The Economy and Bond Market Radar (July 9, 2012)

Sunday, July 8th, 2012

The Economy and Bond Market Radar (July 9, 2012)

Treasury yields headed lower this week on disappointing economic reports and global central bank easing. Two key economic data points bookended the week, with a very weak reading from the ISM Manufacturing Index on Monday, followed by a subpar employment report on Friday. On Thursday we had what appeared to be coordinated global central bank policy easing with the ECB and the Bank of China cutting interest rates by 25 basis points, along with the Bank of England adding ?50 billion to their quantitative easing program. As can be seen in the chart below, the yield on the 10-year treasury fell to the lowest level in more than a month.

Strengths

• Economic data is weak globally, forcing central banks to act which is sparking a bond rally and pushing down yields.
• Domestic auto sales remain a bright spot for the economy with GM, Ford and Chrysler all posting strong sales growth in June.
• Factory orders for May rose 0.7 percent, beating expectations.

Weaknesses

• June nonfarm payrolls were weaker than expected, rising by a meager 80,000, little changed over the past few months.

• The ISM Manufacturing Index fell to the lowest level since July 2009 and indicated contracting manufacturing in June.

• European bond yields remain elevated even after central bank intervention and the EU summit the week before.

Opportunity

• The Federal Reserve reaffirmed its commitment to an ultra-low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China has obviously become more concerned about the economy and has eased twice in the past month.

Tags: 10 Year Treasury, Bank Of China, Bank Of England, Basis Points, Bond Market, Bond Yields, Central Bank Intervention, Central Banks, Domestic Auto, Economic Data, Economic Reports, Employment Report, Gm Ford, Interest Rate Policy, Ism Manufacturing Index, Market Radar, Nonfarm Payrolls, Shifting Focus, Strong Sales, Treasury Yields
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“The Virtue of Necessity” (Saut)

Thursday, July 5th, 2012

“The Virtue of Necessity”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

July 2, 2012

Mikhail Gorbachev understands this rule of political survival: Make what you must do appear to be what you want to do. His economic reports this summer showed the Soviet Union’s desperation deepening, his perestroika failing. With top-level support crumbling, he staged a September coup. In the name of democratization, he concentrated government and party power in himself. That bought him time, but did not solve the most pressing problem: the huge chunk of Soviet production devoted to the military, now approaching 25 percent, four times greater than the U.S. share. Moreover, the cohort of draft-age Russians was shrinking, making military conscription more difficult. With no choice but to cut military spending, “President” Gorbachev turned that sour lemon of declining power into the most delicious lemonade. He came to the U.N. and told the world proudly that he was unilaterally reducing Soviet troop strength by a half-million. Not because he had to, you understand – purely motivated by idealism – [but] because “the use or threat of force no longer can or must be an instrument of foreign policy.”

What a combination of audacity and mendacity. Only the use of force keeps Communist regimes in power; only the “threat of force” from Soviet tanks keeps the people of Eastern Europe from overthrowing their hated puppet regimes. But the U.N. and the watching world heard what it wanted to hear – an uplifting, peaceful speech from an all-powerful Soviet leader that might have come from a freely elected American leader. The more gullible viewers thought they heard a genuine yearning for an end to Soviet expansionism instead of a rationale for a temporary retreat caused by economic necessity.

… William Safire, New York Times, 12/8/1988

“Economic Necessity” was a phrase replete in the media late last week and it brought back memories of the aforementioned quip by William Safire written in 1988. In the current case it is not economic necessity for Russia, but rather the European Union (EU). For months I have opined politicians, bureaucrats, and bankers are the same in Europe as they are here in that they do not want to lose power. And, if the EU implodes they all lose their power. Therefore, my sense has been the powers that be will continue to “paper over” Euroquake and buy time in hopes time will allow the EU to heal itself, just like we did with our Financial Fiasco (2007 – 2009). Manifestly, that “paper over” event is exactly what happened Friday morning with the EU summit announcement and the world’s markets soared. To be sure, some of the upside fireworks came from short-covering because participants have been rewarded for getting “short” in front of previous EU summits where the post-summit announcements have disappointed. This time, however, that was not the case, the announcement was substantial. Still, I think there was more at work than just short-covering.

