Investing Daily

But there’s an old concept in statistics and economic modeling known as parsimony--or, simply, less is more. Economic models and analysis that rely on the consistent application of fewer indicators can often yield better and clearer forecasts.

Regular readers of Pay Me Weekly know that my favorite quick and simple indicator of the US economy’s health is the Index of Leading Economic Indicators (LEI). More particularly, I examine the year-over-year change in LEI; when this indicator turns negative it’s a good sign the US is headed for recession.

Those who followed this index would have spotted the US recession at the end of 2007 or early 2008, even as most economists and market pundits--armed with more complex models--forecasted only a short-term slowdown or a shallow recession.

As I’ve pointed out in recent issues of PMW, the LEI points toward continued weakness.

Source: Bloomberg

The index is subject to revision as new data points become available. But the chart shows that the index hit a low of -3.7 percent in late 2008 and has bounced somewhat off those lows to the -3.4 percent level.

This is the sharpest year-over-year decline in LEI in more than 20 years and is consistent with my view that the US is currently embroiled in the worst recession since at least the early 1980s.

I’ve received a number of questions about the LEI from Pay Me Weekly, Personal Finance and Energy Strategist that all boil down to two basic ones: How exactly is the LEI Index derived, and why did it improve slightly this month.

The Index of Leading Economic Indicators is assembled by the Conference Board using 10 constituent indexes. Here’s a rundown of all 10 indicators, what they each mean and the current outlook.

Average Weekly Hours Worked. This index measures the average number of hours production workers in manufacturing industries work per week.

If you’re a manufacturing company looking to cut costs due to softening demand, your first tendency is something economists call labor hoarding. Basically, that means that you don’t want to incur the costs involved in laying off workers, nor do you want to destroy employee morale by announcing big layoffs. You may also be worried that if the slowdown is only temporary, you’ll be stuck trying to hire those same skilled manufacturing workers back, six or nine months later.

So, you might decide to cut back on the number of hours your employees work. This could be done by cutting back on overtime or giving employees temporary unpaid leave. Similarly, during upturns, as demand increases your first move as a manager might be to increase overtime as a means of boosting output; it takes time to hire and train new workers.

Therefore, the pattern is that managers first cut back on hours during downturns and then, some weeks or months later, the layoffs start in earnest. During upturns, hours worked stabilize and rise, followed sometime later by an increase in payrolls. This is why this indicator is known as a leading indicator.

Here’s a look at hours worked today.

Source: Bloomberg

As you can see, the trends here aren’t encouraging. Hours worked really began to plummet earlier this year and now rests below the levels of the 2001 recession. This indicator fell further in December, a sure sign that it didn’t account for the uptick in the LEI.

A stabilization of this indicator would be an encouraging sign for the market--a sign that the rapid rise in unemployment might be nearing a conclusion. But that’s not likely to happen before midyear at the earliest.

Average Weekly Initial Jobless Claims. Investors are likely more familiar with this employment indicator than weekly hours worked. Basically, it’s a measure of how many workers are filing for unemployment compensation for the first time in a given week. Because weekly claims are inherently volatile from week to week the index averages claims over a given four-week (one-month) period.

This index offers a good gauge as to the state of the employment market--when initial claims rise, you can bet the unemployment rate will soon follow. But initial claims data tends to be more sensitive than data on the unemployment rate or total employment to rising layoffs and deteriorating employment conditions.

Here’s the chart of this indicator.

Source: Bloomberg

There isn’t much need to belabor this point: This indicator is rising rapidly as the employment picture deteriorates. We’re reaching levels consistent with prior nasty recessions, and there’s no sign of an improvement in conditions; this constituent certainly can’t explain the improvement in the LEI for December.

Manufacturers New Orders for Consumer Goods and Materials. This is an index of the inflation-adjusted dollar value of new orders for consumer goods and related raw materials.

When retailers start ordering more goods from their manufacturers, that suggests underlying demand for those goods is starting to turn higher or, at the very least, inventories of those goods are beginning to fall and need to be replenished.

At any rate, as orders pick up, actual manufacturing output would begin to pick up some weeks later as orders are filled. This obviously signals an upturn.

