Income, Housing and Durable Goods

In this week’s downturn, prices of the SP500 almost touched the 26 week, or half year, average of $203.90.  Since August 2012, when the 50 day average crossed above the 200 day average, these price dips have been good buying opportunities as the market has resumed its upwards climb after each downturn.

***********************

Manufacturing and Durable Goods

Preliminary readings of March’s Purchasing Managers’ Index (PMI) showed an uptick back into strong growth.  Survey respondents were concerned about weak export sales as the dollar’s strength makes American products more expensive overseas.  The full report will be released this coming Wednesday.

This past Wednesday’s report that Durable Goods had dropped 1.4% in February caused an already negative market to fall another 1.5% for the day and this marked the close of the week’s activity as well.  New orders for non-transportation durable goods have steadily declined since the fall.  Although the year-over-year comparisons are consistent with GDP growth, about 2.3%, the downward trend is concerning.

***********************
Housing

Existing home sales in February rose almost 5% in a year over year comparison, the best in a year and a half but still below the 5 million annual mark. The positive y-o-y gains during the past six months has prompted some optimism that sales may climb back above the 5 million mark in the spring and summer season.

New home sales in February surged back above a half million.  In a more healthy market, sales of new homes are 6% – 7% of existing homes.  In 2006, that ratio started climbing above the normal range, getting increasingly sicker until it reached almost 18% in May 2010.  February’s ratio was 9%. If the ratio were in the normal range, existing home sales would be over 8 million, far above the current 4.9 million units actually sold.

In a 2014 report the National Assn of Realtors noted that boomers tend to buy new or newer homes to avoid maintenance headaches while younger buyers buy older homes because they are less expensive (page 3).  38% of all home buyers are first timers but the percentage is double for those younger than 33 (Exhibit 1-9 in the report).  As the supply of existing homes is inadequate to meet the demand, prices climb and suppress the demand, forcing first timers to either buy a smaller new home or continue renting.

Sales of new homes and the fortunes of home builders are based on the churn of existing homes.  Since October, the stocks of home builders (XHB) have climbed 20% in anticipation of growing sales, but weak existing home sales may prove to be a choke point for growth.

The larger publicly traded homebuilders also build multi-family units.  Real investment in this sector has tripled from the lows of early 2010 but are still below pre-crisis levels.

The housing market in this country is still wounded.  63% of the population are white Europeans (Census Bureau) but are 86% of home buyers (Exhibit 1-6).  While few will admit to racial prejudice in the current housing market, the numbers are the footprints of this nation’s long history of racial discrimination and socio-economic disparity.  Mortgage companies that made – let’s call them imprudent – credit decisions that helped precipitate the housing crisis are especially cautious, making it more difficult for younger buyers to purchase their first home, despite the historically low mortgage rates.  This market will not heal until mortgage companies relax their lending criteria just a bit and that won’t happen while rates are so low.

**************************
Income

The Bee Gees might have sung “Words are all I have to take your heart away” because they were singing about love, not economics and finance.  Graphs often tell the story much better than words.  A milestone was passed a few years back.  For the first time since World War 2, the growth in income crossed below the growth in output.

This past week, the Bureau of Labor Statistics released a revision to their initial estimate of multi-factorial productivity in 2013.  There is a lot of data to gather for this series.  An often quoted productivity growth rate calculates the GDP of the nation divided by an estimate of the number of hours worked, a statistic that is accessible through payroll reports submitted monthly and quarterly.  The contribution of capital to GDP is much more difficult to assess and is largely disregarded by those like Robert Reich, former Secretary of Labor under President Clinton, who have a political axe to grind.  Truth is on a path too meandering for politics.

Total output in the years 2007 – 2013 was just plain bad, growing at an annual rate of only 1%, a third of the 2.9% growth rate from the longer period 1987 – 2013.  In the BLS assessment, the growth rates of both labor and capital inputs were poor by historical norms but capital input accounted for all of the meager gains in non-farm business productivity.  People’s work is simply not contributing as much to growth as before.  That reality means that income growth will be meager, which will prompt louder political rhetoric to make some kind of change, any kind of change, because voters like to believe that politicians have magic wands.

Employment and Economy Swings Up

April 6th, 2014

Capital Goods

Factory orders, including aircraft, rose in February but general investment spending on capital goods declined.  The leveling off of non-defense capital spending in the past year indicates a lack of certainty among many businesses to commit funds for future growth.

