Hussman on Leading Vs. Lagging Economic Data

Read all of Dr. Hussman's weekly market commentaries here.

Accompanying the news of the "grand and comprehensive" European solution on Thursday was the news that GDP rose at an annual rate of 2.5% in the third quarter. There was already coincident data that the U.S. was not yet in contraction in August or September, so this was no surprise. Still, investors continued the habit of confusing lagging and coincident indicators for leading ones, so the positive GDP figure was taken as evidence that an oncoming economic downturn was "off the table."

I can't emphasize enough that leading evidence is in fact leading evidence. Take, for example, the ECRI Weekly Leading Index. It's certainly not a perfect indicator in itself, but its leading properties are instructive. If you look at the historical points where the WLI growth rate fell below zero, you'll find that weekly unemployment claims (a coincident indicator) were generally still about 3% below their 5-year average. It generally took about 13-16 weeks for unemployment claims to climb above that 5-year average, and even longer for the unemployment rate (a lagging indicator) to rise sharply. That's not much of a lag in the grand scheme of the full economic cycle, but allows a great deal of intervening and often contradictory action in the financial markets.

The tendency to demand predictable outcomes to also be immediate is a dangerous one, because it allows investors to be sucked in by temporary reprieves during what are, in fact, very negative conditions. As I noted in May (see Extreme Conditions and Typical Outcomes ), "It's clear that overvalued, overbought, overbullish, rising-yields syndromes as extreme as we observe today are even more important for their extended implications than they are for market prospects over say, 3-6 months. Though there is a tendency toward abrupt market plunges, the initial market losses in 1972 and 2007 were recovered over a period of several months before second signal emerged, followed by a major market decline. Despite the variability in short-term outcomes, and even the tendency for the market to advance by several percent after the syndrome emerges, the overall implications are clearly negative on the basis of average return/risk outcomes."

The same can be said here of economic prospects. Investors have almost entirely abandoned any concern about recession risk based on a few weeks of benign economic figures. Yet on the basis of indicators that have strong leading characteristics, a broad ensemble of evidence continues to suggest very high recession risks, and even sparse combinations of indicators provide a major basis for concern.

For example, since 1963, when the ECRI Weekly Leading Index growth rate has been below -5 and the ISM Purchasing Managers Index has been below 54, the economy has already been in recession 81% of the time, and the probability of recession within the next 13 weeks was 86%.

If in addition, the S&P 500 was below its level of 6 months earlier, the economy was already in recession 87% of the time, and the probability of recession within the next 13 weeks climbed to 93% (and then to 96% within 26 weeks). Under these conditions, once the PMI fell below 52, the probability of recession within 13 weeks climbed to 97%.

John Hussman: Leading, Lagging, and Coincident Indicators

from HussmanFunds:

"Series that represent early stages of production and investment processes (new orders for durable goods, housing starts, or permits) lead series that represent late stages (finished output, investment expenditures). Under uncertainty, less binding decisions are taken first. For example, hours of work are lengthened (shortened) before the work force is altered by new hirings (layoffs)."

Victor Zarnowitz and Geoffrey Moore, "Sequential Signals of Recession and Recovery"
Journal of Business, 1982

Last week, we got a fresh set of economic indications from the Philadelphia Fed Survey. While the market evidently took relief from the modest uptick in the composite index to -0.7, a quick look at the component indices suggests a worsening of economic conditions in the latest report. Specifically, the Philly Fed new orders component fell to -8.1 from -7.1, which is the third month in negative territory. While there was a slight uptick in the index for number of employees (to 1.8 from -2.7), the better leading measure is the average employee workweek, where the index weakened to -21.6 from -17.1.

As I've emphasized in recent weeks, the U.S. economy is still in a normal "lag window" between deterioration in leading measures of economic activity and (probable) deterioration in coincident measures. Though the lags are sometimes variable, as we saw in 1974 and 2008, normal lags would suggest an abrupt softening in the September ISM report (due in the beginning of October), with new claims for unemployment softening beginning somewhere around mid-October. It's possible that the historically tight relationships that we've reviewed iin recent weeks will not hold in this particular instance, but we have no reasonable basis to expect that. Indeed, if we look at the drivers of economic growth outside of the now fading impact of government stimulus spending, we continue to observe little intrinsic activity.

The strongest forces driving economic expansion during a post-recession recovery phase is expansion in credit-sensitive expenditures such as housing, durable goods (such as autos) and gross investment, and in particular, inventory rebuilding. While capital expenditure for upgraded information technology is the clearest bright spot in recent GDP reports, it also represents a very small share of the economy. Other credit-sensitive classes of expenditure continue to face strong headwinds.