Indeed, “your father’s” recession, and subsequent recovery, saw the two sectors that pulled the economy out of recession, namely autos and homebuilding, recording strong rebounds. Beginning in 2009 autos have done their job since we have gone from roughly a 9 million unit seasonally adjusted annual rate (SAAR) to nearly a 15 million run rate. The laggard has been homebuilding, but that appears to be changing. The Homebuilder’s Index is breaking out of a four-year base to the upside, suggesting the worst has been seen and discounted. Meanwhile, one of the things that got us cautious on housing was the rise in For Sale Inventory that began in mid-2005. Now, For Sale inventories have collapsed (see chart on page 3). The second thing that got us cautious on housing was the rise in the cost of a house at the same time inventories were increasing. Affordability, however, is currently at record levels (see chart on page 3). Such metrics have caused a noticeable improvement in sales. Recent reports indicate new home sales continue to accelerate. The seasonally adjusted annualized pace of new home sales (contract signings) rose 7.6% month-over-month to 369,000 units. Drilling down to the unadjusted data, May sales jumped 25% y/y and increased 6% sequentially, indicating that the positive momentum in housing has continued to build in recent weeks. Moreover, these results came as prices rose, with the median new home price climbing 5.6% y/y to $234,500 in May, which was an acceleration from +5.0% y/y in April. These are not unimportant data points because a pickup in homebuilding would not only add jobs, but should strengthen future GDP numbers. Also helping the economy is gasoline, which has fallen from $3.43 per gallon in April to $2.63 currently (basis the August futures contract). That decline is tantamount to a huge tax cut since every one penny decline in price adds approximately $1 billion to consumers’ purchasing power.

Given such metrics, I expect the same outcome that occurred for the past two summers. That being, recession fears, which caused those previous mid-year declines in equity prices, should give way to no recession with an attendant rise in equity prices. And, the rise may have already begun. Said view would gain traction if the S&P 500 (SPX/1362.13) can sustain an upside breakout above the ~1360 level that has contained recent rallies. If that happens, it would lift the SPX out of the trading range between 1290 and 1360 it has been mired in since mid-May. I think this scenario has a decent chance of playing since my weekly internal energy indicator has a full load of energy. My daily indicator’s energy level, however, was largely used up in Friday’s Fling, so maybe we see a pause and/or pullback attempt early this week that doesn’t get very far. Additionally, despite last Monday’s 138-point Dow Dive, following the previous Thursday’s Trouncing (-250 points), none of my risk and money flow indicators turned negative; and not getting bearish over the past few weeks has been a pretty good strategy.

Nevertheless, bearishness is in the “air” with participants in “panic mode” just like they were the past two summers. CALM DOWN, we have had a panic declines in each of the last two years and survived them. Verily, panics represent opportunity for the well prepared investor because the surest action in the stock market following a panic is the subsequent recovery. It’s almost a rule that after a panic there will be an advance that recovers roughly one-half of the points lost during the panic. Recall, last summer the SPX declined from its early July high (1356) into its “panic low” of August 9th (1101) and from there the bottoming process began. Remember that “bottoms” are a function of not just “price,” but “time” as well. In 2011’s “panic decline” the bottoming sequence took from August 9th until October 4th and from there not only did we recover half of the price decline (19%), but we experienced a 32% rally.

Consistent with these thoughts, if the SPX has a decisive and sustained breakout above 1360, we recommend putting some more cash back to work. Over the past few weeks we have featured non-market correlated situations, with decent yields and favorable ratings from our fundamental analysts, like: Covanta (CVA/$17.15/Strong Buy); Johnson & Johnson (JNJ/$67.56/Outperform); and Rayonier (RYN/$44.80/Strong Buy). This morning we revisit the long-standing theme that the master limited partnership (MLP) complex, which trades on average between 9 – 10 times EBITDA, is likely going to acquire select E&P C-corporations that trade at roughly 4 – 5x EBITDA because it is accretive to do so. Some names from our research universe with favorable ratings from our fundamental analysts that play to this theme, include: Denbury Resources (DNR/$15.11/Outperform); Plains Exploration (PXP/$35.18/Outperform); and Whiting Petroleum (WLL/$41.12/Outperform). And since the Energy sector is the most oversold of the 10 macro sectors, speculators might want to consider some our favorably rated, and thoroughly beaten up, coal stocks that presented at the fourth annual Raymond James Coal Conference. For ideas see analyst Jim Rollyson’s Industry Brief dated June 21, 2012.