A more panoramic view of the past two decades shows a peaking phenomenon at about $68 billion, one which this recovery has not been able to rise above.

Remember that these peaks are in current dollars and do not take inflation into account.  When adjusted for inflation, the trend is not reassuring.  A significant component of capital goods orders comes from the manufacturing sector – manufacturers ordering capital goods from other manufacturers – whose declining share of the economy puts a damper on growth in this area.

**********************************************
Employment

Modestly strong job gains of almost 200,000 in March sparked hope that the winter doldrums are over. The private payroll processor ADP reported 191,000 private job gains in March, in line with expectations and revised their February job gains from 139,000 to 178,000.  The headline this month was that private sector employment FINALLY surpassed the level in late 2008.

Net gains or losses in government employment have been negligible in the past several months.  State and local governments have been hiring enough to offset the small monthly declines in federal employees. Total non-farm employment is still below 2007 levels but so-o-o-o-o close.

While the unemployment rate stayed unchanged, many more unemployed started looking for work.  A reader writes “I read that the labor force has increased by 1.5 million from Jan-Mar, but that doesn’t jive with the number of people hired over that time.  Am I missing something here?”

The labor force includes both the employed and the unemployed.  Unemployed people, including those who retire, who have not looked for work in the past four weeks are not considered active participants in the labor force.   Whether a person was 50 or 80, if they started looking for work, they would then be counted in the unemployed and in the labor force.

The Bureau of Labor Statistics (BLS) states that:
The basic concepts involved in identifying the employed and unemployed are quite simple:
People with jobs are employed.
People who are jobless, looking for jobs, and available for work are unemployed.
People who are neither employed nor unemployed are not in the labor force.
This definition of the labor force uses the narrowest, or headline, measure of unemployment.  Since the beginning of the year, the labor force has increased 1.3 million, 1.6 million since October.

When people get discouraged, they stop looking for work.  Then a friend says “Hey, ABC company is hiring,” and people start their job hunt again.  In the past quarter, a net 800,000 people have come back into the labor force, despite the record number of people retiring and leaving the work force.

As the economy improves, enrollment in for-profit and community college will continue to decline, accelerating from the 2% decline in 2012 – 2013 (NY Times article)  As students start looking for work, they officially re-enter the labor force.

Retirees: According to PolitiFact 11,000 boomers per day become eligible for Social Security.  Let’s say that only 8,000 per day drop out of the labor force, making a total of about 700,000+ who retired this past quarter.  A job market that can continue to overcome the drag from retirement is a sign of strength.

The Civilian Labor Force Participation Rate is the percentage of (employed + unemployed) / (people who can legally work).  So if the Civilian Labor Force were 150 million and there were 250 million people 16 years and over and not institutionalized, 150/250 = .6 or 60%.  The participation rate is currently at 63%.

**********************************************

CWPI

In the March ISM survey of service sector purchasing managers, employment rebounded strongly from the contracting readings of February.  New orders grew stronger; both of these components get more emphasis in the calculation of the CWPI.

Weighed down by the winter lull, the smoothed composite index of manufacturing and services growth has declined for six months in a row but this should be the bottoming out of this expansionary wave. Barring any April surprises, March’s strength in employment and new orders should lead to an uptick in  the composite in the coming months.

***********************************

Investing

What are the chances an actively managed fund beat its benchmark?  Not good.  An analyst at Standard and Poors compared various indexes that her company produces vs the performance of actively managed funds.  In the past five years, only 28% of large cap actively managed funds beat the benchmark SP500 index.  Some mid cap and real estate funds did much worse; less than 20% beat their benchmarks.  Consider also that actively managed funds carry higher annual fees and/or operating expenses because the fund has to pay for the brain power of active management.

Investing, New Orders, Small Business

December 4th, 2013

This will be a mid-week post of various items I thought were interesting.  The private payroll processor ADP is showing private employment growth 215,000, about 15% above expectations.  This weekend, I’ll cover the employment situation and some long term trends.

***************************
When we buy bonds, we are buying someone’s debt. Really what we are buying is the likelihood that they will pay that debt.  When we buy stocks, we are buying someone’s profits – or the future prospects of those profits.  The S&P500 is an index of the 500 largest domestic corporations.  The BEA tracks the profits of all domestic corporations, not just the 500 largest, before tax adjustments. It is rather interesting to look at the ratio of the SP500 index to corporate profits, in billions.

