Price Dividend and CWI

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August 11th, 2013

Last week I wrote about viewing trends in the market through the lens of hard cold cash; that is, the dividends paid by the companies in the SP500.  Today, I’ll revisit that subject in a bit more depth.  Beginning in the last quarter of 2008, reported earnings of companies in the SP500 dropped precipitously, plunging about 90% in the first two quarters of 2009.

The portion of those earnings paid as dividends fell 24% from peak to trough, far less than earnings.

Robert Shiller, a Yale economist and co-developer of the Case-Shiller housing index, uses a smoothing technique for calculating a Price Earnings ratio and graciously makes his data available.  He calculates the 10 year average of real, or inflation-adjusted, earnings and divides the inflation adjusted price of the SP500 by that average.  Because of the low inflation environment for most of the past decade, the difference between the two earnings figures, nominal and real, is slight.

The drop in corporate earnings was extreme, more so than any recession, including the Great Depression of the 1930s.   In the 2001 recession, earnings declined to about half of their prerecession peak.  In the recession of the early nineties, it was about 30%.  In the back to back recessions of the early 1980s, corporate earnings fell about 25%.

While Shiller’s method evens out earnings, it has one drawback, one that no one could have foreseen until 2008 simply because it had never occurred.  The severity of the decline in earnings skewed the ten year average of earnings down over the 2002 – 2012 period.  Since the earnings average is the divisor in the Shiller P/E ratio, it correspondingly makes the ratio of the price of stocks a bit higher than it might otherwise be.

For that reason, I’ll look at a less volatile ten year average of dividends; that is, the inflation adjusted price of the SP500 divided by the ten year average of inflation adjusted dividends.

Today’s market prices are at the twenty year average of the real price dividend ratio, which is about 61.  For a number of factors, market prices as measured by this dividend ratio are higher for the past twenty years than the thirty year average of 51.  The tech and real estate bubbles over-inflated prices but investors have been willing to pay more for stocks as bond yields have declined steadily from their nosebleed levels of thirty years ago.

Let’s crank up the time machine and go back a year.  Here are a few quotes from an October 13, 2012 Reuters article after the market had dropped about 2%:

“Central bank-fueled gains took markets within reach of five year highs in September, but now U.S. stock market participants are shifting their focus back to corporate outlooks, and the picture is not pretty.”

The article quoted the director of investment strategy at E-Trade Financial, Michael Loewengart: “The overall tone is so pessimistic that we may see some upside surprises, but we could still suffer considerable losses if the news is bad.”

“Profits of SP500 companies are seen dropping 3% this quarter from a year ago, the first decline in three years”

It was close to being almost the end of the world.  As you read various comments in the news, keep in mind that these remarks are coming from active traders who see a 5% drop as catastrophic if they have not anticipated it through options and other hedging strategies.  For longer term investors, a 5% drop after a 5% rise over several months is more yawn provoking than cataclysmic.

Through the middle of November 2012, the market would drop another 5%.  Slowing corporate profits and the looming – yes, looming – fiscal cliff spooked investors.  Then, on the hopes that the Fed would do something to offset these negatives, the market regained the 5% lost in the previous month.  In mid-December, the Fed announced that it would double its bond purchasing program and the market has been rising since, gaining 20%.  Has this been a new bubble, one we’ll call the “Fed Bubble?”  Some say yes, some say no.

As we read the daily news, let’s keep in mind that in ten years we will have forgotten most of it.  Some fears will seem silly, some may seem prescient.  Each day there are many predictions, some like this one from December 30, 2001: “By the year 2003, there will be 2 types of businesses, those doing business on the internet and those out of business.” (Sorry, I didn’t write down the attribution).  Some predictions will seem rather silly like the one in March 2009 that the SP500 would be below 500 in a month.

Farmers and businessmen in ancient Rome consulted soothsayers who threw chicken bones and read the pattern in the bones to tell their clients whether there would be rains in the spring and how hot the summer would be.  Sometimes they were right, sometimes they were wrong.

