May-Investments developed its in-house indicator rather than rely on the more traditional LEI, which is published monthly by The Conference Board. With the Federal Reserve adopting Enron-style off balance sheet financing vehicles in order to move the government’s new bond issuance out the doors into buyers’ hands, the old economic indicators are at risk of becoming obsolete. Investors are having difficulty understanding whether today’s economic growth is a mirage, an encouragement, or a house of cards about ready to fall and take investors down with it.
The resulting economic uncertainty causes many investors to remain on the sidelines for fear of a repeat of the 2008 banking panic. Unfortunately, “the sidelines,” as represented by bank and bond interest rates, pays investors little or nothing, so savers are being hurt by the Federal Reserves’ low interest rate policies, which have been crafted to benefit bankers instead of savers. Long-term investors are being asked to use yesterday’s economic indicators in spite of the apples-to-oranges comparison between the economic environment that preceded the 2008 collapse of Shearson Lehman, and the capital-starved world that we’re in today.
Investors could ignore the big picture, but 2008 proved that approach is too risky. Investors could remain on the sidelines, but inflation is persistently destroying the value of money held in the bank while food, energy, and import prices soar higher. Some investors will decide to use the old indicators, ignoring the sea change in monetary policies that have been adopted since 2008. That approach has worked fairly well since the market bottomed in March of 2009. On the other hand, ignoring the new reality won’t make it go away, and doesn’t mean that it won’t eventually matter (a lot).
May-Investments responded to the new economic realities by replacing outmoded economic indicators with a new Leading Economic Indicator of our own. Built in-house and updated monthly, it shows that the economy began a sharp decline in mid-2008, a few months before Lehman’s bankruptcy and the Wall Street implosion. Through 2009, the economy remained mired and didn’t actually turn up until mid-2010, despite traditional indicators that showed the economy recovering a year earlier. The old indicators put too much emphasis on low interest rates, a traditional indicator of stimulative Fed policy. In fact, low rates were put in place to bail out the distressed banking sector, but bank regulators were busy tightening bank capital requirements and lending rules that left banks shrinking loan portfolios, firing commercial loan customers - even those that were current on their loan payments. The world had changed, but the old indicators weren’t reflecting this new world.
As a result of developing our own indicators, we can say with more confidence that the recovery that began in mid-2010 is still underway, and is not a mirage. Retail sales and drilling activity turned up early and are still positive. Corporate profits have fully recovered. In contrast, small business confidence remains spotty. Even bank lending, which held back the recovery for months, recently turned up. These are healthy signs that give us confidence to invest for the long-term, rather than hiding on the sidelines.
There are certainly concerns, and our indicators help us know where to look for them. Overseas activity has been weakening for several months as higher interest rates abroad slow down the rate of recovery in our export sector. More recently, the technology sector has dropped a bit, presumably (but who knows for certain?) as a result of problems facing the tech sector related to the tsunami crisis in Japan.
When we build client portfolios, we can design them to reduce exposure to some risks (we currently have little foreign stock exposure) while embracing other types of risk, where evidence of the recovery gives us more confidence that risk taking will be rewarded. Most importantly, it has helped us keep our foot off the portfolio brakes when the market began rallying last Fall. We still think that the brakes are important. Our best guess is that we remain in a “trading market” that could go down, a lot, just like it has soared off the 2009 lows.
At times we want to be playing offense, while at other times it makes sense to be more defensive. Our Leading Economic Indicator helps us make sense of this new monetary world in which we find ourselves. As I write this, the view is still encouraging.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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