The stock market followed the traditional Leading Economic Indicator up.
The Conference Board organization publishes this indicator which bottomed in the spring of 2009 and has subsequently moved to new highs, perhaps indicating that the current economic rebound is much stronger than the economy we experienced in 2006 and 2007. But does that sound reasonable to you? It doesn’t to us.
For a number of reasons, we’ve been suspicious that the traditional Conference Board indicator has been overstating the magnitude of the recovery. The traditional LEI, for example, considers current monetary policy to be extremely stimulative. In reality, banks continue to restrict access to small business, especially, which has made it nearly impossible for companies to expand and provide jobs for the unemployed.
May-Investments was an early proponent of finding an alternative to the traditional LEI, but many other firms have joined the chorus and a few alternatives to the Conference Board are gaining support. In January, May-Investments was forced to develop its own proprietary LEI in order to have some objective tool to monitor the timing of this economic recovery.
The May-Investments LEI ignores the low level of interest rates, but instead emphasizes whether or not banks are starting to lend. (They aren’t.) Our LEI focuses on areas of potential strength, such as exports and energy independence, but ignores typical industry stalwarts like construction which were ground zero for the last bubble, and are extremely unlikely to drive expansion during the next cycle.
The May-Investments LEI never regained altitude, so we don’t think the real economy will experience a “double-dip,” primarily because we never really thought that we started a new recovery.
The most important question to me, in the short run, is whether the stock market has acknowledged this sluggish “muddle through” reality. It seems to me that the market soared higher along with the recovery in the misleading Conference Board indicator. In reality, we have merely stabilized in recession, which suggests that the stock market might be assuming a stronger recovery than we will ultimately experience.
Although the level of the May-Investments index has remained reasonably stable, behind the scenes the indicators have been weakening. Just a few months ago, eight out of the ten indicators that make up our LEI were improving. A few months ago, only commercial banks and the slow growth of the money supply showed signs of weakness. Since then, the outlook for small business owners, global shipping rates, and manufacturing new orders have all raised red flags. Retail sales are still a positive, but one more month like June and that indicator will flip to the negative as well.
Dip and double-dip worries highlight the single most important focus for investors is the Economy.
Stock market valuations are not worrisome. The market is reasonably priced.
Liquidity is no longer a big concern. The big banks have been bailed out by seniors, mostly, who are being paid virtually nothing on their life savings so that banks can rebuild balance sheets that were decimated by a unique combination of arrogance and incompetence.
The Conference Board has been publishing research for 94 years and traditionally its Leading Economic Index has provided a helpful guide to when the real economy is turning around.
This time is different.
The factors that the Conference Board LEI tracks are not the things that matter most in the new normal post-Lehman world. It doesn’t matter to me if the Conference Board LEI double-dips or not, because that indicator hasn’t been providing an accurate view of the economy on the way up, so it matters little to me where it goes from here.
The stock market, which is theoretically an important leading indicator in its own right, just might double-dip if the real economy weakens from here. If the real economy could start a real recovery, then stocks are reasonably cheap and the market could see a decent rally. If the real economy turns down again, however, I think that the fear will spread that today’s corporate earnings rebound won’t be sustainable, and the market will fall.
I still hope that there is no reason for the market to revisit the March 2009 lows, when our new President was busy nationalizing the auto industry in order to hand it over to the United Auto Workers, and considering nationalizing banks as well. I think his wings have been clipped, and the economic shock and awe that greeted the new administration’s policy ideas has abated somewhat, along with his ability to push through some of the most radical ideas.
The bottom line, though, is that the economy never spiked up, so it isn’t really dipping down. The stock market, however, might just double-dip (go back down) if the economy can’t sustain today’s corporate earnings rebound. Earnings have been much stronger than I’d anticipated. I don’t know whether they can be sustained at current levels, much less keep going up.
The term that others use is that we are “data dependent.” We are not positioned defensively because we anticipate that the economic indicators will turn down. We don't know which direction they're headed. That's why we're watching with such interest what happens to the Leading Economic Indicator.
We are positioned with money on the sidelines because volatility (risk) is so high that we don’t think we’re being paid enough to take on normal market risk, given the uncertainties we face.
If the market falls significantly from here, we’ll go out and add risk to the portfolio at a much more attractive price. If the uncertainty would fall, or the level of volatility would decrease, we would be willing to add risk to the portfolio, at today’s prices and even at slightly higher prices. But without seeing things improve from current levels, it is hard for me to dip, or double-dip, into the reserves we built up after the market rebounded from the 2009 lows.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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