Each day the market goes up – or it goes down.  For the past twenty years it has gone up 54% of the time, down 46% of the time.  Going up seems like an odds on favorite but this is complicated by the fact that the market usually goes down faster than it goes up.  There is also a well documented behavioral phenomenon of risk aversion; people respond more emotionally to loss than we do to gains.

This past Monday came the release of the ISM monthly survey of Non-Manufacturing businesses.  Like the manufacturing survey released a few days earlier, this index also surged upward in July, a welcome relief after the declining numbers in June.  I’ve updated the composite CWI that I introduced a while back and compared it to the SP500 and the Business Activity Index of the Non-Manufacturing Survey.

This composite index is weighted 70% to non-manufacturing, 30% to manfacturing.  Because this CWI relies on past months’ activity as a predictor of future conditions, it responds with less volatility to a one month surge in survey data.  As we can see, the tepid growth that began appearing this past spring is still showing in this index, although it is a strong 55.5, indicating sure footed, if not surging, growth.  It has been above the neutral mark of 50 since August 2009.

The Price is Right?

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August 4th, 2013

First week of the month and several good monthly reports helped propel the SP500 through the 1700 mark this week, making an all time high.  Last week I wrote that the market would be cautious and the first few trading days of the week was exactly that, drifting sideways.  On Thursday the release of a suprisingly strong ISM Manufacturing report gave an upward jolt to the market.  In several recent blogs on the ISM and an alternative composite called the CWI, we could see that manufacturing has been sliding toward the neutral mark of 50 for the past several months.  On Monday, the ISM non-manufacturing index will be released and next week I hope to update the CWI.

Ultimately, the market rides up or down on the anticipation of future earnings.  However, earnings can be “managed,” to put it politely.  Further confusing the earnings picture for a casual investor are the several different types of earnings: operating, pro-forma and GAAP to mention a few.  There are two types of “future”, or projected, earnings: bottom up and top down.

A simpler approach that some investors use is to calculate the Price Dividend ratio.  There is no fudging of cash dividends to investors.  Robert Shiller, author of  the 2005 book “Irrational Exuberance”, updates the data used in his book.   These include the SP500 index, earnings, dividends, the CPI and a Price Earnings ratio that is based on the past ten years of earnings.  The current ratio of 23.80 is lower than the 2006 ratios which were in the high twenties.

But let’s look at the Price Dividend, or PD, ratio.  For the past ten years that ratio has averaged a bit less than 52, meaning that investors have been willing to pay almost 52 times the amount of the dividend to own the stock.  As of June 30th, the PD ratio stood at a bit more than 48, which means that stocks were a bit cheaper than average at this date.  Since then the market has gone up about 6% so that the PD ratio is now about 51, or just about average.

As the market makes new highs, investors are prone to ask themselves if the price they are paying for stocks is too high.  The long term investor might take a different perspective and ask themselves, “How will I feel in ten years if I continued to put money into the stock market now?”  Ten years from now, in the year 2023, the answer will be “Well, I didn’t get a deal and I didn’t overpay based on the information available at the time.  I paid about average.”

McGraw-Hill, the publisher of the SP500 market index, also keeps an index of dividends.

Dividend growth has plateaued and is about a third of earnings, which means that companies are paying a third of their earnings back to investors in the form of dividends.  This is just slightly more than the median for the past ten years.

There was a lot of data to digest in this past week.  The GDP estimates for the 2nd quarter was a sluggish 1.7%, more than the expectation of 1.1%.  But – always that but – the 1st quarter GDP growth was revised down from 1.7% to 1.1%.

On Thursday, the same day as the ISM manufacturing report, came the monthly report on auto sales.  Total sales of light weight vehicles, which includes cars and pickups, increased about 4% this past month to an annualized amount of 16 million vehicles.

When we look at auto sales on a per capita basis, auto sales are still below 5% of the population, a level that would show me that consumer demand and the construction industry (pickup trucks) is healthy.  As we can see from the chart below, the sale of autos stayed consistently above that 5% level for more than 20 years – until the last recession began.

Employment in the production of motor vehicles and related parts is very  weak.

Although vehicle sales includes both imports and domestics, I wanted to see how many autos are sold per person employed in automotive production.  Advances in manufacturing and the mix of import and domestically made vehicles have impacted employment.