Using this metric, the exuberance of the internet bubble is striking, far surpassing the housing bubble of the 2000s. It was a time when investment was high in the new digital economy.  The ingenuity of man had finally overcome the business cycle.   The ratio of stock prices to profits didn’t matter because profits were about to go through the roof, man!

Well, it would take a while but eventually profits did go through the roof.  It took a few years.  As a percentage of the nation’s GDP, corporation profits are near 11%.

So pick the story you want to tell.  1) Stocks are undervalued based on historical ratios of prices to profits.  2) Stocks are going to crash because corporate profits are too much a percentage of the economy, an unsustainable situation.  Both narratives are out there in the business press.

*************************************************

New orders for non-defense capital goods excluding aircraft has been declining of late.

Below is a chart showing the year over year percent gains in new orders and the SP500 index.  There is a loose correlation.  The stock market is usually responding to predictions of future activity as well as political and financial news.   I modified the changes in the SP500 by a little more than half to show the overall trend.

******************************************

In 2012, households finally surpassed 2007 levels of net worth.   In the past five years, household assets have risen by a third, more than $14 trillion dollars. More than half of that increase is the rise in stock asset values. In that same period, liabilities have decreased slightly from the $20 trillion.  All of the decrease and more is in mortgages.  This table shows the unsustainable growth in net worth during the housing boom.

Check out the growth in household debt during the housing boom.  Over 10% per year!  Now look at the growth in Federal debt.  There are only two years where it falls below 5%.  Someone once said something like “What can’t go on forever, won’t”.  How long can a government increase its debt 4x, 5x, 10x the rate of inflation or the rate of economic growth?

***********************************

A short and very informative book on investing by William Bernstein.

Deep Risk: How History Informs Portfolio Design (Investing for Adults)
William Bernstein

*************************************

Words of caution:

“A government big enough to give you everything you want is a government big enough to take from you everything you have.” – Gerald Ford

****************************************

Gallup’s survey of consumer spending in November was the strongest November in 5 years.  On the other hand, early reports of the y-o-y gains in retail spending over the 4 day Thanksgiving weekend indicated a meager 2.3%, barely above inflation.  Same store sales at department stores declined -2.8% in the Thanksgiving/Black Friday week, although they are up 2.5% year over year.  As I wrote about two weeks ago, online shopping is now a significant portion, 20%, of total retail sales.  A more complete feel for the consumer’s mood must include sales on Cyber Monday, the Monday after Thanksgiving.  These showed exceptional gains of 17% over last year’s numbers.

****************************************

ISM’s Manufacturing index was 57.3, the strongest in 2-1/2 years.  I’ll update the CWI after I input today’s numbers from the non-manufacturing report.  I was expecting a slight tapering in the composite.  As we saw a few weeks ago, there has been a positive wavelike action and it appeared as though the economy had hit a crest in October.

****************************************

In 2010, the Census Bureau reported that there were 5.7 million employers (those with payroll, as opposed to sole proprietors), a decrease of 300,000 from the 6 million employers the Census Bureau counted in 2007.  About 5.1 million employers had less than 20 employees and accounted for 14% of the $5 trillion in payroll. Those small to mid-size companies with 20 to 99 employees accounted for another 14% of payroll.  Mega-employers, those with 500 or more employees, paid out about 57% of total payroll in 2010 and constitute a little more than half of private employment.  These large employers naturally have more influence on policy makers in Washington and in state capitols throughout the nation.

 *****************************************

The National Federation of Independent Businesses’ (NFIB) recent monthly survey reported a fairly sharp decline in sentiment among small business owners. A hopeful sign in this report is the improvement in expectations for future sales.  Sentiment was particularly depressed over the shenanigans in Washington and pessimism towards the regulatory environmnent is near all time highs. A blend of small cap stocks has risen about 36% in the past year.  Small cap value stocks have soared 40%.

*****************************************
An interesting historical note from the Social Security administration.  As  preamble, Social Security taxes are collected and put in a “separate” accounting fund before they are immediately “borrowed” for the general spending needs of the Federal government.