And on the downside, when new orders stop rolling into factories it’s a signal that demand is falling and the supply chain is full.

Here’s the chart of this indicator.

Source: Bloomberg

This one did show a very slight uptick in December. But the broader trend remains negative--it’s slipped badly since the summer of 2007.

There are several instances in prior cycles where this indicator has ticked up for a single month before resuming its prior decline. The most recent such example is June of last year; that slight bump amounted to absolutely nothing.

I want to see a more meaningful improvement that lasts another month or two before I get excited about this one. And given the sorry state of the consumer, I don’t see the real trend changing before the latter half of the year.

Finally, the improvement in this index isn’t of sufficient magnitude to explain the December bum-up in the overall LEI index.

Vendor Performance. This index shows the speed at which companies receive deliveries from their suppliers. When delivery speed slows, this index rises.

If you’re a company producing a product and it takes longer for you to get supplies, it likely means your suppliers are struggling to meet demand and are experiencing delays. They may even be running up backlogs of unfilled orders as they attempt to find ways to boost production.

When demand is weak, your suppliers have plenty of spare capacity and will quickly send you the supplies you need; after all, in a weak demand environment they probably need the cash. Therefore, when this index begins to rise, it can be an early sign that there’s been an improvement in demand.

Here’s a look at the index.

Source: Bloomberg

As you can see, this index has deteriorated notably this year and is hitting new multiyear lows. That means suppliers are quickly filling orders for goods, indicative of plenty of spare capacity.

No sign of a turn here, and this indicator certainly weighed on the December LEI figures.

Manufacturer’s New Orders of Non-Defense Capital Goods. This index measures the total inflation-adjusted dollars worth of orders for non-defense capital goods. Capital goods would include heavy equipment and machinery used to manufacture other goods.

If manufacturers need new equipment, it’s a good sign demand for their products is picking up. This indicates an improvement in manufacturing demand. Because defense-related capital goods are more indicative of government demand than overall economic prospect, they’re excluded from the index.

Here’s a chart showing the path of this index.

Source: Bloomberg

There’s a very slight uptick here for the December data, but it doesn’t appear meaningful enough to account for the broader improvement in LEI. Look for more than a one-month bounce in the index before getting excited.

Building Permits. This is a measure of the number of residential building permits issued in the US.

All investors should be familiar with this indicator; it’s a key leading gauge of health in the US housing market, the epicenter of the most recent economic turmoil and financial meltdown.

If consumers are filling for building permits, it typically means they’re planning construction projects. The filing for permits actually leads construction demand by several months.

Here’s the chart.

Source: Bloomberg

Anyone looking for a meaningful improvement in residential construction activity would find solace in this chart. This indicator actually held up well during the 2001 recession because the Fed used extremely lax monetary policy to pump up the housing bubble and promote construction activity.

The unusually nasty decline in building permits depicted in this chart actually led most other components of LEI this cycle, topping out in late 2005. The decline has been more precipitous than normal simply because the bubble took prices and construction activity to much higher, more extreme levels than would normally have been the case. The accelerated decline after mid-summer 2008 is likely a symptom of the credit crunch.

As most investors undoubtedly expected, there’s no sign of a turn here, and the indicator deteriorated further in September. My best guess, and it’s an educated guess, is that falling home prices coupled with extremely low interest rates and no new housing supply will eventually stabilize the US real estate market. I doubt that happens before the end of the year.

Stock Prices. This is nothing more than the S&P 500 Index. The stock market has historically bottomed out roughly five months before the end of a recession. Therefore, stock prices are the quintessential leading indicator.

Here’s a monthly chart of the S&P 500 that’s used in the LEI calculation.

Source: Bloomberg

It would seem a safe bet that anyone who’s read this much of today’s issue is well aware of how the US stock market has been performing in recent months. Suffice to say that this indicator hasn’t helped the LEI and certainly can’t explain the December improvement.

M2 Money Supply. This is a measure of the total amount of inflation-adjusted money in the economy. M2 measures physical currency, checking and savings deposits as well other immediately available, on-demand forms of money.

