Q2 Economic "Hope" Misses The Point
Submitted by Lance Roberts of STA Wealth Management,
The release of the final estimate of the Q1-2014 Gross Domestic Product report took most everyone by surprise by plunging to a negative 2.9% versus a negative 1.8% consensus. However, not to fear, the ever bullish media spin machine quickly stepped in to assuage fears by stating:
"If GDP were truly so weak, we would not expect aggregate hours worked to climb 3.7% annualized through May, jobless claims to remain near cycle lows, consumer confidence to hit a cycle high, industrial production to climb 5.0% at an annual rate over the first five months of the year, core capital goods orders to be up 5.8%, ISM to be above 55, and vehicle sales to hit their strongest annualized selling pace for the year," said Renaissance Macro's Neil Dutta. "GDP is the outlier in these data points. I will roll my eyes and move on. Most of the data we just mentioned is consistent with underlying growth over 3.0%."
See, "You fell all better now, don't cha?" (Okay, I have been watching too much "Fargo" lately.)
This is a problem with the majority of economic analysis. Blinded by the ever pressing need to take a "bullish spin" on the data (negative spins do not attract advertisers, readers or viewers) more important structural analysis is missed. Let's break down that statement above into its parts.
Aggregrate hours worked climbed 3.7% annualized through May.
Annualizing data is the worst offense in economic analysis. It is extremely deceptive as it assumes that every single month going forward will produce a similar result which, especially with economic data, is rarely the case. The reality is that a rebound in activity following the Q1 slump creating a pickup in hours worked. While the 3.7% annualized rate sounds extremely positively and exciting, the reality is that average weekly hours worked was 34.4 in January, slumped to 34.3 in February, and rose to 34.5 in March, April and May. Working 1/10 of an hour longer than in January doesn't sound nearly as optimistic.
Jobless claims are indeed near cycle lows, as they should be at this point in the economic cycle. However, first-time claims are a function of layoffs, terminations and separations. As shown in the chart below, there are only so many employees that businesses can terminate and still maintain operations and at some point will have to "hoard" what labor they have left. This does not mean that businesses are increasing employment due to a stronger business cycle. (For a full explanation of this issue read "Jobless Claims & The Issue Of Full Employment)
Consumer Confidence, ISM
The Consumer Confidence and ISM surveys are good coincident indicators as they tell us much about what business owners and consumers are feeling "right now." Since these surveys are primarily "sentiment" based, rather than "data based," there is less reliability as a forward looking indicator. Sentiment can, and does, change course very rapidly which makes this data much less important for investment purposes.
The ISM Composite Index (an average of the manufacturing and services surveys) shows the high volatility of the data. After a sharp drop in sentiment in Q1, there has been a sharp rebound over the last few months. This is as expected due to rebound in activity as an inventory restocking cycle proceeds.
A couple of important things to notice about the ISM. While the current rebound has certainly been encouraging, the index has failed to eclipse any of the old highs since the financial crisis. The entire recovery has been a systemic run of declines and rebounds which has been the hallmark of the overall anemic recovery. Secondly, notice that activity tends to rebound just before the onset of a recession as a "last gasp" of activity occurs. It is important NOT to get lost in a single data point but putting the data into context.
The context of these ongoing "recovery seizures" are more clearly shown in the following chart of the Chicago Fed National Activity Index (one of the most overlooked economic indicators) which is a broad national composite of 85 subcomponents. Each stint of "recovery" has given way to the underlying weakness in the ongoing "struggle through" economy.
Lastly, auto sales are no longer as much of a leading indicator as they once were historically. In the 1970's automobile sales made a much large percentage of the economy than they do today. Furthermore, as I addressed at length in "Auto Sales - Hype vs. Reality:"
"The current level of unit sales has risen from its lows but now appears to be reaching a potential saturation point. At the bottom of the financial crisis, the quantity of sales suggested that the average American would keep their existing vehicle for 25 years. Today, that is no longer the case and much of that excess replacement need is likely filled.
Furthermore, with dealer inventories reaching extreme levels, financial incentives to move cars out of the showroom will continue to become an ever more pressing need. Subprime auto loans are already back in vogue along with little or no money down deals. Since that worked out so well last time, why not do it all over again?"
Economics Vs. Investing
All of this anlaysis and "spin" on the economic data misses the real point. As individuals, we are investing capital in business models that should produce an expected return over time based on several factors: 1) the price paid, 2) projected future cash flows, and 3) the point within the current business cycle.
If we pay too much for a projected stream of cash flows at a very late point in a normal business cycle - the net return will be extremely low, if not negative.
The only reason that we care about economic data is solely to determine the current point within any given economic or business cycle. In the financial markets, our sole job as investors is to "buy low and sell high" and those "low points" highly correspond to the lows in the economic cycle as shown in the chart below.
Currently, the parabolic rise in the markets, extreme bullish optimism, and high levels of complacency are "trumping" the drop the Q1 GDP in "hopes" that it was indeed just a "weather related anomaly." This is very similar to what happened in late 1999 as the economy began its slip into a recession. The initial drops in GDP were disregarded by analysts and economists until it was far too late. The same thing occurred again in 2007 with Bernanke's call of a "Goldilocks Economy."
When it comes to evaluating the underlying strength of the economy, one of the most important measures is the level of "final sales." While GDP measures total domestic production, final sales reflects the demand by consumers, businesses, and government. Since the economy is almost 70% driven by consumption this number is far more important in determining what is happening beneath the headline GDP report. The chart below shows real, inflation adjusted, final sales.
The current downturn in real final sales suggests that the underlying strength in the economy remains extremely fragile. More importantly, with final sales below levels normally associated with the onset of recessions, it suggests that the current rebound in activity from the sharp decline in Q1 could be transient. This is particularly the case with energy, gasoline and food costs rising sharply which saps discretionary spending capability of consumers.
Furthermore, a major problem with economic analysis overall, from an investment standpoint, is that the data is highly subject to revisions, manipulation and subjectivity. Making investment decisions today based on data that could be sharply revised over the next year is extremely dangerous. This is why economic data is only useful in determining the potential point within a given economic cycle that an investment is being made. Given that the current economic recovery is more than 60 months old, which is extremely long by historical measures, the odds of substantial investment growth from this point in the cycle are very low.
As individuals, it is entirely acceptable to be "optimistic" about the future. However, "optimism" and "pessimism" are emotional biases that tend to obfuscate the critical thinking required to effectively assess the "risks" related to making investment and portfolios related decisions. The current "hope" that Q1 was simply a "weather related" anomaly is also an emotionally driven skew. The underlying data suggests that while "weather" did play a role in the sluggishness of the economy, it was also just a reflection of the continued "boom bust" cycle that has existed since the end of the financial crisis.
As I discussed recently in "Shiller's CAPE:"
"History suggests that the current period contains high levels of investment risk which have provided exceptionally poor levels of future returns. The data is clearly warning that future market returns are going to be substantially lower than they have been over the past five years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed."
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