It is also important to understand that while consumption represents roughly 70% of economic activity, it is by far the least volatile component of GDP, particularly when durable goods are excluded. The main sources of fluctuation in GDP growth are credit-sensitive expenditures and inventories. Given the recent buildup of inventories and the expenditures on autos and home buying that were brought forward by programs such as cash-for-clunkers and the first-time homebuyers' credit, we are likely on the downside of those bursts of spending. For that reason, it appears likely that the positive growth of GDP in recent quarters will have relatively poor follow-through. A careful examination of sub-components of GDP growth leaves little reason to expect actual economic activity to deviate from what is already suggested by weak leading indicators.

If we observe both an improvement in those leading indicators and an improvement in market internals, our evaluation of investment conditions would be more constructive. For now, however, we remain defensive about risks that still appear significant.

On the housing front, last week's comments from Rick Sharga, the V.P. of RealtyTrac, are worth noting - "We're on track for a record year for homes in foreclosure and repossessions. There is no improvement in the underlying economic conditions. Whether things fall precipitously depends on government and lenders controlling the inflow of new foreclosure actions. If the market is left to fend for itself, you may see more serious price depreciation."

Lender Processing Services concurred, with its senior V.P. noting "Loans that have been delinquent for a historically long period of time are just now beginning to move through the pipeline. As of July 2010, the average length of time a loan in foreclosure had been delinquent was nearly 470 days. Now, after the intensive efforts of the last year or two, remaining home retention options appear to be exhausted and servicers are beginning to process more of these seriously delinquent loans."

My view remains that the underlying condition of the U.S. housing market is one of deep insolvency. The Treasury, Fed and the FASB have effectively made a policy out of opaque disclosure, so that at least the deterioration in the housing market is slow to appear on the balance sheets of major banks and financials. At present, the FASB allows "substantial discretion" in the valuation of mortgage-backed securities, which I suspect are being carried at a higher level than the value that the underlying cash flows (mortgage repayments) can actually support. Given that there is little pressure to disclose losses, and that mechanisms are in place (at least until the end of 2012) for the Treasury to bail out the entire flow of bad mortgages that funnel through Fannie Mae and Freddie Mac, it's not clear whether the growing mountain of delinquent and unforeclosed mortgages will provoke an abrupt crisis. My own expectation is that fresh economic pressure would provoke contagious pressure on the housing market to an extent that would be difficult to obscure.

That said, if the U.S. economy averts a period of fresh economic weakness, we could instead observe a more drawn out period of stagnation and price pressure. Ultimately the bad assets have to be placed on the market, which suggests further price pressure in the next few years. Weak labor conditions would also contribute further mortgage deterioration. Long-term, deficit-led inflation might be able to avert mortgage losses as home values gradually rise above the principal balances, eroding the real value of the debt, but this appears very unlikely in the immediate few years.

On the subject of inflation, I should emphasize that while I expect inflation pressures to be contained for several years, the impact of massive deficit spending should not be disregarded simply because Japan, with an enormously high savings rate, was able to pull off huge fiscal imbalances without an inflationary event. We may be following many of the same policies that led to stagnation in Japan, but one feature of Japan that we do not share is our savings rate. It is one thing to expand fiscal deficits in an economy with a very elevated private savings rate. In that event, the economy, though weak, has the ability to absorb the new issuance. It is another to expand fiscal deficits in an economy that does not save enough. Certainly, the past couple of years have seen a surge in the U.S. saving rate, which has absorbed new issuance of government liabilities without pressuring their value. But it is wrong to think that the ability to absorb these fiscal deficits is some sort of happy structural feature of the U.S. economy. It is not. It relies on a soaring savings rate, and without it, our heavy deficits will ultimately lead to inflationary events.

Hyperinflation is a much different story, and as I've said before, I am not in that camp. This doesn't exclude the possibility that enough policy mistakes will change that, but for now, my inflation outlook is flat for several years and then accelerating in the second half of this decade.

As Peter Bernholz notes in Monetary Regimes and Inflation (an economic study of inflation, including more than two dozen cases of hyperinflation), "The figures demonstrate clearly that deficits amounting to 40 per cent or more of expenditures cannot be maintained. They lead to high [inflation] and hyperinflations, reforms stabilizing the value of money, or in total currency substitution leading to the same results. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflations... [In nearly all] cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present."

At present, U.S. federal expenditures are about $5 trillion, versus about $4 trillion of revenues, and GDP of about $14.6 trillion. So the federal deficit is running at about 20% of expenditures, but less than 7% of GDP. This is not a profile that is consistent with hyperinflation, but it is also not a benign policy. Continued deficits will have substantial economic consequences once the savings rate fails to increase in an adequate amount to absorb the new issuance, and particularly if foreign central banks do not pick up the slack. We're not there for now, but it's important not to assume that the current period of stable and even deflationary price pressures is some sort of structural feature of the economy that will allow us to run deficits indefinitely.