And with that, I’ll look briefly at the Employment Report for July released this past Friday.  On Wednesday, ADP reported 200,000 private jobs gained, giving a brief upward impetus to the market.  As I noted last week, caution would be the watchword of this week and that caution showed in later trading on Wednesday.  The ADP report did give some hope that the BLS employment report would show an approximate gain of that many jobs.  Instead, the employment gains from the BLS were disappointing, at 162,000.   A further disappointment were the small downward revisons in May and June’s employment gains, totalling -26,000.

The unemployment rate declined, from 7.6% to 7.4%, but for the wrong reasons.  For any number of reasons – disappointment, frustration, going back to school, retirement – 240,000 people dropped out of the work force.  This is close to the reduction of 257,000 in the ranks of the unemployed.  After declines or relative stability in the number of “drop outs” in recent months, this month’s surge was particularly disappointing.

Job gains in the core work force aged 25 -54 remains relatively flat.

While older workers continue to add jobs

Business Services and Health Care jobs continued their strong job gains but gains in the health care field have slowed from 27,000 per month in 2012 to only 16,000 in 2013.  Sit down for this one – government workers, mostly at the local level, actually gained 1,000 in July.

Despite the decline in unemployment, the tepid employment and GDP growth reports likely reassured many that the Fed is unlikely to stop or reduce their quantitative easing program in the next few months.

Credit Patterns

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July 28, 2013

Economic growth is hampered when credit growth declines.  In 2008, we experienced a sharp decline in confidence and lending that has only now reached the levels before the decline.

When we look at the big picture, we can see that we are now at more sustainable growth trends.

The amount of outstanding commercial and industrial loans is almost at the level last seen in 2008.

A smiliar slow recovery in business loans occurred during the 2001 recession.

Although housing evaluations have been rising, the amount of revolving equity lines of credit (HELOC) continues to decline.  The total outstanding is still high but approaching a more reasonable trendline of growth.

Recently rising bond yields have contributed to banks’  operating profit margins but the corresponding value of banks’ bond portfolios has fallen quite dramatically.

This decline in asset value affects bank capital ratios, which makes them less likely to increase their lending. which will be an impediment to economic growth.

This Wednesday the first estimate of 2nd quarter GDP will be released.  Real GDP growth is expected to be about 1.1%, less than the meager 1.8% growth of the 1st quarter.  Slowing growth may revive interest in bonds.  The recent sell off in bonds has probably been an over reaction incited by fears that the Federal Reserve will reduce its bond buying program dubbed “Quantitative Easing.”  While there are positive signs in the economy, they do not indicate any impending robust growth.

In addition to Wednesday’s release of GDP figures, the payroll firm ADP will show their monthly report of private employment growth, guesstimated to be slightly below the 188,000 gain predicted for June.  The BLS monthly labor report follows on Friday and will be watched closely.  Unemployment has been stuck in the mid-7% range since March and reductions in unemployment have been largely due to people either leaving the work force or taking part time jobs because they could not find full time work.

The Federal Reserve has said that its target for withdrawing its quantitative easing program is an unemployment target of 6.5%, with a caveat that inflation remains tame. A slow economy will naturally reduce inflationary pressures and improvements in the labor market are slowing as well.  In short, the Fed is likely to continue its monetary support for another year at least.

For a month now, the stock market has risen steadily in small increments, making up the losses that began in the third week of May.  Volume typically declines during summer months but this year’s volume of trading in SPY, the ETF that tracks the SP500 index, is 20% lower than this same time last year.  This week, we may see a market hesitation before the release of both the GDP and labor reports.

Continuing Unemployment Claims

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July 21st, 2013

Since I’m on the road this will be a short piece.  Every week the Bureau of Labor Statistics (BLS) releases their estimate of new unemployment claims based on a compilation of state filings for unemployment.  Labor market analysts pay more attention to the 4 week moving average of this series because the weekly numbers can be volatile or affected by weather and holidays.

