The Eye of the Storm

By Frank Barbera CMT. April 14, 2009

There are statistical ‘turns’ in the economy and then there is the ‘real deal.’ The “real deal” is defined by an actual improvement in the economy on Mainstreet in terms of material job creation, better wages, higher productivity, etc. None of that is likely to happen for some time as the US economy is undergoing what will be a structural change likely to last five years or more. Without a cleansing of the Banking system, ‘zombie banks’ will not be in lending mode, and without new lending, it is highly doubtful that a genuine recovery will appear on the horizon any time soon.

That said, there is now little doubt that a ‘headline’ recovery bounce is destined to appear in the months just ahead. In classic leading fashion, the rally in the US stock market seems to be discounting this event in advance. In this week's update, we spend some time with an overview of recent economic data and what some of the current data implies for the months just ahead. In my view, the Bottom Line strongly suggests that we will be treated to a period of five or six months wherein the economic headlines will improve. Yet, what most investors need to understand is that this type of ‘recovery’ is largely a statistical mirage caused by a rebuilding of the inventory cycle.

It is the economic equivalent of a stock market so called ‘dead cat’ bounce where after being sold down very hard, stocks have a natural tendency to move counter-trend for a period of time, retracing some of the period of lost ground. So too does the economy at times reach a point where it is hard for the data to remain so compressed, and for new data to deteriorate much further from where prior data left off. As a result, once economic data reaches major trend extremes, a bounce develops as the negative rate of change begins to naturally slow. Unfortunately, while this makes for uplifting short run headlines, that’s about all you end up with, as once the bounce phase is over, Phase II of the contraction can take control and pound things down to still lower lows. In my view, we are a long way from anywhere near convinced that any of the measures put forth in recent months will do anything to make the economy revert to a self reinforcing growth mode. In fact, the more we look at it, the more we are getting concerned that the interlude ahead may be most akin to the ‘eye of a hurricane,’ that relatively brief period of time in the middle of the storm where the sun comes out, and hope emerges that the worst is over. That is what we believe stands directly ahead, and we sincerely hope we are wrong.

Nevertheless, with this in mind, let’s take a moment and look at what some of the latest data series are suggesting. Over the years, I have found any number of good coincidental to leading indicators for the broader economy, with ISM Purchasing Managers Series one of the best predictors. In my work, I tend to focus on the manufacturing data which has a far longer history, and continues to be reliable through successive cycles. In this vein, within the spectrum of ISM sub-series, the New Orders index tends to be an early downside leader, and a good warning gauge of approaching recession. As a leading edge indicator, New Orders also tend to turn up long before other series. On the other end of the spectrum, the ISM Inventory series tends to be very coincidental, or even lagging somewhat at important turns. For our purposes, having a good lagging indicator is terribly valuable as it helps to ‘book-end’ each cycle. In the chart below, I show the ISM Manufacturing New Orders Index in the thin line, and the ISM Manufacturing Inventory series in the bold line. Notice that the Inventory gauge is currently still falling sharply and is at multi-decade lows. Notice also that New Orders tend to turn long before other series, and right now with Inventories massively depressed, there is a nascent upturn in New Orders (to replenish inventories) already underway.

Above: ISM New Orders (Thin line) and ISM Inventories (Bold line)

Above: the ISM Inventories Series which is neutral at 40, and recession “depressed” at values below 35 resides at 32.20 as of the March reading.

To get a strong idea precisely when an economic extreme might be taking place, we like to compare these two series, the New Orders and Inventories more directly computing the ratio of New Orders to Inventories. In the chart below, we show this ratio as the dashed line in comparison to the lead series for the ISM. Notice how the New Order to Inventory Ratio tends to shoot higher well ahead of the main series. In the chart below, we show the action for the 1980-1982 deep recession which end up as a ‘double dip.’

Above: ISM Data Series Ratio of New Orders to Inventories (dashed) versus ISM Composite (1980-81).

Above: ISM Data Series Ratio of New Orders to Inventories (dashed) versus ISM Composite (1974).

In the next chart, shown above, we show the same ratio coming out of the 1974 recession, where again, the dashed line began to shoot higher long before the actual ‘recovery’ began to take shape.

Next, we update the same indicator for today’s climate where we see that the Ratio of New Orders to Inventories is once again beginning a sharp mega-spike to the upside.

Above: ISM Data Series Ratio of New Orders to Inventories (dashed) versus ISM Composite (today).

What this tells us is that in the months ahead, a lot of the economic data that gets reported each month is going to start to lift. When the kind of major cycle extremes such as the ones just seen begin to appear, the normal outcome is a sharp statistical recovery in the data which will be taken as ‘good news’ by most. In the months ahead, it is highly likely that more and more commentators will begin talking about an ‘end to recession,’ the ‘new recovery’ etc. This will be especially true of the kings of babble on CNBC, which managed to avoid having prescient bears like Peter Schiff as a guest in the months ahead of the collapse while simultaneously telling the American public that the American economy was the ‘greatest story never told’ in the months before everything imploded in 2008. In addition to the ISM data series, the Conference Board has two time series which are also good forecasting gauges for more important economic turns. The first of these is the Ratio of Leading Economic Indicators to Lagging Economic Indicators which is shown in the top clip in the chart below.

