Health Care and Utilities, which are typically thought to be more high-yield, risk-off sectors:

Filling out the middle of the pack we have Materials, Energy, Financials and Consumer Staples:

With traditionally risk-on sectors Industrials and Consumer Discretionary joining Telecom at the bottom of the pack:

Thus far in 2014, sector performance suggests more of a risk-off, reach-for-yield stock market, with Health Care and Utilities decisively outperforming more risk-on sectors like Energy, Industrials and Consumer Discretionary. It is also noteworthy that typically-safer Consumer Staples stocks have outperformed Consumer Discretionary stocks. Although sector performance such as this is not unusual following the outsized gains stocks posted in 2013, it suggests a slightly fatigued, over-extended market overall. With the Fed more likely to continue leaning towards a more hawkish stance on further stimulus and the level of interest rates in its upcoming meeting, stocks appear as vulnerable for a correction as they have all year.

Phil Davis has a great post this morning (07.23.14) where he discusses the financial media’s distorted reporting of GDP growth in the US and around the world. He specifically cites a Bloomberg article that references “accelerating growth.” Let’s look at a couple of graphs and watch as GDP growth accelerates. First graph below shows quarterly GDP growth in Japan, the UK, Germany and the US since the 4th quarter of 2009.

Does everyone see which country is driving the “acceleration?” Yep — Japan and its Godzilla-size QE experiment. Next let’s take a look at the weighted average growth rate of the 4 countries (the US consistently accounts for 60% of the total GDP of all 4 countries). Japan’s 1-quarter bolus to the “acceleration” of GDP growth has lifted the average all the way to a spectacular . . . 1.4%. (Yes, the rates are annualized.)

Let’s add a trendline to the above graph and have another look:

Adding to Phil’s point: if the trendline points downwards, but the financial media calls it accelerating, then it must be so. Dissent at your own peril.

As we begin the second half of 2014, let’s take a look back at how equities and interest rates performed in the first half of the year. The first chart shows that U.S. large-cap stocks (the S&P 500) posted strong gains of about 7% in the first half, but small caps (the Russell 2000) lagged with a total return of just under 4%.

When large-caps lead small-caps we usually think the market is in a bit of a “risk-off” mode, which is confirmed by the gradual decline in the 10-year Treasury note yield, shown in the chart below. Despite the chants of “great rotation” from the financial media, the long-predicted rise in interest rates has not yet materialized.

Growth stocks edged out value stocks with total returns of 7.37% vs. 7.00%:

Utilities led the way as investors reached for yield, with Energy and Materials stocks posting strong gains, most likely in anticipation of the highly-touted expected increase in inflation that has also failed to materialize:

Consumer Discretionary stocks lagged along with other “risk-on” sectors like Financials and Industrials:

Overall, investors were handsomely rewarded in the first half of 2014, considering that U.S. stocks rose 30% in 2013. But the market’s internals are weakening, as investors repositioned to play defense in the second half of the year. Now that former doves like the St. Louis Fed’s Jim Bullard are arguing for the Fed to exit markets sooner rather than later, expect an immediate increase in volatility at the first sign that the Fed is actually backing off. But it’s important to note that thus far the Fed has only talked about accelerating the taper. As pointed out by Phil Davis today, the Fed continues timing its cash injections to aid end-of-quarter window dressing. What would stock values look like in a market that was not supported by the Fed? It’s been a long time since we’ve had an answer to that question — so long that many have probably forgotten the concept altogether.

[Data from S&P’s Capital IQ]

Five years of persistently slow growth and a sluggish labor market, increasing global instability and a new Fed Chair that openly contradicts herself — U.S. stocks seem to be able to shrug off any sort of news as long as there’s Fed stimulus to be had. Investors who have anticipated a correction in this “teflon market,” where bad news doesn’t stick, have been thwarted short squeeze by short squeeze. The latest argument for a market decline has been that we are overdue for a correction (a decline of 10% or more). Let’s take a look at the history of corrections by decade, from 1945-2014, and see just how overdue we might be.

The table below shows the percentage of overlapping periods when the month-end level of the S&P 500 has been at least 10% lower than the end-of-month level 1, 3, 6 and 12 months prior. Above-average frequencies are bold and shaded, with below-average frequencies in red.

The data show that decades characterized by an above-average frequency of corrections are reliably followed by approximately two decades of complacency, featuring a sharp decrease in the frequency of corrections.

Therefore, while it may feel as if stocks are overdue for a correction, it is not uncommon for stocks to remain in bull mode without correcting following a decade of volatility and low returns, such as the 1970s and 2000s. Stock values may correct for any of the usual reasons, such as an information shock or overvaluation concerns, but not for the simple reason that a correction is overdue. Thus far the 2010s are playing out similarly to the 1950-1969 and 1980-1999 periods in terms of having a below-average frequency of stock market corrections.

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.” — Upton Sinclair

Market pundits seem to have the most difficult time embracing the concept of overvaluation. This morning on CNBC, Art Hogan once again demonstrated how to dance around the issue when he stated:

“What’s actually happening in the marketplace is, like it or not, the movement in the market mirrors almost exactly the move in earnings growth,” Hogan said. “If you look at how much the markets have gone up on a percentage basis, [earnings and the market are] almost identical or within a percentage point or two of each other.”