The call for this week: In my opinion, last week the Commodity Index bottomed and the Dollar Index topped. If so, recession fears should abate in the months ahead. Moreover, if a recession was really on the horizon “junk” bond yields would be rising on worries of increased defaults and that is not happening with the iShare High Yield Fund (HYG/$91.29) attempting to make a new reaction high (i.e., lower yields). Further, if we are heading into a recession, why is the Market Vector Retail ETF (RTH/$42.26) within 1% of new all-time highs? Meanwhile, investors are frozen by the negative narrative of world and economic events and investors have been liquidating domestic mutual funds for about 30 months, investment sentiment is dour, NYSE short interest versus the SPDR S&P 500 ETF (SPY/$136.43) is rising, and there is a huge amount of cash on the sidelines, all of which is inconsistent with a stock market that is vulnerable to a big decline. With the aforementioned proprietary metrics, and the tons of internal energy built up in the markets, if the SPX can sustain a breakout above 1360 the upside could surprise even the “bulls.”

Click here to enlarge

Click here to enlarge

Tags: Afo, Audacity, Chief Investment Strategist, Communist Regimes, Draft Age, Economic Necessity, Economic Reports, jeffrey saut, Mendacity, Mikhail Gorbachev, Military Conscription, Political Survival, President Gorbachev, Saut, Sour Lemon, Soviet Expansionism, Soviet Leader, Soviet Tanks, Troop Strength, Virtue Of Necessity, William Safire
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Our House: Is the United States the Best House in a Bad Neighborhood? (Sonders)

Wednesday, June 6th, 2012

June 4, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The June 1 employment report was a dud, but other economic reports were a bit rosier.
• The eurozone debt crisis and slowing global growth remain the greatest risks.
• A muddle-through economy continues to be the most likely path.

I won’t try to put lipstick on the pig that was last Friday’s May jobs report, but I will try a little lip gloss. Somewhat lost in the mire of the dire reaction to the report were several other more-positive readings on the economy. That’s testament to the likelihood that there are many more drivers to today’s malaise than just jobs growth, or lack thereof. It seems clear we’re in the midst of the third consecutive mid-year economic slowdown, driven by similar forces, most dominantly the eurozone debt crisis.

Questions about recession risk are as rampant now as they were last fall, but I remain in the camp that believes we will avoid one in the short-term. Part of the reason is not rosy: as the saying goes, if the plane never got off the runway, a crash is much less likely. It’s the “blessing” and the curse of a muddle-through economy. I wouldn’t bet the farm on a recession being avoided and I have as cloudy as crystal ball as anyone, but that remains my view.

First, the lip gloss

The weakness in the employment report was largely across the board. Payroll employment was up a meager 69,000, about half the consensus expectation, while the unemployment rate ticked up a tenth to 8.2%. The weakness was largely concentrated in three areas: business services, leisure and hospitality, and construction.

The weakness in construction probably reflects a “give-back” from the exceptionally strong, warm-winter-weather period in the beginning of the year. The other two segments tend to see their hiring lag movements in energy prices, and given their surge during the first four months of this year, the weakness is not terribly surprising. The good news is that energy prices have plunged since then.

There are some other caveats, too. The household measure of employment, from which the unemployment rate is derived, showed an increase of 422,000 and an increase in the number of participants in the labor force. The latter explains why the unemployment rate ticked up, but may also show some increased confidence about landing a job. However, it also points to expiring unemployment insurance benefits, which is forcing some participants back into the labor pool.

It’s not all bad

We also know that many of the leading indicators for job growth remain healthy, including:

• Employment components of the Federal Reserve’s regional manufacturing surveys
• Hiring plans, sales, profits and jobs-hard-to-fill at multi-year highs
• Jobs-hard-to-get at multi-year lows
• Job openings (JOLTS survey) at a four-year high
• Average hours worked at a 20-year high
• National Federation of Independent Business plans to hire at a cycle-high

Friday also brought the latest Institute for Supply Management (ISM) manufacturing index, which registered a reading of 53.5—still well above the 50 reading that separates an expansion from a contraction, and consistent with economic growth remaining comfortably above recession territory. On top of that, the new-orders component of the ISM index (both the index overall and the new orders component are key leading indicators) is not only at a cycle-high, but the “prices paid” component, measuring inflation, has collapsed in the past month. As noted by Wolfe Trahan, the best US gross domestic product (GDP) readings have generally come in the wake of large declines in inflation. And stocks generally do well when leading indicators of growth (new orders) are stronger than inflation pressures (prices paid).

Wall of worry is back

Sentiment has also improved markedly over the past month, thanks to May’s weakness. When I last wrote about sentiment in early April we highlighted the market’s elevated risk of a correction due to overly-optimistic sentiment (a contrarian indicator). As you can see below, that sentiment has reversed and is approaching territory that’s usually supportive for stocks. But frankly, I’d feel better if sentiment got even more pessimistic. We may need to see a little more capitulation before the market can find its legs.

Enough Pessimism?

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 29, 2012.

