New Leading Economic Index unveiled

May-Investments is set to roll out its own index to monitor U.S. economic activity at Tuesday's Economic Forecast luncheon on January 19th. The traditional LEI, published by The Conference Board, may not be as helpful during this recession, which began in December of 2007, if the credit-driven nature of this cycle is significantly different than previous recessions. The new index is designed to provide a more accurate signal of when a sustainable economic rebound has arrived and will be published throughout the course of the year in The Business Times.

The Conference Board LEI index is comprised of ten factors, but a single component, real M2 money supply, makes up over a third of the data point. Now, I’m as big a fan of money supply as a signal as anyone, but because of the credit-driven nature of this economic bust, the Fed is pushing money out into the system yet banking policies are anything but easy. Whereas an expanding money supply normally signals an easing in monetary policy, because lending standards have gone way up, this time the signal is providing a misleading signal that funds are available for expansion.

Average weekly manufacturing hours are another heavily weighted factor, with more than a 25% weighting in the final indicator. The stimulus program obviously helped move some cars off lots, so we’ve seen a strong rebound in the manufacturing hours statistics. However, if all we did is pull 2010 sales forward into 2009, so consumers could take advantage of the cash for clunkers program, then we’ll see that strength evaporate pretty quickly. The argument is that this component of the LEI is really giving investors a head fake, and the strength in that heavily weighted component may be unsustainable.

The next biggest weighting is in an indicator that compares short-term interest rates, which are extremely low, to longer-term rates. Normally, when the difference is large – as it is today – it indicates that the Fed has lowered interest rates in order to stimulate borrowing and economic activity. Again, in a traditional manufacturing based recession, low rates help turn things around. Today, however, it’s not the price of money that is the obstacle. The lending standards are so tight that even individuals with high credit scores trying to refinance an existing loan are running into crazy and unforeseen objections on the part of the bankers with whom they are dealing.

The government hasn’t lowered interest rates in order to stimulate borrowing. Regulators are making it extremely difficult for banks to make loans, and the banks themselves would rather use the cheap capital to fund internal needs. Banks have raised the price of both existing consumer and business loans, and the cost of funds is approaching zero. The Federal Reserve is trying to bail out incompetent bankers on the backs of elderly savers, and then the bankers are surprised at the populist outrage against financiers that is felt around the country!

This third component of the traditional LEI is responsible for about half of the recent increase in the LEI indicator, which turned positive in the Summer of 2009 and is indicating that we are in the midst of an economic recovery. I think it’s totally misleading, and if I’m right it means that the Conference Board’s number is giving a false signal this time around.

May-Investments is scheduled to unveil its new indicator on Tuesday, January 19, at its annual Economic Forecast luncheon. The new, proprietary, indicator will look at a broader spectrum of indicators, eliminating the disproportionate influence that the current money supply indicator has on the index. The new index also tweaks the indicators to compensate for changes in the global economy.

We just popped a huge real estate bubble, I seriously doubt new building permits (a component of the current LEI) is going to lead us out. On the other hand, manufacturing exports might lead us out, so we’ll add the Baltic Dry Index as a factor and drop components that aren’t appropriate to the credit-driven type of recession which we face.

We began forecasting the real estate recession in October of 2006. The firm has tracked local and national foreclosure rates since its launch in 2005. The real estate bust unfolded pretty much as we expected, until in September of 2008 when we just about lost the banking system after Lehman and AIG imploded. Now, I don’t quite know what this economy is capable of doing. But I need an updated indicator to help us monitor where we are in the recovery, so we’ve been forced to create our own.
 
In addition to reviewing last year's economic and market forecasts, and current portfolio positioning, the presentation will unveil the components of the new leading economic index and show what it is telling us about the current economic recovery.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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