Each month the BLS releases their estimate of the number of unemployed and the percent of unemployment but this figure comes from a survey of households.  People surveyed report that they are unemployed and BLS interviewers substantiate responses by asking additional questions. However, there really is no independent verification that someone who says they are unemployed is actually unemployed.

As the states update their tally of those unemployed who continue to claim benefits, the BLS reports the number as Continuing Unemployment Claims.  While no number is entirely accurate, there is a greater degree of accuracy in this number of unemployed.  It does not include those who have not filed for unemployment or those who have run out their benefit period and are no longer eligible for benefits.

I wanted to compare this fairly reliable number with another somewhat reliable number – the number of employed from the Establishment survey.  This total is based on a survey of companies who report the number of employees on their payroll.  While this total has some problems it has proven to be more reliable than the employed number from the Household Survey.

Below is the number of continuing unemployment claims.  Four years after the official end of the recession in June 2009, continuing claims are still at levels seen in the earlier two recessions.  This indicates the persistent underlying weakness in the labor market.

Comparing continuing claims to the total employed reveals some surprises.

This metric shows the severity of unemployment in the recession of the early 1980s; the percentage surpassed the peak in this past recession.  We can see that current levels are high but not dangerously so.  We have seen higher levels during periods of robust growth in the mid to late 1980s and in the recovery years in the mid 1990s.  What we want to see is a continued decline in this percentage.

Economic Activity Indexes

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July 14th, 2013

A few weeks ago I wrote about a constant weighted index (CWI) of the monthly Purchasing Managers survey. Presented by economist Rolando Pelaez in a 2003 paper, the CWI assigned various fixed weights to the separate components of the survey.

The Purchasing Managers Index, or PMI, covers manufacturing industries, now a relatively small part of economy.  In the past thirty years, our economy has become dominated by service industries which are surveyed separately each month.  The composite of the non-manufacturing survey is the Business Activity Index, or BAI.

Two weeks ago, June surveys for both sectors indicated a very slight expansion.  The service sector edged up but is hardly robust.

Wanting to see what a composite Manufacturing, Non-Manufacturing index would look using Mr. Pelaez methodology, I combined the components of each survey, assigning 70% to the service sector and 30% to the manufacturing sector.  Did I get out my R statistics program and run multiple regressions to find the combination of percentages that fit the historical data best?  No.  While the manufacturing sector is less than 20% of the economy, it has powerful influences on the service industries in a community.  How much effect?  Using my gut, I came up with 30%.

The results surprised me.  The graph below starts in 1997 and includes the latest June figures.  It compares this composite index, labelled M+NM (manufacturing and non-manufacturing), with the service sector BAI and the SP500 stock market index.  The composite index loosely follows the  BAI, which is an easily available index that an investor can find by typing in “Fred Business Activity Index” into Dr. Google.

The chart shows a divergence between the recent rise in the stock market and the recent decline in business activity.

Let’s take away the clutter and look at the BAI itself.  Growth has slowed but this may just be a normal dip in the business cycle – nothing to be alarmed about.

For the past month the stock market has been trading on whether the Fed, and China, can keep holding up the world’s economy.  Corporate earnings this past quarter are expected to show lackluster growth, economic activity indexes are showing a somewhat lackluster expansion – and the stock market makes new highs.

It’s a head scratcher.

Job Trends

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July 7th, 2013
A better than expected June labor report released this week prompted some speculation that the Federal Reserve may begin tapering its quantitative easing program as early as this fall.  The employer survey reported a net gain of 195,000 jobs and the gains of earlier months were revised up 70,000.  Government workers continue to decline. We will see that the modest strength in the labor market is part of a mixed employment picture.    The unemployment rate remained steady at 7.6%; the year over year percent change in this headline index continues to chug along in the “good” territory.

70% of workers – about 95 million – are employed in private service jobs, most of which showed strong gains in the past quarter.

14% of workers are government employees; federal, local and state governments continue to shed workers.

As the number of workers declines, the number of people served by each worker continues to rise, approaching levels last seen in the early 1980s and mid-1970s.  The government work force would need to decline a further two million, or 10%, to reach the level of 15 people per government worker.  That level is still far below the comparatively lean government worker levels of the 1960s and earlier.