Manufacturing renaissance

Longer term, we remain optimistic about the prospects for both the US economy and stock market relative to the rest of the globe. As I’ve noted consistently, we have a “renaissance” story unfolding here in the United States; particularly within manufacturing and domestic energy. Housing is also becoming a major tailwind (more to come on that in future reports.)

I got back from a trip to China 10 days ago and my conversations in Hong Kong and Shanghai largely supported my view that even in the face of a “muddle through” economic-growth environment, from which this country is unlikely to exit any time soon, there are bright spots worthy of attention. In fact, maybe tellingly, nearly everyone with whom I had a conversation was more pessimistic than the consensus about China’s growth prospects but more optimistic than consensus about US growth prospects. And this was the sentiment of both local Chinese as well as US ex-patriots with business in China.

Tags: Bad Neighborhood, Blessing And The Curse, Charles Schwab, Chief Investment Strategist, China, Crystal Ball, Debt Crisis, Dud, Economic Reports, Economic Slowdown, Employment Report, Energy Prices, Eurozone, Global Growth, Last Friday, Liz Ann, Muddle, Payroll Employment, Senior Vice President, Unemployment Rate, Warm Winter Weather
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James Paulsen: Investment Outlook (May 2012)

Wednesday, May 2nd, 2012

Is it Déjà Vu all Over Again?

April 30, 2012

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)

After nearly six months of persistently better-than-expected economic reports and a regularly rising stock market, metrics on the economy have turned a bit more mixed lately while stock market prices have struggled in recent weeks. This has caused many to wonder whether the economy and the stock market are headed again toward another “spring swoon” like those experienced during 2010 and 2011.

Spookily, conditions do seem remarkably similar today to those which preceded the last two spring thaws. In 2010, the stock market peaked on April 23 and in 2011 it peaked on April 29. Well, it’s April again and stocks are struggling? Moreover, in each of the last two years, just like this year, the spring stalls were preceded by improved economic reports and by a surge which carried stock prices to new recovery highs. Finally, rising gas prices have again played a dominant role in recent months as they did leading up to both of the last two spring swoons.

So, is everyone best advised to simply “Sell in May and Go Away”—something which worked well in each of the last two years? Although similarities to past swoons are troubling and while the recovery will inevitably “ebb and flow,” there are several critical differences evident this year which should help keep the economy and the stock market out of “swoon’s way” during the balance of 2012.

Economic Policies are More Accommodative

Economic policies are notably more accommodative today compared to either 2010 or 2011. In 2010, the pace of the M2 money supply had slowed to a restrictive 1 percent annual pace, and in early 2011 it was only rising at a very modest 4 to 5 percent pace. By contrast, today, the annual growth in the M2 money supply has persisted about a robust 10 percent clip since last fall!

In both early 2010 and early 2011, the 30-year national average mortgage rate (Chart 1) rose above 5 percent prior to the spring swoons. Today, the mortgage rate is near an all-time record low below 4 percent! Significant accelerations in consumer inflation ravished household real incomes prior to both the 2010 and 2011 economic stalls. As illustrated in Chart 2, the annual rate of consumer price inflation jumped from -2 percent (deflation) in mid 2009 to about +2.5 percent by early 2010. Similarly, the annual inflation rate rose from about 1 percent at the end of 2010 to about 3.5 percent by 2011 springtime. These spikes in consumer prices significantly reduced real household income gains. Today, by contrast, real incomes are being boosted by a decline in the consumer price inflation rate from about 4 percent last fall to 2.7 percent currently!

While the Japanese tsunami had ravished U.S. manufacturing supply chains last year, today the “Japan bounce” is helping revive U.S. industrial activity. Finally, global economic policy officials are almost universally accommodative today. Until last fall, euro-zone officials refused to ease interest rates or expand the ECB balance sheet. Recently, however, both policies have been eased significantly! Similarly, until late last year, most emerging world economic policy officials were attempting to moderate recoveries by tightening policies. Now, nearly all of the emerging world is easing conditions to reaccelerate recoveries.

In both 2010 and 2011, economic policies were decidedly more restrictive and probably played a significant role in the resulting economic and stock market swoons. Today, however, much more accommodative global economic policies should bring a more favorable outcome.

U.S. Economic Recovery More Mature

The spring swoon in 2010 hit before the economic recovery had even reached its first anniversary. Today, the recovery is much more mature and therefore less vulnerable to swoons than it was in either 2010 or 2011.