When the inflation-adjusted money supply grows, that means monetary policy is easy and expansionary. This tends to be stimulatory for the economy.

Here’s a chart of the money supply.

Source: Bloomberg

The government is the key player when it comes to money supply. Easy Fed policy and deficit-financed spending would tend to push the money supply higher, as do the steady parade of government bailouts we’ve witnessed in recent quarters.

Unprecedented government actions have rapidly pushed the money supply higher in recent months, and December brought one of the largest percentage increases in the money supply in history.

 This indicator is the key to understanding why the LEI jumped in December--it was a massive jump in the money supply. This single factor counteracted all the negative indicators I outlined above.

10-year Government Bonds Less Fed Funds Rate. This measures the different between the yield on a 10-Year US Treasury bond and the current federal funds rate. This is essentially a measure of the steepness of the yield curve.

There are a few reasons why this might be important. First, when short-term interest rates are low (fed funds rate is low) relative to longer-term bonds--a steep yield curve--it’s an indication the US central bank has been easing monetary policy.

Also, when the yield curve is steep it tends to help the banks. The reason is that banks take in customer deposits and pay short-term interest rates on those deposits. As short-term rates have fallen, you’ve probably noticed the interest you’re paid on savings accounts and certificate of deposit accounts has also fallen.

The banks turn around and lend that cash out to consumers and businesses at longer-term interest rates. When the yield curve is steep, the spread banks earn between the cost of cash (deposit rates paid) and the interest rates they receive on loans grows, increasing profitability.

Granted, a weak lending environment and a lack of willingness to lend mean this isn’t as beneficial as it normally would be. That said, it’s generally a positive.

Here’s a chart of the current interest rate spread in the US.

Source: Bloomberg

As you can see, the yield curve has steepened rapidly since early 2007 when it was inverted--back then short-term rates were higher than long-term rates. An inverted yield curve is typically an indication of tight monetary policy and a looming recession for reasons exactly opposite to the analysis I offered above.

This indicator is tending to be supportive of the LEI; however, in December it did pull back somewhat. I have no doubt the Federal Reserve will keep the yield curve relatively steep to support the economy.

Index of Consumer Expectations. This data is collected by the University of Michigan and is derived via a series of questions asked to a large sample of consumers. It’s designed to discern their expectations for economic prospects for their family and the nation as a whole.

When consumer’s expectations for the future become more positive, they tend to spend more money, and that helps support economic growth. When they’re not optimistic, consumers tend to cut back and save money in case their circumstances change for the worse. Therefore, improving expectations are a leading signal of growth.

Here’s the chart of this indicator.

Source: Bloomberg

This chart shows that consumer expectations have been gradually deteriorating since early 2007. There was an improvement over last summer, but that quickly faded in the fall credit crunch.

The small uptick in December looks to be nothing more than a temporary blip. A move back up over the 70 area that’s sustained for a month or two would be a good indication for the economy.

Bottom line: The only LEI constituents showing any signs of improvement are those directly controlled by government policy. It’s fair to say that whether you agree with the government’s methods or not, the massive jump in money supply and easy monetary policy are having some effects.

Chief among those is the slow thawing out of the credit markets I highlighted in the January 16, 2009 PMW. I also Twittered a short comment about this on At These Levels yesterday--Chesapeake Energy (NYSE: CHK) managed to sell $1 billion worth of bonds, a move I doubt would have been possible just a month or two ago.

Over the longer term, all these stimuli spell major increase in inflationary pressures, and quite possibly renewed weakness in the dollar. My top play on those trends remains gold and other physical commodities.

But government action can only go so far. Before I call a sustainable recovery, I want to see the thawing in credit conditions push through into an improvement in other parts of the economy. In other words, I want to see a stabilization and move higher in some of the other major components of LEI I outlined above.

This is something I’ll be watching; look for ongoing commentary here and on At These Levels.

In closing today’s issue, I’d like to extend a special invitation to all Pay Me Weekly subscribers to attend the Atlanta Wealth Conference, hosted in a beautiful mountain setting in northern Georgia. This conference has always been a personal favorite of mine, as it’s smaller than most with only 175 attendees.

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