Macroeconomic Indications Are Bullish…Now When Does The New Bull Start?
As
an active participant in the bond market for many years, it has always
interested me to observe the two very different ways in which bond and stock
investors gauge the condition of the economy.
Quite simply, it has become glaringly apparent to me that the bond
investor looks at the economy from the top down and the stock investor looks at
it from the bottom up. In other
words, bond investors tend to get their guidance on the economy by looking at
macroeconomic data while stock investors get their guidance from Corporate
America.
While
bond and stock investors can argue over which methodology is better, history
tells us to respect the gauges that the bond market uses to foretell the future.
Numerous studies support this conclusion so perhaps we should take a
closer look at some of the best top-down indicators to use when trying to make
predictions on the economy and hence, corporate profits.Â
In
virtually all cases below, the historical lead time has been 6-12 months. Most
of these indicators turned bullish within the past three months. So these are
not what I’d call precise timing mechanisms and this may mean the market may still have some
downside risk. But, from a big picture standpoint they give you a good
confirmation of any bullish evidence you may see using standard technical tools.
Spending
Comes First
The
first principle that I follow is that the demand side of the economy is far more
important to follow than the production, or supply side of the economy.
The premise is that changes in final demand will inevitably impact
production at some point so it is best to get you clues about the future from
the demand side of the economy.
Here’s
a current illustration of this premise: I
hear from a lot of money managers and hedge funds that they keep hearing about
weakness in the trucking sector. They
feel that the weakness in that sector is an indication that a rebound in the
economy is nowhere in sight. My
answer to them is this: Of course the trucking sector is weak!
Companies are trying to reduce inventories so they are selling their
goods out of inventory!yes”> Data on the trucking sector is more of a coincident indicator
and gives virtually no indication of the future.
It would be more appropriate, therefore, to follow data on demand to
gauge whether the truckers might see more activity in the coming months.
Another
example of the fallacy of following the supply side of the economy is the
misleading signal that often comes from data on industrial production and the
like. I have seen numerous examples
where production levels in the economy went against the grain of demand figures
and therefore sent a false signal on the economy. Following
a period of very weak sales, a department store suddenly experiences a solid
couple of months of sales. But the
company lacks the confidence in the outlook so they continue to cut back on
orders for new appliances. The
result: a drop in the department store’s inventory level, a decline in
manufacturing orders, and a decline in industrial production. Obviously,
therefore, it’s best to watch demand since it leads production.
Another
basic premise that I follow is to recognize that since the economic calendar is
dominated by manufacturing statistics, investors are apt to be misled on the
future direction of the economy. The
economic calendar is simply laden with data on the production end of the economy
and this materially affects investors’ perceptions on the economy.
I am usually glad for this as I feel it gives me an edge.
The markets tend to be lulled into a false impression on the economic
outlook because they put too little emphasis on the demand side of the economy.So
where should you look to gauge the demand side of the economy?
Here’s a few places:
1)
Call up the major
retailers.
Several of the major retailers, including Wal-Mart, Target, and J.C.
Penney release weekly recordings on Monday morning and give insight into their
performance from the prior week. That’s
what I call timely! Listen closely
to the merchandise categories that are selling well.
There’s a lot of valuable information there. Indications are
that store sales are off to a good start at the start of second quarter. This helps to explain the improved behavior of the retailers’ stocks recently.
2)
Track mortgage
applications.
Every Wednesday the Mortgage Bankers Association releases an index on
mortgage application for home purchases and for mortgage refinancing.
Both indexes contain valuable information on the future direction of the
housing industry with a very short lead time of just a few months at most. In turn, the
health of the housing industry speaks volumes about the economy.
The indexes are also a great gauge of the extent to which there is
responsiveness to the Fed’s interest rate changes.
In Japan, for example, a lack of responsiveness has been an important
sign that low interest rates would fail to revive the economy.
But with mortgage applications soaring in the U.S., it is apparent that
the Fed’s recent rate cuts are working. Record
new home sales in March are a clear sign of this.
Moreover, there are likely to be roughly $700 to $800 billion of
mortgages refinanced this year, putting extra money into the pockets of millions
of households pretty quickly.
3)
Track automobile sales.
Next to the housing sector, the automobile sector is the second most
important consumer sector to track. The
automobile sector is a key gauge of consumer behavior and an important leading
indicator on the economy. The
automobile has a substantial impact on the monthly manufacturing statistics and
therefore substantially influences investors’ perceptions of the economy.
The recent performance of the automobile sector and its impact on the
economy clearly illustrates its far-reaching impact.
Just consider the events of the past 6 months or so: Around the
middle of 2000, automobile sales began to falter.
But automobile manufacturers kept their production levels high and their
inventories grew sharply. In
response, the automobile manufacturers cut production sharply.
They closed factories for weeks resulting in the layoff of thousands of
workers. What followed, of course,
was a deepening of investor pessimism, a rout in the stock market and a drop in
bond yields. For those investors
who kept their eye on the automobile sector and automobile inventories in
particular, they had a big heads up. Now,
the tables have turned; as a result of sharp cutbacks in production and
stronger-than-expected sales automobile inventories have fallen from a high
level of 90+ days supply in January to a more normal level of roughly 65 days
supply recently. In turn, the auto
manufacturers have raised production sharply.