Several recent economic reports portray a maturing economy. In the first quarter, average monthly job gains were in excess of 200 thousand for the first time in this recovery. Initial weekly unemployment insurance claims have finally fallen below 400 thousand and the unemployment rate is enjoying its most persistent decline of the recovery. Additionally, the present situation consumer confidence index (Chart 3) has risen to a new recovery high, the economy has enjoyed the most robust retail spending of the recovery, auto sales have again recovered to about a 15 million annual pace, and an array of recent housing reports suggest the greatest level of housing activity since the industry collapsed. Finally, bank loans (Chart 4), absent during much of the first two years of this recovery, have risen steadily during the last year!

While the economic recovery has not yet surged ahead with strong momentum, many of the traditional engines of growth which often suggest a sustainable recovery (e.g., job creation, consumer and business confidence, improvement in big ticket spending propensities on cars and homes, and better bank lending) are now increasingly evident. With the economy simultaneously firing on so many more cylinders than it was in early 2010 or early last year, it appears much better equipped to weather adversities.

Household Fundamentals Much Improved

The U.S. household is also much less vulnerable to shocks compared to earlier in this recovery. Consumer fundamentals have improved markedly in the last year. The job market has finally come to life, consumer confidence has risen to its highest level of the recovery, and real wages and salaries are rising by about 2 percent in the last year compared to a negative growth rate in early 2010. The U.S. personal savings rate has averaged 5.1 percent in the last four years which represents the highest persistent savings rate in more than a decade, and the U.S. household liquidity ratio (cash holdings as a percent of net worth) has been hovering about a 20-year high since the start of the recovery. Moreover, despite virtually no recovery yet in housing prices, households have already regained almost two-thirds of the loss in net worth experienced during the crisis.

Tags: April 29, Chief Investment Strategist, Critical Differences, Dominant Role, Economic Policies, Economic Reports, Investment Outlook, M2, Market Metrics, Money Supply, Pace, Rising Gas Prices, Six Months, Spring Thaws, Stock Market Prices, Stock Prices, Swoon, Swoons, Wells Capital Management, Wells Fargo
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Is it 2010 and 2011 All Over Again?

Thursday, April 26th, 2012

Following a string of weaker than expected economic reports over the last few weeks and today’s much larger than expected drop in Durable Goods Orders, investors are increasingly asking if the market is setting itself up for a repeat of 2010 and 2011.  In the chart below, we highlight the annual performance of the S&P 500 so far this year, as well as in 2010 and 2011.  As shown in the chart, in both 2010 and 2011 the S&P 500 rallied in the first four months of the year.

In 2010, the S&P 500 was up 9.2% when it reached its first half peak on 4/23.  From there, the index dropped sharply and was down as much as 10% YTD before rallying when the Fed stepped in with QE2.  In 2011, we saw a similar pattern.  When the S&P 500 reached its first half peak on April 29th, the index was up 8.4% on the year.  From there, it was a downward slide as the index fell roughly 20% through October.  Then late in the year, the market once again rallied when the Summer ended and the Fed stepped in with ‘Operation Twist.’

This year, the market finds itself in a similar position as the month of April comes to a close.  At its peak on 4/2, the S&P 500 was up 12.8% on the year, but it has since seen a minor pullback.  This pullback coupled with recent weakness in economic data and the on-going European debt crisis has investors worried that this could be a long hard Summer.

Will 2012 turn out a lot like last year?  Only time will tell, but while there are some similarities between now and then, there are also some key differences.  For starters, the economy is at a higher level now than it was then.   Additionally, while most global Central Banks had a bias towards tightening early last year, this year the bias is towards easing.  Finally, last year’s peak in the market and economic activity came just weeks after the earthquake in Japan.  As we noted back then, when the world’s third largest economy essentially grinds to a halt, the global economy will feel an impact.

Tags: Amp, Bias, Central Banks, Debt Crisis, Downward Slide, Durable Goods Orders, Earthquake In Japan, Economic Activity, Economic Data, Economic Reports, Four Months, Global Economy, Half Peak, Investors, Month Of April, Months Of The Year, Pullback, Qe2, Starters, Ytd
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Leading Indicators and the Risk of a Blindside Recession (Hussman)

Sunday, January 15th, 2012

Leading Indicators and the Risk of a Blindside Recession

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy

Over the past few weeks, investors used to setting their economic expectations based on a “stream of anecdotes” approach have seen their economic views evolve roughly as follows:

“After a brief ‘scare’ during the third quarter, economic reports have come in better than expectations for weeks – a sign that the economy is on a gradual but predictable growth path; Purchasing managers reports out of China and Europe have firmed, and the U.S. Purchasing Managers Indices have advanced, albeit in the low 50′s, but confirming a favorable positive trend, and indicating that the U.S. is strong enough to pull the global economy back to a growth path, or at least sidestep any downturn; New unemployment claims have trended gradually lower, and combined with a surprisingly robust December payroll gain of 200,000 jobs, provides a convincing signal that job growth is on track to improve further.”

