mis-Leading Indicators Underestimate the Economy and Stocks

Every major financial institution along with an enormous cottage industry of individual analysts collect a plethora of data on the economy in an effort to glean the future. The US creates and shares more macro-financial metrics than any country on the planet on the economy. By observing past correlations that generate almost 100% accuracy to signaling economic recessions, these analysts frequently make prognostications about the future. A private group known as The Conference Board compiled leading, lagging and coincident (current) indicators that are relied upon as a core measure of the current economy and what should be around the corner. For well over a year their Leading Index of Economic Indicators (LEI) has been foretelling a contracting economy with sharply higher unemployment. Most forecasters and economists had expected the “waiting for Godot” recession in either 2022, 2023 or 2024 and advised a defensive posture for investors until the storm passed. While there were a few clouds of uncertainty as the Fed pushed interest rates rapidly higher in 2022 and 2023 to fight 40 year high inflation rates, the economy held strong at full employment and above trend consumption. In fact, despite almost 2 years of Central Bank (Fed) tightening, there has been growing evidence of economic blue skies and sunshine over the past few quarters. The LEI is a mis-leading indicator skewed with a bias toward manufacturing and not the exploding information technology that rules the world today. Our accelerating economy actually fits with the current bottoming LEI patterns historically where the economy turns higher when LEI stops falling. It turns out that in an era of free money and excess consumption, the LEI can be very misleading as the data slows from extreme to normal, mimicking a 2nd derivative recession signal. The real risk here is that the economy is so strong that inflation begins to accelerate again in the back half of the year. If that occurs, investors may start selling stocks in anticipation of rate cuts turning into rate hikes.

The Purchasing Managers Index (PMI) is another well worn forecasting tool. It measures the relatively small manufacturing sector (12% of GDP) and remains a very popular indicator of economic trends. This index is simply a poll of manufacturing managers that asks if activity is increasing or decreasing compared to the past. It’s logical that when the PMI survey among companies is in decline for 14 months in a row, as it is today, that business sales and earnings “should” also be feeling the pain along with increased firings vs hirings. This has clearly not been the case this cycle as manufacturing employment remains at multi-year highs. Stock prices in this sector have also broken out to all time peaks. Additionally, transportation companies serving the industrial market have more demand than they can handle and workers are hard to find or train to ship product.  Like the LEI, the PMI is also biased by the deceleration from extreme COVID era stimulus to more healthy growth patterns. With our personal involvement in global manufacturing, we can share that we have yet to see any rolling recession this decade reach any sector we serve in aerospace, military, autos or industrial … Supply chain and reducing record backlogs have been our biggest challenge for the last 2 years. Our industry is glad to see slower growth rates in order to improve supplies and profit margins. As business activity works off the pent up consumer demand that created elevated backlogs and as onditions normalize, then PMI surveys will likley move back over 50 into expansion territory. For this cycle the PMI is both misleading and underperforming reality.

Another reliable harbinger of a future economic contraction is the degree of credit tightening by the banking system. Higher interest rates and tougher loan qualifications naturally discourage borrowing and spending. Credit tightening in 2023 rose to levels that have always signaled that the economy was either on the cusp of a recession or that the contraction was well underway. Due to excess demand and free money from excessive COVID stimulus, loan demand has been subdued. Now that the Fed has stopped raising borrowing rates to the banking system, banks have begun loosening credit conditions.

There are many more failed relationships with virtually 100% track records prior to this cycle, such as the inverted yield curve, but we’ll summarize to say that analysts have misused some previously proficuous indicators. The more accurate correlations this cycle are labor market conditions, consumer default rates, credit spreads and many coincident indicators that all continue to show real time that the economy is strong. Forecasters with a Bearish bias love to alarm with monthly new record highs in consumer credit card debt. Yet, if consumer assets are growing even faster and their debt to service ratios are healthy, then why lament of the secular growth in credit happy shoppers?  No worries here so far as default rates are low, consumer credit ratings are high and the job market is very strong. It’s extremely hard to have a recession with a massive labor shortage and robust consumer balance sheets.

 While employment conditions and current indicators in general are more important to watch for signs of trouble, the explosion of Artificial Intelligence (AI) is also instructive to observe. The semiconductor chip sector (SMH chart) piloted by architect leader NVDA, has 50% equity gains in just over 3 months. The parabolic jump in valuations is grounded in equal gains in company orders and will keep investors clamoring for pullbacks to join this early innings trend.

Before we throw out the yellow caution flag on stock market risk over the next month or two, it’s worth mentioning a couple more positives. Corporations are buying back shares of their stock above peak 2023 levels. Companies are earning high yields on their large cash holdings while paying down debt secured at very low rates from pre-inflation debt coupons, before the interest rate spike in 2021-2023. Inflation on a 6 month basis is already in the Fed’s 2% target range and the anticipation of Central Bank rate cuts will keep the wind at the stock market’s back until cuts arrive. Finally, we will mention a double edged sword, that stocks frequently rise during election years, especially after the first quarter. However, we have what appears to be the two candidates with highest combined disapproval rating ever during the most politically charged environment of modern times that is fraught with unceratain outcomes. Will either side accept the results or allow a candidate to be jailed or removed using the 25th Amendment?

On the longer term outlook, the Bull market will continue this year. However, once year over year inflation rates remove the favorable base effects this summer, we feel the strong economy will begin pushing inflation gradually higher and shift the narrative from more rate cuts to potential rate hikes in late 2024. This should trigger a months long deep correction in stocks late this year or early 2025. The shorter term technical outlook remains strong into mid to late February. At that point, seasonality turns decisively lower, weighed down by excessive Call option buying, the elevated Greed index and extreme asset manager equity exposure. 

A topping formation may be starting today (02-09-24), but seasonality peaks on the 15th/16th followed by the much anticipated NVDA earnings report on the 21st. It’s a Bull market, but risk levels will be elevated from the 2nd half of February to the 2nd or 3rd week of March.

The SP 500 Index has already moved beyond most of the Bullish forecasts for all of 2024 just over the vaunted round number of 5,000. This index has a 5 to 9% risk into the expected March low when new investors purchases can be engaged.

 

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