 President Roosevelt strenuously objected to any attempt to introduce general revenue funding into the program. His famous quote on the importance of the payroll taxes was: “We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program.” 

In 1937, the Supreme Court ruled that the Social Security Act was constitutional.  The majority opinion, penned by Justice Cardozo: “The hope behind this statute [the Social Security Act] is to save men and women from the rigors of the poor house as well as from the haunting fear that such a lot awaits them when journey’s end is near.”

**************************************

Quite often, our auto or homeowner’s insurance company changes insurance plans on us.  The insurance company sends us a notice that, due to legislative changes or revised company policy, there is a new codicil to all insurance contracts.  Premiums may go up.  The insurance company’s liability may be reduced. Your old plan is being cancelled and reissued with a “-1A” after the policy number. Some of us may skim read the new changes, most of us shrug and sign the new contract and that is the end of the story.  Imagine the headlines: “MINIMUM DEDUCTIBLE RAISED TO 1% OF HOME’S VALUE.  ALL HOMEOWNERS’ INSURANCE CONTRACTS CANCELLED.”  This is what happens.  The old insurance contract is no longer available.

What is the response when the same thing happens to private health insurance  plans under Obamacare?  “Obamacare Forces over 800,000 in N.J. to change insurance plans” is the bold caption of one news story.  People who are unsympathetic to the new health care law will not make the distinction between “insurance plan” and “insurance carrier.”

Corporate Profits and New Orders

Wednesday’s release of durable goods orders showed a rather large downward revision to July’s data and an increase in August’s orders.  The transportation component makes the overall reading of this report quite volatile.  A more consistent read is gained by excluding transportation and defense goods, which showed a less dramatic 3.3% decline in July, followed by a slight increase of 1.5% in August.  The year on year increase is 7.6%.

In nominal dollars, not adjusted for inflation, we have reached the level of new orders before the recession began in late 2007 – early 2008.  Had the economy stayed “on trend” new orders would be over $84 billion this year.

When adjusted for inflation, we are at about 2006 levels – seven years of no net growth.

Second quarter corporate profits are up almost 6% and have tripled in the past ten years.

Despite all the daily and weekly responses to political as well as economic news, the SP500 stock market index essentially rides the horse of of corporate profits.  The market’s fluctuations reflect changing current expectations of future profits.  Except for the “irrational exuberance” of the late 90s, there is a remarkable correlation between the SP500 and corporate profits.

Focusing on the past ten years, we can see these two forces as they dance around each other.   As sales and profit emerge over each quarter, companies guide analysts estimates of profits up and down.  The market renegotiates its value based on these revisions of emerging profit estimates.  As a rule of thumb, an investor with a mid term horizon of 1 – 3 years might grow wary when these trends diverge as they did in the late 90s and 2006 – 7.

 

As a percent of the total economy, profits have doubled over the past ten years.  At the trough in 2008, when some financial pundits were forecasting the end of capitalism, profits as a percent of GDP were at the 25 year average.  Investors had become used to this lop-sided economy where corporations grab more of the economic pie.

A growing share of profits is earned overseas; that growing globalization and two decades of effective lobbying have enabled corporations to lower the tax bite on those profits.

The taxation of corporations is a two-edged sword.  One effect of more taxes for corporations means less dividends to investors, who probably pay taxes at a higher rate than the effective rate of corporations.  During the 1980s and 90s, dividends averaged around 40 – 50% of earnings after taxes.  In the past decade and especially after the cash crunch of 2008, corporations have retained more of their earnings as an emergency cash cushion, paying investors about 30 cents on each dollar of earnings.  That rush to safety will probably reverse itself in the coming years, prompting corporations to pay out more in dividends as a percent of profits.

There may be volatility in the market in the coming days and weeks as Congress wrestles over the funding and implementation of the health care act, threatening to shut down most non-essential functions of the entire government.  A similar budget battle in late July and August of 2011 was accompanied by an almost 20% drop in the market.  The longer term trend is told by the rise in corporate profits, by the rise in industrial production and by the rise in new orders.  A move downward in the market may be a good time to put some cash to work, or to make that IRA contribution for 2013.

Labor and Money Flows

September 1st, 2013

On this Labor Day weekend, I’ll review some things that caught my attention this past week.