The major part of the attrition in government jobs seems to be over.  Local governments are adding employees while the federal government continues to shed employees.

Job gains continue to come in lower paying retail and food service jobs.  In 2013, employment finally surpassed early 2008 levels.  The average wage of $14 to $17 per hour in these industries is far below the $24 average of all workers and the $20 average of private production and non-supervisory workers.

Much higher paying jobs in Professional and Business Service industries continued to show strong gains and have also climbed above 2008 levels.  The average wage in this category is 15% higher than that of all workers.

Over seven million people not counted in the labor force or in the headline unemployment rate say they want a job now.  Four years after the official end of the recession, the number of “kind of unemployed” remains high.

The number of involuntary part-time workers increased by 322,000, or about 4%, to 8.2 million, over 5% of the total labor force.  These are workers who are working part time but want full time jobs.  A healthier labor market would have about 3% of these unwilling part timers.

As the number of housing starts increases, the unemployment rate among construction workers continues to decline and dipped below 10% this month.  Lower lows in this unseasonally adjusted index of unemployment is a good sign.

But the year-over-year percent change in construction employment is still not robust enough to reverse the heavy job losses since the onset of the recession.

The core work force aged 25 – 54 dropped by 100,000 and continues its slight upward struggle above the recession depths.

A decline in this prime working age population is partly responsible, but the 1.6 million decline in population is but a third of the 5 million plus decline in employment for this age group.

A 2004 paper by a BLS economist, Jessica Sincavage, provides an interesting historical perspective on multi-decade generational trends in the unemployment rate.  She noted “The characteristics of today’s younger workers differ from those of their baby-boomer counterparts in several ways that may affect the former group’s impact on the labor force and the unemployment rate now and in the future. Among the relevant characteristics affecting both groups are school enrollment patterns, race and Hispanic origin, and women’s labor force participation.”

In 1979, over 42% of the last of the boomer generation aged 20 – 24 were enrolled in school.  In 2002, under 37% of the “echo boomer” generation aged 20 -24 were enrolled.  Easy job availability, the growth of the internet and the sustained rise of the stock market during the 1990s persuaded many younger workers that the opportunity cost of going to college was simply not worth it.

The onset of this recession has divided the prime work force into two groups.  For those with a degree unemployment has remained low.  For those without the higher education, unemployment is almost double.  In a curious correlation, the unemployment rate for three groups is about the same – the general labor force,  workers above 25 years with a high school only education, and Hispanics.

The third factor noted by Ms. Sincavage is the participation rate of women in the labor force. In her 2004 paper she observed “In 1979, the participation rate of women 16 to 34 years was about 63 percent; by 1999, it was 70 percent.” By the mid 2000s, this cultural and demographic bulge began to decline.  The rate for all women has now declined below the levels of the early 1990s.

Although there was a lot to like about this month’s labor report, recent job gains are swimming against an undertow of shifting demographics and labor demands from employers.  A casual reading of the headline numbers might lead one to discount these long term negative trends.

The Great Moderation

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June 30th, 2013

Economists cite a number of factors to account for the growth during the 1980s and 1990s, a period some call the “Great Moderation” because it is marked by more moderate policies by politicians and central bankers.  Causes or trends include less regulation, lower taxes, lower inflation than the 1970s, the rise of emerging economies,  and a more consistent rules based monetary policy by the Federal Reserve.  Often underappreciated, but significant, was the huge increase in consumer credit. Household spending accounts for 2/3rds of the economy.  A new generation, the boomers, emerging fully into adulthood in the early ’80s, welcomed the broader availability of credit.  Like their parents, the boomers took on the burden and responsibility of owning a home, the largest portion of a household’s debt load, but unlike the previous generation, the boomers sucked up as much credit as they could get for cars, clothes, vacations, home furnishings and the growing array of electronic devices.

When we look at the non-mortgage portion of household debt, the rate of growth is more restrained – a mere 80% increase in per capita real dollars.