I can understand this view in the sense that the data points are correct – economic data has come in above expectations for several weeks, the Chinese, European and U.S. PMI’s have all ticked higher in the latest reports, new unemployment claims have declined, and December payrolls grew by 200,000.

Unfortunately, in all of these cases, the inference being drawn from these data points is not supported by the data set of economic evidence that is presently available, which is instead historically associated with a much more difficult outcome. Specifically, the data set continues to imply a nearly immediate global economic downturn. Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) has noted if the U.S. gets through the second quarter of this year without falling into recession, “then, we’re wrong.” Frankly, I’ll be surprised if the U.S. gets through the first quarter without a downturn.

Three basic issues are at play. One is that analysts aren’t making distinctions between leading, coincident and lagging data. The second issue is that there is little effort to measure the predictive strength of a given economic data point (or set of data points) in explaining subsequent movements in the economy. The third is that analysts seem to be forming expectations report-by-report (what I call a “stream of anecdotes” approach) instead of taking those reports in context of the full ensemble of data that is available at each point in time.

Let’s examine the seemingly most “compelling” data point first – the fact that December payrolls grew by 200,000. Surely that sort of jobs number is inconsistent with an oncoming recession. Isn’t it? Well, examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began. These were not small numbers. The average payroll growth (scaled to the present labor force) translates to 200,000 new jobs in the month of the recession turn, and about 500,000 jobs during the preceding 3-month period. Indeed, of the 80% of these points that were positive, the average rate of payroll growth in the month of the turn was 0.20%, which presently translates to a payroll gain of 264,000 jobs.

Likewise, in 5 of the past 10 recessions, the ISM Purchasing Managers Index was greater than 50 just weeks before the recession began, and the new orders component of that index was greater than 50 in most cases, immediately prior to the recession.

Very simply, neither a strong monthly employment gain nor a slight uptick in the PMI are informative signals that recession risk has eased. Both the PMI and the level of payroll job growth are what one might call “weak learners.” It’s not that these figures aren’t useful – just that neither of them has a particularly good record by itself of signaling recessions. As it happens, a PMI below 54, coupled with year-over-year payroll growth below 1.3% is a stronger “learner” than either of the two data points individually (see the 2007 comment Expecting A Recession ). That combination – which is actually alternate Condition 4 of our Recession Warning Composite – remains in place at present, as are the other conditions in that Composite. Our more complex ensemble models also indicate strong recession risk.

The chart below provides a good picture of the behavior of non-farm payroll growth in the months before and after a recession begins, based on all U.S. postwar recessions. Notice in particular that in the month a recession starts, payroll job growth has not only been positive in 80% of cases, but has actually been higher, on average, than the three preceding months. Neither the level of job growth nor its short-term trend had any “leading” information content at all about the subsequent direction of the economy.

Notably however, the month following entry into a recession typically featured a sharp dropoff in job growth, with only 30% of those months featuring job gains, and employment losses that work out to about 150,000 jobs based on the present size of the job force. So while robust job creation is no evidence at all that a recession is not directly ahead, a significant negative print on jobs is a fairly useful confirmation of the turning point, provided that leading recession indicators are already in place.

I’ve discussed the “positive surprises” argument (see When Positive Surprises are Surprisingly Meaningless ) and the negative implications of the European ISM, despite last month’s uptick (see The Right Kind of Hope ) in other recent comments. Suffice it to say that broadly speaking, the recent “surprises” in the data reflect minor fluctuations within overall levels that remain fairly tepid, and more importantly, that remain clearly unfavorable as an ensemble.

How to spot a leading indicator

I want to begin this section with a simple statement – I do not hope for a recession. Rather, that is the expectation that the data forces on us. Frankly, much of my time in recent weeks has been devoted to analyzing data in the hope that a more compelling case could be made for avoiding a recession, since that would free us to be more constructive should market internals improve. But that’s not what the evidence indicates here, and the recent economic data hasn’t reversed that conclusion – not yet at least. I like to think I do a good job of showing you the same things that I am seeing. I don’t challenge rosy outlooks because I enjoy being defensive – I don’t. In fact, I can hardly wait for market conditions where risk is priced appropriately. It’s just that Wall Street’s simplistic cases that stocks are cheap and recession is “off the table” just don’t hold water when we examine the data.