The employment picture has shown steady but slow improvement.  The weekly survey of new unemployment claims continues to show downward movement.  In a survey that is about 13 years old, called the JOLTS, the BLS gathers data on Job Openings, Layoffs and Turnovers.  A component of this survey includes the number of employees who have quit their jobs, referred to as the “JOLTS quit rate.” In the aggregate, it indicates a hive intelligence, the estimation of millions of people about the prospects of getting another job.  Decades ago, researchers asked a number of people to estimate the number of jelly beans in a jar.  Each estimate has very small chances of getting close to the actual number, but the average of all estimates was found to be almost exactly the number of jelly beans in the jar.  I don’t know whether this experiment has been replicated but it is interesting.

After recent months of surging new orders for durable goods, July’s report, released Monday, showed signs of caution and a “return to the mean” of a positive upswing this year.

Although this past month’s data was negative, industrial production shows a clear uptrend.

In an analysis released a few months ago, the Federal Reserve examined data from the 2010 triennial (every 3 years) survey of households and estimated that inflation adjusted net worth per household (green line in the graph) has just climbed back to the level it was almost ten years ago.

 

On the positive side, average net worth is not less than it was ten years ago.  On the negative side for those nearing retirement, it is not more that it was ten years ago.

On Friday, the Personal Consumption and Expenditures (PCE) report showed a 1.4% year over year percent gain, indicating the tepid growth in household spending.  Below I’ve charted the percent gain in PCE vs the percent gain in GDP for the past thirty years.

We are still below the low points of the 1980s, 1990s and early 2000s.  The Federal Reserve is projecting GDP growth of 3 – 3.5% in 2014 but this may be another in a string of rosy forecasts by the Fed, who have repeatedly revised earlier rosy forecasts.  If the Fed were a contractor, it would be out of business due to poor estimating.  A $16 trillion economy is not a kitchen remodel by any means, but it does illustrate how difficult it is for the best minds to make even short term predictions of the economy from the vast amounts of sometimes conflicting data.  Consider then the folly of the Government Accountability Office (GAO), the economic watchdog created by Congress and mandated by Congress to come up with ten year estimates of economic growth and the consequences of existing and proposed legislation.  Those in Congress continue to trot out these fantasy numbers to support or criticize policy and legislation.

Washington continues to vacuum in money and talent from the rest of the country.  Of the richest counties in per capita income in the U.S., the Washington metro area has two of the top three.  The other county in the top three is a stone’s throw from the metro area.  As Washington politicians convince the rest of us that they have the solutions, lobbyists and graduates flock to the concentration of power, jobs, money and influence.
 
Bond yields have increased more than 1% since the spring, meaning that the prices of the bonds themselves have fallen dramatically.  Most of this change has been a reaction to forecasts for stronger growth and a tapering of the Fed’s stimulus program called Quantitative Easing.  Washington is sure to get in the way of stronger growth for the economy as a whole.  Policy out of Washington is designed to promote strong economic growth for Washington.

The market research firm Trim Tabs regularly monitors money flows into and out of the stock and bond markets.  They  reported today that outflows from the stock market in August were half of the record inflows in July.

The blood spilled this year has been in the bond market.  Trim Tabs reports that outflows from bond funds and ETFs have totalled more than $123 billion in the past three months.  Flows into bond funds and ETFs were about $750 billion in 2012, almost a doubling from the $400 billion invested in 2011. (Fed Flow of Funds tables F.120, F.121)

While the prospect of higher rates may have been the trigger that caused a reversal of bond inflows, the underlying current is also an overdue correction of the surge of investment in bonds in 2012.

Households continue to shed debt in one form or another so that total liabilities continue to decline. However, every man, woman and child in this country is carrying, on an inflation adjusted basis, 2-1/2 times the amount of debt they carried thirty years ago.  This level of household liability will continue to put downward pressure on growth.

This next week will kick off with the ISM manufacturing report on Tuesday and finish the week with the monthly employment report.  Year over year percent gains in employment have been steady and guesstimates are for maybe 200,000 net job gains.  150,000 net jobs are needed to keep up with population growth.

The Fed meeting is coming up in mid-September so this employment report will be watched closely to guess the next steps the Fed will take. 