The parents of the boomer generation, dubbed by newscaster Tom Brokaw as the “Greatest Generation”,  had been habitual savers.  By 1980, the personal savings rate was about 10% of disposable income.  By the middle of that decade, the Greatest Generation began retiring and withdrawing some of that savings.  Their children, the boomers, did not have a similar sense of frugality.

Rapid advances in technology led to the introduction of new electronic toys for adults.  Credit cards, once reserved for the well to do, became ubiquitous.  Consumers parted with their money more painlessly when charging purchases.  Financing terms for automobiles became more generous,  allowing more people to purchase new cars, which became increasingly expensive as regulators mandated more safety controls.

After thirty years of gorging on credit, households threw up.  The past six years could be called the “Great Diet” or the “Great Purge” to get over the three decade credit binge.

We can expect rather lackluster growth for several more years as households continue to shed those ungainly pounds debts.  Not only are households shedding debt but also certain kinds of assets. In 2009, the Federal Reserve reported that households and non-profit corporations owned $400 billion in mortgage securities like Fannie Mae and Freddie Mac.  In the first quarter of 2013, the total was $10 billion.  (Table of household assets and liabilities)

Households continue to keep ever higher balances in low yielding savings accounts and money market funds, indicating the high degree of caution. The big jump in deposits was probably due to higher dividends and bonuses paid in the last quarter of 2012 to avoid higher taxes in 2013.

For the past two weeks, global markets shuddered at the prospect of the Federal Reserve easing up on their quantitative easing program of buying government bonds.  Some have proclaimed that it is the end of the thirty year bull market in bonds, causing many retail investors to pull money out of bonds.  In several speeches this past week, Reserve Board members have reassured the public that quantitative easing will be here for several years.

As we have seen, households still shoulder a lot of debt weight, making it unlikely that either this economy or interest rates will experience a surge upward in the next several years.  An aging and more cautious population together with a declining participation rate in the work force indicates that another “Great Moderation” is upon us.  The previous moderation was one of political policy.  This moderation is led by consumers.  We can expect – yes, moderate, or lackluster – growth over the coming years.  The positive tradeoff for this subdued growth is the probability that the underlying business cycle of growth surges and corrective declines in economic activity will be subdued as well.

Summer Sale

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June 23rd, 2013

It would be a mistake for the casual investor to think that the decline in the market this week was due entirely to Fed chairman Ben Bernanke’s comments regarding future Fed policy.  There was little that was not anticipated.  The Fed will continue to follow a rules based approach to its quantitative easing program, scaling back its purchases of government securities if employment improves or inflation increases above the Fed’s target of 2%.  Bernanke also reiterated that the Fed would increase its purchases if employment does not improve and inflation remains subdued.  So why the drop?

Shortly after the conclusion of each Fed meeting, Bernanke holds a press conference, where he issues a ten minute or so summary of the meeting and issues discussed.  He then takes about twenty questions.  At the start of this past Wednesday’s press conference at 2:30 PM EDT, the market was neutral as it had been all morning.  The Fed chairman was more specific about the anticipated timeline of the wind down of quantitative easing if the economy continued to improve.   Although he was essentially repeating himself, the voicing of a specific and concrete timeline evidently jolted some sleeping bulls who surmised that the party was over; in the final hour of trading the SP500 fell a bit more than 1% in the final hour.  For many traders, it was time to take profits from the eight month run up in prices.  “Quadruple witching”, a quarterly phenomenon that occurs when stock and commodity options and futures expire, was approaching.  The few days before this event usually see a spike in volume as traders resolve their options and futures bets.

With much of the Eurozone in a mild recession and slow growth in emerging markets, the rest of the world perked up their ears as the central banker of the largest economy envisioned an easing of monetary stimulus sometime in 2014.

Overnight (Wednesday/Thursday) came the news that the Shanghai interbank rate had shot up from about 4% to 13%, a rate so high that it threatened to seize up the flow of money between Chinese banks.  This bit of bad news from the second largest economy added additional downward pressure on world markets.  For some time, analysts covering China have been warning about the amount of poorly performing loans at China’s biggest banks.  The spike in interbank rates, prompted by the Chinese government, was an official warning to Chinese banks to be more cautious in their lending practices.