The following graph shows that Hogan is correct — the stock market and earnings have indeed grown at a similar rate since March 2009. However . . .

. . . the problem is that stock values since 1982 have increased 1600%, while earnings have grown about 600%.

Hogan focuses on one slice of the data — starting from an artificially-depressed bottom in earnings in March 2009 — and matches up the growth rates in the two series over the last cyclical bull cycle. Over the entire secular bull/bear cycle, however (1982-2013), stock values have appreciated at almost three times the rate of earnings growth.

Hogan tries to cram a secular, multi-decade bull/bear story into one cyclical bull market cycle, with the net effect of conflating the bull/bear/overvaluation debate. Just as he is paid to do.

Bottom line is the market will not correct until the final two indicators flash — when Ed Yardeni and Abby Joseph Cohen are trotted out to revive the “coordinated global boom” meme they pushed all the way up to the 2008 financial crisis — then you’ll know it’s time to run for the exits.

The recent revision to Q1 real GDP growth, all the way down to a dismal -0.6%, has sparked a debate in the financial media that is somewhere between wild and desperate. CNBC trotted out the usual cast of “experts,” some pontificating that negative GDP growth “didn’t matter,” with others proclaiming that negative GDP growth represented truly good news, as economic activity for the rest of the year was poised to rebound (reminiscent of Liz Ann Sonders’ “coiled spring” hypothesis, which she hyped steadily from 2009 to 2012, before finally letting the meme drop). And just this week, Charles Hugh Smith posted an elegant diatribe (Our “Make it Look Good” Economy Has Failed) in which he claims that the numbers used to portray economic activity have been massaged into a positive narrative that is completely disconnected from reality.

In this post I will provide graphs of the long-term trend in several key economic indicators (most of which are included in The Conference Board’s leading or coincident economic indexes) and let readers answer the key question for themselves: “Is the U.S. economy growing or not?”

Let’s start with the biggie, growth in real GDP. The graph below shows that growth has been trending inarguably lower since the late 1990s.

Next is nominal and real Durable Goods orders. If the following graph were a stock chart, we would immediately recognize a classic “triple top” formation. (The resemblance to the S&P 500 is also clear.) We have achieved the same level of Durable Goods orders as in 2000 and 2008 — with both previous tops immediately preceding recessions!

Next we’ll look at real and nominal Capital Goods orders, ex-aircraft to smooth out unusual one-time data points. The real series is in a protracted bear market — not only is the series not growing, it’s clearly shrinking. Capital Goods orders have failed to keep up with inflation (which is negligible, given all the deflationary fears permeating the environment).

How about New Building Permits for Private Housing? After all, we’re allegedly in a housing boom, are we not? If your definition of “boom” is when builders pull the same level of permits as during the depths of the 1982 and 1991 recessions, then I guess we’re in a boom.

Overall, it’s hard to miss Charles Hugh Smith’s point: the trends in these key economic variables are anemic, and bordering on pathetic. Yet, every day now, “the same Broadway kick-line of dancing clowns” (in John Hussman’s words) that told us credit risk was contained in 2008 are telling us that all the numbers are pointing toward sustained economic recovery.

All of this makes me nostalgic for the days of relatively harmless memes, like “ketchup is a vegetable.” Now, before you scoff, did you know that the king of condiments was officially classified as a vegetable by a 2011 Senate bill? Maybe all we need is for Congress to pass a law declaring that negative GDP growth is officially good news, and we can all stop worrying.

Permabull David Tepper of Appaloosa Management spooked investors at this year’s SALT Conference with his “I am nervous, I think it’s nervous time” pronouncement (read more at Zero Hedge or Business Insider). One year ago Tepper gained credibility with his prescient warning that short sellers were “digging their own graves,” as all the major stock market indexes continued rising for the rest of 2013. Now that Tepper is signaling something between caution and bearishness, suggesting that Central Banks have contributed to a mindset of “coordinated complacency,” it looks like a good time to review some hedging strategies for the downside-minded among us (I’ll use pre-open charts and prices from May 15 2014).

Adding to investors’ nervousness is the disconnect between small-cap stocks (measured as the Russell 2000 index), which are struggling to find support at their 200-day moving average:

and the S&P 500, which has found consistent support at its 50-day moving average:

If you’re interested in speculating on a mild May correction, you might consider a bear put spread. Below I’ve graphed the payout from buying 1 Sept. SPY 190 put ($6.92) and financing most of that position by simultaneously selling 1 Sept. SPY 187 put ($5.62). The position costs $1.30 net, and pays off a maximum $1.70 if the SPY declines by 1.5% or more).

For those of us who are only short-term bearish and interested in hedging a long equity portfolio, buying the Sept. 187 put for $5.62 provides a little portfolio insurance, as shown below. Based on a May 14 closing price of $188.75 for the SPY, this position caps your losses at -3.9%, including the cost of the put option.

And, for those who think a market decline much larger than -3.9% is likely, simply buying the Sept. 187 put allows for a more aggressive downside bet:

I recommend watching the Friday closing action closely — it will be interesting to see the extent to which traders will feel comfortable staying long over the weekend. A weak final trading hour on Friday would add to the market’s nervousness.