Things That Spring

April 14th, 2013

Across the land, springtime wakens the trees and flowers, birds chirp and squirrels chatter.  From the buildings where the humans live comes the wailing and gnashing of teeth as many procrastinators spend this last weekend before the tax deadline in a spring ritual of angst.  The lost W-2 form is finally found beneath the Netflix DVD that has lain casually on the bookcase, waiting to be watched.  The 1099DIV form is found beneath a birthday card that was never sent.

Lay aside your problems; let’s climb inside the hot air balloon and look at the big picture.  A few weeks ago, economic growth for the fourth quarter of 2012 was revised marginally higher into positive territory, but dropping from the annualized growth rate of 3.1% in the 3rd quarter of 2012.  Let’s look at GDP from a per person basis since WW2.  Until the recession hit in late 2007, economic growth had consistently outpaced population growth.  Then POOF! went the economy and blew away a big gap in GDP.

Let’s zoom in on the past ten years to see the effect.  On a per person basis, the gap is $5,000 of spending that simply didn’t get spent.

Call it the GDP dust bowl of the 2000s, similar to the dust bowl of the 1930s when the wind blew the top soil from the prairie of the Oklahoma panhandle and forced many families from their farms.  In this case, the wind blew away a lot of jobs and chunks of home equity.

Policy makers in Washington want to close that $5000 per person gap.  If they could write a law forcing everyone to spend that $5000, they would.  Instead, they keep giving away money in unemployment benefits, food stamps, disability benefits, crop subsidies – all to keep people from not spending even less and making the problem worse.

Retail sales account for about 1/3rd of the total economy.  Including automobile sales and parts, consumers are still below twenty year averages.

This past Friday, the monthly report on retail sales showed little change from the past month.  When we look at per person real retail and food sales and take out automotive sales we get a feel for core sales, those that we make on a frequent basis.  Once again, we see the same gap that we saw in GDP.  Since mid-2009, this core consumer spending has grown 2.3% annually, above the 1.8% annual growth trend from 1992 through 2006, but it still down $2000 a year from what we would have spent if we had stayed on the same trend line before this past recession hit.

To make it a bit clearer, let’s look again at that chart and compare the 15 year annual growth rate from 1992 to the longer 21 year growth rate.  It has fallen from 1.8% to 1.1% annual growth.

GDP measures spending; let’s look at Gross Domestic Income, or GDI.  A fundamental principles of economics is that it takes money to spend money.  A six year old asks a parent “Why can’t we just go out and get more money?” to which the parent replies “Whaddya think money grows on trees?!”  End of Chapter One in the Parent’s Guide to Economics.

When we compare the country’s income to spending, we find that a dip in income below production precedes recessions.

After the 2008 – 2009 crash and recovery in national income and spending, both are limping along.

A few weeks ago came the monthly New Orders, an indication of business confidence.  As regular readers know, I have been watching this declining trend since September of last year, when the percent change in New Orders was negative.  The recent rise has been a welcome sign of growing confidence but new orders fell 2.7% in February and now hover around the zero growth line. 

On a quarterly basis, the year over year (y-o-y) percent change is still firmly in negative territory, meaning that businesses are not putting up more money to invest in new equipment.  Why?  Because they are still not sure about consumer spending. The six month run up in the SP500 stock index might lead a casual observer to think that the economy and companies are gearing up.  New Orders indicates that there is much more caution out there than the stock index would indicate.

This past Friday, business’ caution to commit to new investment was only reinforced when the latest Consumer Sentiment index was released.  After climbing the past few months, confidence is sinking again.  Maybe it’s the extra 2% coming out of paychecks since January 1st.  Whatever it is, it doesn’t inspire many business owners to put a lot of money into expanding their production.

When the stock market is trading on hope, it looks six months ahead.  The recent run up is hoping for double digit profit growth in the second half of this year.  When the market trades on fear, it looks ahead about 2 seconds, faster than the normal investor can or should react.  Let me get out my broken record for another spin, cue the needle and play that same old song “Diversify.”

P.S. For those of you who are more active investors, check the latest post from Economic Pic in my blog link list on the right.  It shows the past 40 year returns for a strategy of selling the SP500 index in May and buying the long term government / credit index.  The iShares ETF that tracks this index is ITLB.  A comparable ETF from Vanguard is BLV.

Predictions and Indicators

January 20th, 2013

I was talking with someone this week who thought that, this year or next, the financial world would melt down.  This week someone else asked what I thought was going to happen this year.  The S&P 500 index is approaching the highs of 2007.  Is this a good time to invest in stocks?