On Thursday morning came the news that jobless claims had increased, adding more downward pressure.  The SP500 opened up another 1% lower that morning and dropped a further 1.5% during the trading day. This classic “one-two” punch knocked the market down about 4%.  European markets fell about 5%, while emerging markets endured a 7.5% drop in two days.

In the past four weeks, there has been a decided shift in market sentiment.  When the market is bullish, it tends to shrug off minor bad news.  As it turns toward a bearish stance, the market reacts negatively to news that just a few months ago it largely ignored.

Over the past two months, long term bonds have declined 10% and more.  Here is a popular Vanguard long term bond ETF that has declined 12% since early May.

For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.

Business Cycles

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June 16th, 2013

The manufacturing sector accounts for less than 20% of the economy but is probably the major cause of business cycles in the economy.  In the 1990s, the growing development of technology and business services in the U.S., together with what was called “just in time” inventory management, led some economists to declare an end to the business cycle. Cue the loud guffaws.

May’s monthly report on industrial production released Friday showed no monthly gain, after a decline of .4% in April.  The year over year change in the index was just under 2%.  In a separate report from the Institute for Supply Management (ISM) released a week ago, the Manufacturing Purchasing Managers Index (PMI) index for May fell into contraction, its lowest reading since June 2009, when the recession was ending.


New Orders and Production components of this index saw sizeable decreases.  Computer and electronic businesses reported a slowdown that they attributed to the sequester spending cuts enacted a few months ago.

The latest data for non-defense capital goods excluding aircraft from the U.S. Dept of Commerce showed an uptick after a period of decline in the latter half of 2012; however, there is a month lag in this data set.



The sentiment among small businesses improved somewhat, as shown by the monthly National Federation of Independent Businesses (NFIB) survey.  The overall index of 94 indicates rather tepid expectations of growth by small business owners.  Plans for capital spending to expand business are still at recession levels.

A business builds inventory in anticipation of sales growth.  Since the beginning of this year the net number of small businesses expanding inventory has finally turned positive.

  In a 2003 paper, economist Rolando Pelaez tested an alternative model of the Purchasing Managers Index that would better predict business cycles, specifically the swings in GDP growth.  Assigning varying constant weights to several key components of the overall PMI index, his Constant Weighted Index (CWI) model is more responsive to changes in business conditions and expectations.  In early 2008, the PMI showed mild contraction but Pelaez’ CWI model began a nose dive. It would be many months before the National Bureau of Economic Research (NBER) would mark the start of a recession in December 2007 but the CWI had already given the indication.  In May of 2009, the CWI reversed course, crossing above the PMI to indicate the end of the contractionary phase of the recession.  It would be much later that the BEA would mark the recession’s end as June 2009.


The CWI index is rather erratic.  We lose a bit of its ability to lead the PMI when we smooth it with a three month moving average but the trend and turning points are more apparent in a graph.

Before the 2001 recession the CWI index led the PMI index down.

OK, great, you say but what does this have to do with my portfolio?  Smoothing introduces a small lag in the CWI but it is a leading, or sometimes co-incident indicator of where the stock market is headed over the next few months.

Let’s look at the last six years.  In December 2007, the smoothed CWI crossed below the PMI, which was at a neutral reading of about 50.  The stock market had faltered for a few months but as 2008 began, the CWI indicated just how weak the underlying economy was.  The NBER would eventually call the start of the recession in December 2007.  In June 2009, the CWI crossed back above the PMI.  Coincidentally, the NBER would later call this the end of the recession.

The period 2000 – 2004 was a seesaw of broken expectations, making it a difficult one to predict because it was, well, unpredictable.  I did not show this example first because this period is a difficult one for many indicators.  Before 9-11, we were already in a weak recession.  Although the official end was declared in November 2001, the effects were long lasting, a preview of what this last recession would be. In 2002, we seemed to be pulling out of the doldrums but the prospect of an Iraq invasion and a general climate of caution, if not fear, prompted concerns of a double dip recession.

An investor who bought and sold when the smoothed CWI crossed above or below 50 would have had some whipsaws but would have come out about even instead of losing 15% over the five year period.