Above: (top clip) the Ratio of Leading to Lagging Economic Indicators

This ratio actually peaked in the early 1950’s and despite the recovery cycle of the 1980’s and 1990’s, never made new highs. This speaks to the altered nature of the US economy, wherein deeper structural problems led to a less robust secular expansion in the most recent decades, with the recovery of 2002-2007 the weakest recovery pattern ever seen. Looking back, this was an excellent warning that the depth of the ensuing recession would be ‘the deepest since the 1930’s.”

Nevertheless, as can be seen on the next two charts, the middle clip and the lower clip of the chart above, the Rate of Change for the LEI Leading to Lagging Ratio, and even the Wilder RSI on the Leading to Lagging Ratio, both of these are now at levels from which a recovery bounce is all but a done deal. In addition to the LEI, the Conference Board also maintains a long standing sentiment survey which measures Consumer Confidence. Within this survey, the data series on Forward Expectations is especially helpful at this juncture, showing extreme values and a bullish set up on Rate of Change which would indicate an improvement in the social mood going forward in the months ahead.

Above: Conference Board Gauge of Forward Expectations (top) and Rate of change on Forward Expectations (below).

Thus, readers should understand that where the economy is concerned, 'the data’ is bound to improve for a period of time as the spring and summer approach. Nevertheless, the question remains how will the markets handle this “good news” and more to the point, is it already being discounted? In my view, the odds are highest that only a portion of the potential economic bounce is currently being discounted into stock prices. I believe, at least for now, the odds are high that the bear market bounce in equity prices will probably have a few more months to run, albeit in highly irregular movements (both down and up). (See articles presented in prior two updates - 03/31/2009, 04/07/2009.) To that end, the odds are highest that both the economic news will improve for a period of time, and that stock prices will be somewhat higher than they are today (maybe not much) a few months from now. For investors, buying oversold values and selling into overbought values will be the name of the game.

In addition, there is one market where the concern level should be at record highs, and that is the Bond Market. Going back over the long history of Bond Yields and the ISM New Order Index, we find that when the economy tends to ‘bounce,” long term interest rates tend to begin rising. So far, despite Dr. Bernanke’s grand Q/E announcement of March 18th, the only shock and awe result has been the undesired result of rising, not falling long-term rates. Think about it, over the last few months the economic data has been positively horrible, and the stock market horrible along with it for most of that time. Now during that time, did Bond yields fall? They did at the end of 2008 but not during the first portion of 2009. If a market can’t move higher on good news, then the odds are that market is exhausted and is topping out. This would seem to be the case as Bond prices have been unable to move higher in the face of good news for bonds (which is recession/deflation), and yields have come nowhere close to last December's low water mark near 2% on the 10 Year Bond. Now, layer on an “improvement” in the economic data in the months ahead and we would be surprised if Bond yields did not bolt through 3%.

Above: The 10 Year Bond Yield and the ISM New Orders gauge shown as a histogram with +50 as the zero line. When New Orders are above +50, yields tend to back up.

IF rates do begin a steady rise in the months ahead, given the state of the US Residential Housing Market and even the Commercial Real Estate market, one wonders whether or not the economic ‘good news’ might in fact turn out to be another dose of ‘bad news.” Perhaps things might be different if the supply of unsold homes were lower, and the burgeoning supplies for commercial real estate were not still expanding. However at this stage of the cycle, while a fair amount of REFI activity has taken place as rates have dipped in the last few months, a new cycle of rising long term rates would seem to suggest upward pressure on mortgage rates dead ahead and a reduction in affordability. For a Real Estate market already reeling from excess inventories, and a banking system reeling from bad debt, the last thing we need now is a steady rise in long term rates. As a result, we are not all sure that a forthcoming period of economic ‘bounce’ may not end up producing more harm than good as an inventory replacement cycle does not equate to a self reinforcing recovery.

Above: 30 Year Fixed Rate Mortgage (Bold) and 30 Year Treasury Bond (thin)

Still missing under the checklist of key items for a recovery are household debt ratio’s at more manageable levels and a much higher national savings rate. In addition, we can now look back at the last four to five recovery cycles and note that each one created successively fewer and fewer jobs, with the quality of jobs also degrading consistently from cycle to cycle. This suggests that America is likely heading for an eventual currency crisis, which through devaluation will result in a cheapening of American labor and potentially down the line, the beginning of a new cycle of reverse globalization where manufacturing returns to the US. For now, while a bounce is on the horizon, it has all the earmarks of a “hollowed out” event, one which will have an empty ring for the average guy on the street, and one which may kick start a new cycle of rising interest rates accompanied by a steadily falling Dollar. While the newspapers and cable channels may herald this as good news, in my view the risks ahead are for a temporary lull followed by a second and eventually even deeper crisis phase.

While many comparisons have already been made between what the US faces in the coming decade and what Japan went through in its ‘lost decade’ of the 1990’s, considering the US has nothing like the national savings that Japan to fall back on, the outlook for the decade ahead remains negative. Perhaps a vague idea of what a US ‘lost decade’ could resemble, we aligned the recent low in the S&P with the low in July 1992 in the Nikkei and let the Nikkei do the rest of the talking on the chart below. All in all, if this outcome is anything close to what develops, it would seem that we are now in the eye of the storm, a disquieting and unsettled place, but for now, a welcome pause.

Above: The S&P 500 to date, (and just out of curiosity) the Nikkei 225 July 1992 forward action to the right of the arrow as a driver and guide for S&P future behavior. A long shot to be sure, but not impossible that the “lost decades” may have more than a few comparisons.

That’s all for now,

Frank Barbera

© 2009 Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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