November 2011 |
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In light of the recent positive turn in US economic data, it is appropriate for us to address our continued contrarian view and conservative investment strategy. Like 2010 before it, starting this past spring US economic growth slowed to a near crawl. And, like 2010, this year’s slowdown was preceded by a broad downturn in many of the leading economic indicators.
However, over the past six weeks, the coordinated downturn in economic data has at least paused. We would describe the trend in the most recent data as “stabilized” rather than undeniably “positive”. Investors once again appear to be concluding that it was only a rough patch in the continued recovery.
We are clearly skeptical of this conclusion.
It is important to note that most of the headline-grabbing economic releases of late concern items such as GDP, retail sales, the jobs picture and corporate earnings. All of these are - at best - coincident indicators - and at worst - lagging indicators of the future path of the economy. It is simply not unusual for coincident and lagging indicators to show flashes of strength prior to the onset of a recession.
To illustrate, the first official guess regarding US economic growth for the third quarter of 2007 was a robust 3.9%. Yet, this was only three short months prior to the onset of the great recession. Similarly, the initial guess on job creation back then was a positive 166,000. Yet, by March 2008 we began to see very serious job loss figures. Similar examples can be highlighted just prior the start of the 2001 recession.
Today, we are showing some job growth over the past two months. They are, in fact better than the zero jobs initially reported In August. And the most recent GDP report came in at a positive 2.5% following near-stall speed in the first half of 2011. Judging from recent moves in the stock market, investors are clearly relieved following the very weak data in the summer.
The primary lesson is that coincident and lagging indicators don’t help investors anticipate and prepare for the damaging effect of recessions. Coincident indicators simply reflect the here and now and lagging indicators tell you about a pitch that’s already landed in the catcher’s mitt. These types of indicators are not the types of pitches investors should be swinging at!
They should be looking for indicators that truly lead the onset of a downturn. The longer the lead-time, the more difficult it is to have conviction in the face of contradictory coincident and lagging economic data. Additionally, not all indicators – short-leading, long-leading or coincident indicators - will line up in unison. That is precisely why making forecasts and taking contrarian action is so difficult.
For example, we currently struggle with the strength in consumer spending during this entire recovery. People are buying stuff lately at a clip not seen since housing-led heyday of mid-2005. Without this strength, there would truly be no economic recovery.
We are flummoxed by it given the weak job and wage growth, the massive loss of wealth and the still-recessionary readings of consumer confidence. We know that households still have a way to go before they reduce their debt load to levels registered just back in the 90s, a decade where household debt was already at record levels. This is a long process and they are only about one third of the way through it. Our conviction is that without robust job growth, significant wage growth, an increase in consumers borrowing, and/or lasting increases in their wealth, consumer spending growth is very unlikely to continue at this pace.
We are also amazed at the strength in corporate profits during this recovery. After firing millions of people, companies have ridden the ensuing strength in business investment and consumer spending to record profits. Profit margins for corporations are at all-time highs and are elevated by a massive 50% higher than the average margins of the past. While company earnings have been strong, our conviction is that the laws of capitalism (that is, fierce competition) have not been repealed. For this reason, we believe profit growth is slowing and will likely slow further.
By the way, the natural cycle in profit margins and profit growth is a long-leading indicator of future economic growth. Business leaders prudently adjust their plans when they see future pressure on their profits and it leads them to produce less, trim their labor costs and hire less. This leads consumers to watch their spending, companies lower their prices and profit margins naturally shrink. It does this until equilibrium is established. This is precisely what the business cycle is all about.
Many investors, market strategists and economists simply believe that past trends will continue into the near-term future. Then, they almost always extend the trend-line forward. This is referred to as “nowcasting”. That practice works until it doesn’t. Reading the signs of these turnings points is what forecasting is all about.
Recently, ECRI - a firm with a very good long-term record - made the boldest recession warning we’ve ever heard. On September 30th, ECRI’s Lakshman Achuthan said “(a recession) cannot be averted...we are seeing the weakness spread widely.” He further stated, “There’s a contagion, like a wildfire, among the forward-looking indicators that’s not going to be snuffed out.”
Beyond ECRI’s call, money managers like John Hussman use a mix of market-based indicators and economic data to make their macro-economic judgments. Among others, he uses items such as stock price movements (lower than six months ago), credit risk on bonds (growing risks lately), manufacturing indicators (much lower than months ago) and consumer confidence readings (down now for many months). He made his definitive recession call on August 8th.
While we are always reviewing our assumptions and trying to challenge our convictions, we are taking the messages sent by groups such as ECRI very seriously. We know that stock markets decline, on average, about 30%-35% during normal recessions. Europe’s serious issues may not make a new recession all that normal. Now that stocks have recovered a good portion of the summer’s decline, our concerns remain.