I’ve written a lot in recent months about the distinction between leading, coincident and lagging indicators. One of the ways to distinguish these is to calculate a whole set of correlations between an indicator and what it is intended to predict, using various leads and lags. If a given indicator is correlated with whether or not the economy was in a recession say, 6 months later, we would say that the indicator has a certain amount of usefulness as a “leading” indicator. In contrast, if a given indicator is correlated with whether or not the economy was in a recession say, 6 months previously, we would say that the indicator has a certain amount of usefulness as a “lagging” (or “confirming”) indicator. The stronger the correlation at a given point, the more useful that indicator is as a leading, coincident, or lagging indicator. Importantly, it is the strength of the correlation, not simply where the correlation curve peaks, that defines the usefulness of the indicator. [Geek's note - it's more elegant to do this work in the frequency domain, but correlations work nicely for the purposes here].

The chart below is a little bit busy, but presents the correlation profile of a variety of widely followed indicators, as well as an ensemble of recession indicators we track (see Measuring the Probability of Recession in the September 5 comment). In the chart below, month zero represents the start of a recession.

Notice that about 9 months prior to a recession, the Conference Board Leading Economic Indicators, the ECRI Weekly Leading Index and the 6-month change in the S&P 500 often show some weak leading characteristics, but the correlation is too small to make inferences very reliable. Advancing to about 6 months prior to a recession, a few more indicators begin to show a weak correlation with the oncoming recession, including our own ensembles, as well as the average of Fed surveys (such as Philly Fed and the Empire Manufacturing survey) and the ISM Purchasing Managers Index. Still, at that point, the correlations are typically fairly weak. Though none of these indicators are particularly good at anticipating a recession even 6 months out, the Conference Board Index of Leading Economic Indicators (LEI) has historically had a slight edge looking two quarters ahead (the LEI makes a very interesting study on its own here, so more on that below).

Once a recession is within three months away, the strongest leading indicators are our own ensemble and the ECRI Weekly Leading Index (though I expect that an ensemble of ECRI’s other indicators, such as the long-leading and coincident measures would, in combination, give an even stronger overall signal than the WLI alone). The 6-month change in the S&P 500 approaches its strongest correlation with an oncoming recession with only a 1-3 month lead, suggesting that investors wishing to anticipate recession-linked stock market weakness would want to focus on indicators have even better leading characteristics than stocks themselves.

Once a recession hits, our recession ensemble, the ECRI Weekly Leading Index, and the average of multiple Fed surveys have the strongest likelihood of confirming the downturn in real-time. Immediately following entry into the recession, as noted earlier, payroll growth tends to turn negative. Though recessions tend to be preceded by sub-par employment growth over the preceding 3-12 month period, the 3-month growth rate of payrolls actually acts as a bit of a lagging indicator, reaching its highest correlation with a recession – not surprisingly – about 3 months after the recession starts.

New claims for unemployment have very slight short-leading usefulness, but new claims, the unemployment rate, and the slope of the yield curve (flattening) actually have much better lagging characteristics, so these should be used primarily to confirm an ongoing recession (particularly if the NBER hasn’t made an official determination yet), rather than to anticipate a downturn. The yield curve generally flattens significantly coming into a recession, but the change in the yield curve (not plotted) is also most useful as a lagging indicator. Consumer confidence has mixed characteristics, with weak leading characteristics and somewhat greater usefulness as a lagging indicator, but in any case is too much of a “weak learner” to be used in isolation.

At present, our own recession ensembles, as well as ECRI’s official views, remain firmly entrenched in the recession camp. This feels more than a little bit disconcerting, as the entire investment world appears to have the opposite view. My problem is that the data don’t support that rosy “U.S. leads the world off the recession track” scenario. Leading data leads. Lagging data lags. Weak data is weak data. To anticipate a sustained economic upturn here would require us to place greater weight on weak, lagging data than we presently place on strong leading data. It’s really that simple. If the evidence turns, we will shift our view – and frankly with some amount of relief. At present, though, we continue to expect a concerted economic downturn.

The LEI and monetary bias

One of the interesting aspects of present conditions is the apparent disconnect between the Conference Board’s index of leading economic indicators and the ensemble of other economic indicators that we follow (including ECRI’s indices). The LEI is a composite of 10 measures, including the average workweek, jobless claims, new consumer orders, capital equipment orders, vendor deliveries, building permits, consumer expectations, stock prices, the yield curve, and real M2 money supply.