Indeed, after subtracting nearly 2 points from GDP in the first quarter,
increased levels of automobile production in the second quarter are expected to
add roughly 1 to 1.5 points to GDP. That
is quite a turnaround! From this I
know to expect strength in manufacturing data and to expect investor confidence
to be bolstered in the process. This
is one key reason why I have been bullish recently.yes”> For starters, the monthly sales figures are an excellent
gauge as are comments from the manufacturers on the business conditions they are
experiencing. Second, Wall
Street’s industry analysts produce excellent reports that sum up the
industry’s developments. Third,
Lucky Consulting releases estimates on car sales for each given month. Fourth, many
economic services produce data on the sector.
Basically, there’s information on the sector just about everywhere so
just keep your eyes open.
4)
Follow the money:
Financial assets are merely
instruments that individuals use to express their sentiments through the use of
money. This is what makes the money
supply so relevant. Obviously, the
more money that exists in the financial system, the more money there is to
invest in financial assets. Despite
the substantial impact that the money supply has been shown to have on the
markets and the economy, I find that only the smart money follows it.
I look at M1, M2, M3, and the monetary base.
M2 and M3 sometimes contain distortions as they contain money market
funds, savings accounts, and time deposits.
In times of strain in the financial markets, M2 and M3 often get bloated
as investors shift from stocks to cash, so you need to try to strip out those
components. If you are unable, then
just look at M1 since it basically includes just checking deposits and cash.
Since these components are transactions balances, M1 is a very good gauge
of current economic activity. When tracking the money supply, keep in mind that M2
and M3 growth over 6 to 7% or so annualized is considered strong.
It is notable that the money supply decelerated sharply last year as the
economy slowed. It’s extraordinary! The data is is indicating the economy will be stronger by the end of the summer so expect better corporate earnings by then.
The money supply is released every Thursday afternoon by the Federal
Reserve and the data is widely available on the Fed’s website, on newswires,
in daily newspapers and in Barron’s.
5)
Lend some time to loan
data and corporate bond issuance:
In Japan, bank loans have barely grown for 10 years and they have been
down for three straight years. Without
lending activity, it is awfully difficult for an economy to expand.
Existing companies that borrow money use the money for expansion while
new companies use borrowed money for startup. The United States is not immune to
slowdowns in loan activity. In
2000, for example, there were numerous months where loan growth did not grow at
all. Since lending activity is an
important leading indicator on the economy, the lack of loan growth last year
was a red flag on the economy. Lending
activity is a leading economic indicator because borrowed money takes time to
work its way through the economy. For
example, if a company borrows $10 million to build a new factory, the factory
will take time to build and ground might not be broken for months. But that process is already underway and it is only a metter of months at best before the recent pickup in lending finds its way into the economy.
I like to follow commercial and industrial (C&I) loans in
particular. Also track total
bank credit as this data will tell you whether or not banks are expanding their
balance sheets. The data is released every Friday at 4:15 pm by the Federal
Reserve and is widely available in the same place you will find the money supply
data. You should track corporate
bond issuance on the same premise as for loan data; quite simply, companies
that borrow money in the corporate today will be spending money tomorrow.
On average roughly $7 billion of new corporate bonds are sold each
week, so when the tally differs this means that a change in the economy is on
the horizon. In the first three
months of this year, corporate bond issuance was nearly double that of the prior
year. This resoundingly points to a
stronger economy in the months ahead.
6)
Set your sights on
spreads:
One way that bond investors express their sentiments about the future
direction of the economy is by either widening or narrowing the interest rate
spread between corporate, agency, and mortgage securities over that of U.S.
Treasuries. When they are
optimistic, the spread narrows as investors drive the prices of the so-called
spread products upward and yields downward.
When they are pessimistic, spreads widen to reflect an increasing level
of default risk as well as risks to corporate cash flows.
A great gauge of spread activity is by using the Standard and Poors
speculative-grade credit index, an index of high yield bonds.
In the latter half of last year spreads widened sharply from about 600
basis points over Treasuries to roughly +1084 basis points on January 2, 2001.
But when the Fed cut rates, spreads began to narrow and they are now at
+940 basis points. The narrowing
trend is an indication that bond investors are less worried about the risk of
rising default rates owing to their increased optimism for an economic rebound.
Keep in mind that the bond investors who drive the direction of spreads
look at default risks extremely closely and therefore make more than just an
educated guess about the future direction of the economy.
Spread activity is therefore a great way to gauge the economic outlook.7)
Be industrial about
commodities prices: As
the economy turns, the subsequent changes in supply and demand get manifested in
numerous commodities prices. This
is an easy concept to grasp; for example, if the housing market is turning,
lumber prices should rally (excepting supply shocks, etc.). So you get a very early lead on turning points in the economy.
I use both the Journal of Commerce industrial materials price index and
the Bridge-CRB raw industrials index as key gauges of industrial materials
prices. These indexes include
commodities such as benzene, print cloth, cowhides, burlap, tin, tallow, nickel,
zinc, etc.
This is a positive sign for the economy.
8)
Take inventory of the
situation:
As I highlighted earlier, I like to follow data on the demand side of the
economy because it gives a solid lead on the inevitable events that follow on
the production side of the economy—