The present day reading of both the CWI and PMI are at the neutral reading of 50.  Given the rather lackluster growth of the manufacturing sector, the robust rise of the stock market since last November indicates just how much the market is riding on expectations and predications of the future decisions of the Federal Reserve regarding future bond purchases and interest rates. Over the past thirteen years, when the year over year percent change in the stock market hits about 22%, the percentage of growth in the index declines.

So what is a normal run of the mill investor to do?  The CWI, a predictor of business cycles, is not published anywhere that I could find. This and many other indicators are used by the whiz kids at investment firms, pension funds, by financial advisors and traders, to anticipate business conditions as well as the movements of the markets.  But look again at the SP500 chart above and remember that it is the composite of millions of geniuses and not so geniuses trying to anticipate the market.  As I have mentioned in previous blogs, when that percentage change drops below zero, it is time for the prudent investor to consider some portfolio adjustments.  Since 1980, the average year over year percent change in the SP500 is 9.7%, using a monthly average of the SP500 index. Despite the recent 20% gains, the average year over year percent gain during the past ten years is only 4.9%.  If we look back to the beginning of the year 2000, the average is only 3.1%.  Those rather meager gains look robust when compared to the NASDAQ index, which is still 25% below its January 2000 high.  Think of that – thirteen years and still 25% down. The Japanese market index, the Nikkei 225, is at the same level as it was in early 1985, almost thirty years ago.  Both of these examples remind us that we need to pay some  attention or pay someone to do it for us.

Goldilocks Jobs

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June 9th, 2013

In the long running comedy series “Frasier,” Frasier or Niles would often order a latte  in their local neighborhood bar, being careful to note exactly how they wanted the drink made.  Friday’s employment report was made to order – not too strong so as to hasten the end of the Fed’s latest bond buying program and not so weak as to confirm fears of another summer swoon.

Slowly and inexorably the number of employed trudges up the recovery hill.  The unemployment rate ticked up a scosh to 7.6% as more people tried to find work.  The year over year percent change is still in good territory.

On the not so good side, the percent of the total population that is working is still below the 30 year average of almost 44%.

The unemployment rate of those with a college degree is far below that of the general labor force but is still 50% above the average of the early 2000s.

Student aid loans have passed a trillion dollars (source).  To put that figure in perspective,  student loan debt is about 10% of the $11 trillion in outstanding debt of residential mortgages (source)

Changes in the bankruptcy laws in 2005 exempted student loan debt from bankruptcy.  Over the next decade or so, will the investment in education pay off?  Let’s hope so.  100 years, an 8th grade education became a standard used by employers to winnow job applicants in a tough job environment.  70 years ago, the new standard became a high school education.  For the past 30 years, we have moved to a 4 year degree as the new standard.
We now spend more on defense and more on Medicare that the $500 billion total amount spent by the state and the federal government on K-12 education. (source) Community college educators are painfully aware that many students are simply not prepared to take college courses.  Local communities used to fund 70% of K-12 education.  Thirty years ago, homeowners protested ever rising property taxes to fund K-12 education and, since that time, local funding has dropped below 50%.

If we expect our children to develop the skills for a college education, we are going to have to find an alternative model of funding.  The states have relied on an ever increasing share of Federal funding for K-12 education.  Although the percentage of Federal spending on K-12 is small, less than 10%, the aging Boomer generation will command ever more spending of general tax dollars in addition to the Medicare taxes collected.

The core work force aged 25 – 54 struggled upwards

but the participation rate, the percentage of the population in the labor force, is still weak.

The “total” unemployment rate, which includes those working part time for economic reasons, continues to drift down but is still high.

Understand that this represents over 20 million people, a bit more than the entire population of New York State.  Turn on C-Span sometime and tell me how many committee hearings on jobs there are.  Immigration, federal surveillance and the targeting of conservative groups by the IRS are important matters, yes, but why aren’t politicians in Washington talking about jobs?  There are several reasons: no one has a clue; no clear political advantage to be gained; constituents are not writing letters to their representatives and senators about jobs.

Welcome to the “New Abnormal.”