Tags: Anecdotes, Economic Cycle Research Institute, Economic Data, Economic Downturn, Economic Evidence, Economic Expectations, Economic Reports, Economic Views, Ecri, Global Economy, Growth Path, Hussman, Inference, Lakshman, Leading Indicators, Payroll Jobs, Predictable Growth, Purchasing Managers, Recession, Unemployment Claims
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When “Positive Surprises” Are Surprisingly Meaningless (Hussman)

Sunday, December 18th, 2011

When “Positive Surprises” Are Surprisingly Meaningless

by John P. Hussman, Ph.D., Hussman Funds

In recent weeks, investors have abandoned all material concern about the likelihood of oncoming recession, largely because U.S. economic reports – though very tepid on an absolute basis – have come in persistently “better than expectations.” Objectively, the best showing has been in new claims for unemployment. The 4-week average has eased slightly below 400,000 in recent weeks, to a level that would no rmally be consistent with slightly positive payroll growth, though not enough to absorb normal labor force growth (the unemployment rate dropped last month partly because hundreds of thousands of people stopped looking for work). My concern here is in taking these labor numbers as predictive, in the face of an abrupt drop in federal withholding tax deposits.

As economist John Williams observes, “starting in October, a divergence developed: Whereas year-to-year change in BLS estimated payroll earnings continued at a more-or-less constant, positive level, tax receipts fell quite markedly. Where the Treasury numbers reflect full reporting, the BLS data are sampled, heavily modeled and usually heavily revised. The implication is that the BLS has overstated average earnings and payrolls meaningfully in recent months.”

The pattern in withholding tax deposits mirrors what we’ve seen in a whole ensemble of reliable leading economic measures we track – a sharp initial deterioration in early August, followed by a slight bounce into October, followed by resumed weakness that reinforces our concerns about the economy (see Have We Avoided A Recession? )

Labor figures are subject to strikingly large seasonal adjustments. The seasonal adjustment factors for non-farm payroll employment vary between 1.0157 and 0.9920, which doesn’t mean much until you put these numbers in context. Given total non-farm payroll employment of about 132 million workers, these adjustment factors mean that in any given month, the effect of seasonal adjustment on the reported payroll employment figure amounts to something between +2.1 million and -1.1 million jobs. Likewise, two-thirds of the new unemployment claims reports over the past year have been subsequently revised upward by several thousand. That’s not to diminish the importance of these figures in economic analysis, but instead to emphasize the importance of smoothing and other forms of noise-filtering that reduce the impact of short-term volatility. Suffice it to say that the improvement in new unemployment claims strikes me as a legitimately hopeful development, but there is too much short-term noise, and inconsistency with other economic evidence (reliable leading indicators, falling tax withholdings) to draw a convincing signal.

More broadly, the real question is how much importance should we put on the fact that economic data has delivered consistent “positive surprises” in recent weeks? Don’t all these surprises significantly short-circuit the risk of probable recession?

On that question, the evidence is very clear. No, they do not.

In order to properly understand economic “surprises,” it’s important to recognize that unlike actual economic data, where fluctuations have to do with, well, the actual economy, economic surprises are – by definition – measured relative to the subjective expectations of economists and Wall Street analysts. Unfortunately, analysts tend to be all-or-none. Instead of allowing for a normal ebb-and-flow of data, they form expectations that overshoot both on the pessimistic side and on the optimistic side. As a result, once the economy experiences an initial softening, expectations turn lower, often very aggressively. Over the following weeks, economic data can continue to be fairly soft, but because expectations have collapsed, the new data is interpreted as being “above expectations.” After a while, that experience of positive surprises causes analysts to over-correct by forming overly optimistic expectations, which is predictably followed by a period where the data, unless it is spectacular, almost cannot help but disappoint.

My observation is that this cycle of optimism and pessimism tends to run just over 20 weeks in each direction, though that is certainly not a magic number of any kind, and is best interpreted as a tendency. To give you an idea of how this regular pendulum of hope and despair affects the data in practice, the chart below presents the Citigroup Economic Surprises Index (a tally of how often recent economic reports have either beat or fallen short of consensus expectations). The blue line, to the thrill of anyone who enjoys Trigonometry, is a sine wave with a period of 44 weeks.

Notably, the Economic Surprises Index was near current levels just as the market was peaking before the 2007-2009 recession, was at a similarly high level just before the market collapsed violently in 2008, and reached a significant peak in March of this year, not far from where the S&P 500 topped out. Suffice it to say that the trend of positive economic “surprises” in recent weeks says more about the tendency of economic analysts to swing too far between optimism and pessimism than it does about the objective economic evidence, which remains tepid at best.

How broad is your sample?