Finally, given probable economic pressures and continued strong demand for default-free instruments, the likelihood of sustained upward pressure on bond yields remains limited here. At some point, probably years from now, we'll face a likely sustained increase in bond yields. We're often asked how that sort of environment would affect the Strategic Total Return Fund, given that we don't short bonds, and we don't buy "inverse floaters" or the like. A simple answer is that just as poor valuations and weak market returns have kept us from taking much exposure to stock market risk during the past decade, while the S&P 500 has gone nowhere, rising interest rates will limit the ability to profit from interest rate exposure. Water can't be squeezed from stones. Frankly, however, the returns of the Strategic Total Return Fund since its inception have not been dependent on a great deal of interest rate exposure in the first place. Even our present portfolio duration of 4 years is well below the average duration of the bond market.

So to a large degree, I expect we'll simply continue what we normally do, which is to vary our exposure in proportion to the expected return/risk profile of the various markets and security groups that we invest in. Markets rarely move in a straight line, and there is typically enough cyclical fluctuation within secular trends to present many opportunities to vary market exposure and portfolio duration. We have the ability to invest in a range of assets such as inflation protected securities, precious metals shares, and foreign currencies, as well as utility shares and other assets. An extended period of rising interest rates is likely to produce a bias toward shorter portfolio durations rather than longer ones. However, I don't expect that economic cycles would be eliminated, and to that extent, I don't expect that we'll be at a loss for opportunities to vary our investment exposures over the course of those cycles.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, mixed market action, increasing bullish sentiment (approaching levels of overbullishness), and clear overbought conditions. As we've observed for months now, the stock market is still trading between widely followed support and resistance levels, with the S&P 500 bouncing off of the higher end of that channel last week. My primary concern is still the "recognition window" that I believe we have entered. The next several weeks will be important. As noted above, however, if leading measures of economic activity improve and internals improve, we'll be willing to accept a moderately more constructive position, but even here, our latitude to do so is somewhat restricted by valuations that are historically rich. As always, our intent is to align our position in proportion to the return/risk profile we expect. There's a moderate positive range that we'd be willing to operate within if we observe improvement in various economic measures, but for now, the evidence continues to warrant a strong defense. Both the Strategic Growth Fund and the Strategic International Equity Fund are tightly hedged.

In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 4-years, and we are maintaining a range of 15-20% of assets allocated between precious metals shares, foreign currency exposure and modest holdings of utility shares.

David Rosenberg Points Out Something Fishy With Latest Economic Data

The latest batch of data has been highly confusing, to say the least. The chain store sales data were skewed by one-offs, such as retroactive jobless benefit checks that were mailed out in early August and the growing number (17 this year) of States offering sales tax holidays. We estimate that absent these influences, year-on-year sales growth would have been closer to 1% than 3%.
The spending data also belied the information contained in the Conference Board’s consumer confidence survey, as the facts-on-the ground ‘present situation’ index sagged to 24.9 in August from 26.4 in July — only 5% of the time in the past has it been so low. The ISM manufacturing index, which really got the ball rolling on this ‘take out the double-dip’ trade, managed to spike even though the three leading sub-indices — new orders, backlogs and vendor performance — all declined in what was a 1-in-100 event.
Not only that, but the employment component of the ISM surged to its highest level since December 1983, and yet the manufacturing employment segment of the payroll survey fell 27,000 — the first decline this year and the sharpest falloff since last October. Furthermore, the manufacturing diffusion index slumped to a seven-month low of 47 from 53 — in other words, fewer than half of the industrial sector was adding to staff requirements last month. It begs the question as to what exactly the ISM is measuring.
The list of inconsistencies in the data didn’t stop there. The entire increase in private sector employment in August was in the service sector — mostly health and education, which says little about the cyclical state of the economy. Yet 90 minutes after the jobs number was released, we got the ISM non-manufacturing survey and it flashed a contraction in services employment to a seven-month low of 48.2 from 50.9 in July.
Just a tad confusing, but the newly found bullish view of the economy is sort of corroborating evidence.
The employment report did not detract from the view that the economy is losing steam. The fourth quarter of a recovery typically sees real GDP growth of over 6% at an annual rate, but in this post-bubble credit collapse, what we got this time was 1.6% at an annual rate in Q2.
Moreover, there is nothing in the data to suggest anything but a further slowing in Q3, and the only reason why there is no contraction this quarter is because it looks as though we are getting another lift from inventories — though now the buildup looks involuntary, which will cast a cloud on fourth-quarter GDP barring a sudden reversal in the declining trend in real final sales.
Private payrolls were +247,000 when the equity market peaked in April, it slowed to +107,000 by July and was +67,000 last month. What does that suggest about the trend? Ditto for goods-producing employment, which was +67,000 in April, subsequently softened to +37,000 by July, and in August was the grand total of zero.
One can easily draw the conclusion from the data that we have dodged a bullet. But that does not mean we are out of the woods. Employment is a coincident indicator. Leading indicators, such as the ECRI, continue to deteriorate and to levels still consistent with nontrivial double-dip risks. Keep this in mind — private payrolls came in at +97,000 in November 2007 and the “Great Recession” began the next month. In other words, the +67,000 tally we saw today basically tells you nothing about how the pace of economic activity is going to unfold as we move into the fall.