I don’t know.  In the early 1970s, Alan Greenspan, who would become head of the Federal Reserve in the late 80s, called for a bull market just a few months before the market imploded and lost almost half its value.  Recently released minutes of meetings of the Federal Reserve in 2007 showed that some members were worried about contagion from the decline of the housing market to the rest of the economy but the overall sentiment was that housing and employment weakness was a needed and normal correction to an economy that had gotten a bit too frothy.  No melt down anticipated there.

All any of us can know is what has happened and even that knowledge is imperfect.  Regulators who are privy to information that might spook the markets often conceal that information and hope to contain the damage.  Brokers and managers at large investment houses actually help build bubbles, skimming off fees and derivatives profits in the process.

With an imperfect assessment of the recent events, and a non-existent knowledge of the future, investors face the choice of putting their savings under the mattress or sending out their vulnerable savings into the economic fog.

Over the past few years, I’ve looked at several indicators that have been fairly reliable foreshadowings of coming recessions.  Before I look at those, let’s look at the big daddy indicator: the stock market.  Over the course of a week, millions of buyers and sellers try to anticipate the direction of the economy and corporate profits.  The majority of the time the market does anticipate these downturns but we need to look beyond the main index, the S&P500.  Instead we look at the year-over-year percent change in the index.  Below is a monthly chart of that percentage change.

The percent change drops below zero when the majority of investors do not believe that the market will increase over the next year.  You may also notice that it is a good time to buy the market when the y-o-y percent change declines 15-20%.

When we look at the past twenty years, the lack of confidence has been a reliable indicator of the past two recessions.  The graph below is the y-o-y percent change in a quarterly average of the S&P500.

These charts are easily available at the Federal Reserve database, FRED.  Just type in “Fred SP500” into your search engine and the top result will probably be a link to a chart of the index.  (Link here ) Click the “Edit Graph” button below the chart, then change the Frequency under the resulting graph to Monthly or Quarterly to smooth out the graph.  Just below the Frequency field is a drop down list of what you want to chart.  Select “Percent Change from Year Ago”, then click “Redraw Graph”.  Fred does all the work for you.

As of right now, the majority of investors are somewhat hopeful that there will be an increase in the index in the coming months. 

Another indicator I look at is the y-o-y percent change in the unemployment rate (UNRATE).  This is the headline number that comes out each month.  When the percentage change goes above 0, it’s probably not the best time to putting more money to work in the market.

Although the unemployment rate is still high, the yearly percent change is healthy.  As someone quipped, “It’s not the fall that kills ya, it’s the change in speed when ya hit the pavement.”  The change in each of these indicators is the key aspect to focus on.

Entering “Fred Unemployment” into a search engine should bring up as the top result a link to the unemployment chart.  Follow the instructions I gave for the SP500 and Mr. Fred will do all the number crunching.

Looking at a broader index of unemployment, the U-6 rate, gives no indication of near term economic decline.  Below is the percent change in that index.

Another indicator is New Orders in Nondefense Capital Goods Excluding Aircraft.  As I noted the past few months, this has been worrisome.  We don’t have sixty years of data for this indicator but a decline in the y-o-y percent change in new orders has foreshadowed the past two recessions.  Recent monthly gains give some hope but the decline in equipment investment shows a lack of business confidence for the near term future.

The last index I look at is a composite indicator put together by the National Bureau of Economic Research, NBER, the agency that makes the official calls on the start and end of recessions.  The Coincident Economic Index combines employment, personal income, industrial production, and manufacturing and trade sales.   In a healthy or at least muddling along economy, the percent change should stay above 2.5%.

You can access this by typing “Fred Coincident” into a search engine and the top result should be the graph for this indicator.  Follow the same instructions as above to show the percent change.

Except for New Orders there does not appear to be anything immediately worrisome.  According to Standard and Poors, (the S&P in the name of the S&P500 index), estimated operating earnings for 2013 are about $112 (Source).  At a 15.0 P/E ratio, that would put fair value of the SP500 at 1680, or 13% above its current level of 1486.  The problem is that the estimates of 2013 earnings have been drifting down from $118 last March.

