January 20, 2008
Every month The Conference Board publishes its measurements of the U.S. Leading Economic Indicators (LEI) Index. The LEI Index is comprised of the following ten (10) data points:
- Average weekly hours, manufacturing
- Average weekly initial claims for unemployment insurance
- Manufacturer’s new orders, consumer goods and materials
- Vendor performance, slower deliveries diffusion index
- Manufacturer’s new orders, nondefense capital goods
- Building permits, new private housing units
- Stock prices, 500 common stocks
- Money supply, M2
- Interest rate spread, 10-year Treasury bond less federal funds
- Index of consumer expectations
Don’t feel like you have to memorize these inputs, just understand that historically, cyclical turning points in the leading index have occurred before those in the aggregate and coincident economic activity. Said another way, there is some predictive power in these numbers regarding recession versus growth.
Among other reasons, I like to track the LEI Index because it is not widely followed in the media. There were many good predictive data points that have been sterilized due to their “discovery” by the media. In so much that the ten data points that comprise the LEI Index are not widely discussed (with a couple notable exceptions, such as stock prices and building permits), this is a useful way to package a bundle of important pieces of information and track their collective direction.
Led by plunging building permits, the LEI Index fell 0.2% in December; its third straight monthly drop, and fourth drop of the past six months. Three consecutive drops is a harbinger of slowing growth. Admittedly, the LEI Index is not perfect (unfortunately no data set is). For example, the LEI Index gave a false signal of contraction in July 2006. In that instance it turned out that we had a weak Q3 2006 (1.1%) followed by a weak Q1 2007 (0.6%) which were followed by two subsequent quarters of about 4% growth.
A better rule of thumb for predicting a recession is a six-month annualized growth rate of the LEI Index of -2% (with more than half of the components weakening). This month the six-moth rate remained unchanged at -1.6%. The trend of the LEI is consistent with GDP growth of between 0% and 1%. This is in line with late December predictions shared with you in our Outlook 2008 report:
“The final (Q4 2007) GDP number will likely be pretty close to flatline (+/- 1%), with an improvement in Q1 2008 (0% – 1%) thus averting a technical recession for 2007 and mostly likely averting a recession for 2008 (a recession is defined by two consecutive quarters of declining growth). “
That quote was extracted from the portion of the report describing the direction of the economy as “Not a Recession, But Still Lousy.” However, as John Maynard Keynes said, “When the fact change, I change my mind. What do you do, sir?” Unfortunately, given the deterioration of the labor markets in December, that description, at best, has been downgraded to “hopefully not a recession, but still really lousy.”
With just over a week to go until the preliminary release of Q4 2007 GDP numbers, no predictions mean much at this point, but it does appear that my earlier estimate of growth between +/-1% will hold. But Q1 2007 figures may also slip down to that range (it is too early to collect critical data, but it looks as if January will also have below-trend job growth as well as slower export numbers).
That, in part, explains the unprecedented 10% drop of the S&P 500 in the first two weeks of January. And when I say “unprecedented” I don’t mean that this has not happened in the post-WWII era or that this has not happened since the Great Depression. I mean that this has not ever happened – it is the worst start to any calendar year on record.
In our Outlook 2008 we explained that the first four to five months would be markedly different from the second part of the year. We defined the risk level of the market at 1,300 points on the S&P 500 with our most likely target at 1,365 points. With the 1,365 level broken so quickly and so decisively it is fairly likely the lower risk level of 1, 300 points will be reached. Granted, that is only a drop of 2% from these levels so I am not exactly going out on a limb in saying that our predicted risk level will be achieved.
Given the rapid, unprecedented drop in stock prices since the start of the year, the big question is, will we have to change that risk level? And if so, what is to be done in portfolios? In my view, at this moment it is an unimportant exercise to try and figure out if the risk level should be changed, or at least to officially print another number. Still, given the July 2007 repeal of the no-tick rule for short-sales (you used to only be able to sell short a stock after it ticked-up in price, that rule has been abolished allowing for a piling on of short-sales on downward price movement), I am growing more concerned that, in the short-term, momentum may become more important than fundamentals. As such, I may be more prepared than I have been in the past to play defense when typically I remain unfazed and unconcerned regarding the stock market’s typical gyrations.
More important is the second part of that question – what is to be done in portfolios? That is too broad a question to be answered when managing the portfolios of individuals with different goals and concerns. Nonetheless, I will try to answer that question here, but encourage you to call us if you prefer to discuss specifics.
Broadly, we started this year believing that the first four-to-five months will be markedly different than the second part of the year. My concern now is that we are still correct on that call and that the last two weeks are not simply a shorter version of that five-month expectation. Said another way, I am afraid that the last two weeks did not wring out all of the possible volatility that we were expecting. Instead, my concern is that the magnitude of volatility (even if not necessarily the magnitude of stock market price changes) is far greater than we had expected.
At these short-term oversold levels of the market, it would be reasonable to expect a rally from either these or near levels (1,300-1,275 points). So while I am not opposed to reducing beta right now (i.e. selling equity), there is the likelihood of a rally from these levels. However, my concern is that the rally will be weak in breadth (i.e. a rebound will come from a reduction of supply where sellers stop selling and not necessarily from new buyers stepping in to exhibit a resurgence of demand – after all price levels of stocks are ultimately only a function of supply and demand). A rebound at these or near levels could last months, or it could be far shorter.
So what are we going to do with portfolios? I would like to give you something decisive (even better, something rosy). But the truth is that some of my next steps may be dependent upon the health (or lack thereof) of any potential rally’s breadth.