For the past few years there has been a pattern of declining earnings estimates.  Something seems to be getting the way of early optimistic forecasts.  However, even if operating earnings were to actually come in at $100 for 2013, an investor with a ten year or more time horizon couldn’t say that she had overpaid at current market levels.

A favorite theme of 1950s sci-fi movies was the underwater creatures who had been turned by nuclear radiation into a gigantic monsters lurking on the seabed.  The tranquil calm surface of the water gave no hint of the monster swimming beneath the surface.  Then came an upswelling of water seen from the shore, a crashing crest of wave and the creature erupted from the liquid depths. For many investors, there may be that same sense of foreboding.  European banks loaded up on government debt; the Federal Reserve buying the majority of newly issued U.S. debt this past year; trillion dollar U.S. deficits; persistently high unemployment;  perhaps that is why there is so much cash floating around. 

The MZM money stock includes cash, checking accounts, savings accounts and other demand type accounts, money market funds and traveler’s checks; in short, it is money that people can demand now.  The percentage change has moderated recently and shows neither confidence or fear, of investors not knowing whether to step left or right.

For the long term investor, a showdown over raising the debt ceiling in the next few months may present another buying opportunity before the April 15th deadline to make IRA contributions for the 2012 year.

Capital and Consumer Spending

If I hit my thumb with a hammer, maybe it won’t hurt this time.  Not likely.  Last week I noted a warning sign in non-defense new orders for capital goods, excluding aircraft.  As I noted previously, aircraft orders are volatile; they may be up 30% one month and down 30% a few months later because orders for planes are placed in rather large blocks with the actual delivery of the aircraft occurring over many months.

A few days ago the most recent durable goods report came out for September, showing a continued decline in the year-over-year gains for new orders.  Declines like this have preceded the past two recessions.

We like to think that this time may be different. Our imagination is capable of soaring the heights of creativity in art and science.  In the economics of our personal lives, it can lead to fanciful thinking.  Fanciful notions led many to buy houses with little money down at the height of the housing boom, thinking that somehow they would refinance when mortgage payments escalated after a certain period.  Magical thinking induced many to increase their credit balances far beyond their means to pay, thinking that they could pay down their credit balances by refinancing their homes.  No matter how much homes went up in value, housing prices would continue to rise.  Then they didn’t.

The chart below shows the housing inflation.  Recessions in the latter part of the past century had caused housing starts to decline to 400,000 before recovering.  In the 2001 recession, easy money and loose standards for mortgage securitization curbed the natural decline.  The bill eventually came due in 2008.

Single family homes create jobs; the market has shown life recently but is still very weak.

The Conference Board’s Consumer Confidence index rose 9 points to 70 in September and is about the same level as this past February, when confidence started sliding to a summer low point of 60.   The new consumer survey is due to be released next week and analysts are predicting another increase of 3 to 4 points. Consumers are feeling upbeat but the decline in new orders shows that businesses continue to be cautious as the prospect of rising taxes and budget cuts next year dampens any optimistic planning.  The slowdown in Europe and Asia contributes to the gloomy reading of Moody’s Business Confidence survey.  Rising consumer confidence before the critical Christmas shopping season may alleviate the pessimism of businesses if consumers actually open up their wallets and spend but retailers have not been building inventory ahead of the shopping season.

While these two forces tug at each other, a prudent investor might exercise some caution.

New Orders

No, this is not about the New Order, the conspiracist’s nemesis.  This is about New Orders of Capital Goods.  When companies forecast sales growth ahead, they place orders for capital equipment to meet the projected increase in demand.  One version of the monthly report on new orders excludes aircraft orders which are volatile; fulfilling the order – the delivery of the new aircraft – are structured over time.

Below is a chart of the year-over-year percentage in new orders excluding both aircraft and defense spending.  I have used quarterly averages to smooth and show the trend. (Click to enlarge in separate tab)

As you can see, there are warning signs of recession or very low economic activity as the quarterly change is close to zero. The most recent monthly change has, in fact, dropped below zero.

The value of new orders has a fairly strong correlation with the S&P500 stock index, adjusted to scale.

Some have suggested that business plans are on hold till after the election and the coming negotiations over budget sequestration, or the “fiscal cliff.”  If so, this may be a temporary drop. The stock index usually either anticipates or is concurrent with the drop in the dollar amount of new orders.  Further gains in the index may be minimal unless this new order indicator of business sentiment turns upward.