Major Indicators Are All Positive, But Is It Time To Get Fearful?

July 7, 2016

Major Indicators Are All Positive, But Is It Time To Get Fearful?

  • Economic data is strong and positive.
  • Neither jobless claims nor consumer spending show signs of weakness.
  • The issues remain in valuations, optimism and low yields.

Introduction

In the post-BREXIT world, there is a lot of speculation but no one knows what will happen. This article is going to provide a general outlook on how the economy is doing and try to extrapolate trends while ignoring the noise provided by the media.

Unemployment

As initial unemployment claims are reported on a weekly basis, the number can be used to forecast the monthly job report. On Friday the Bureau of Labor Statistics will release its job report for June. The previous report was scary with 38,000 jobs were added, but the number of initial unemployment insurance claims still remains at multi-year lows as well as the current unemployment rate, which sits at 4.7%.

figure 1 jobless claims
Figure 1: Initial unemployment insurance claims. Source: FRED.

 

figure 2 unemploment rate and claims
Figure 2: Unemployment rate and claims since 1990. Source: FRED.

By plotting the unemployment rate and claims we can see that the unemployment claims precede changes in the unemployment rate. Any increases in jobless claims are clues that there may be trouble brewing though the market may not recognize it yet. What’s most alarming about the above data is the impossibility for the unemployment rate to stay stable. As it is coming close to the natural unemployment rate, we should expect a trend shift in the coming years, though what we cannot know is if the unemployment rate will drop lower or if it will go up next month.

Consumer Spending

Consumer spending is growing and shows no indications of slowing down. A slowdown in consumer spending is also a leading indicator, and only after it begins to drop does it indicate trouble in the economy.

figure 3 consumer spending
Figure 3: Consumer spending and GDP. Source: FRED.

Similar to consumer spending, the consumer sentiment index is a great signal for forecasting a recession. The index hit its lows in the midst of 2008 while the deepest part of the recession was half a year later. It is now at its pre-recession highs, which would indicate there is no trouble for now.

Since consumer spending is still strong and consumer sentiment sits at its pre-recession highs, neither of these indicators point to trouble in the short term.

4 figure consumer sentiment index
Figure 4: Consumer Sentiment Index. Source: University of Michigan.

Inflation

Inflation is tame compared to the 1980s, but it has picked up somewhat since the Great Recession indicating the economy is healthier.

Over the last 12 months, overall prices increased by 1%. Energy prices are at multi-year lows and favorable weather conditions have brought high crop yields which lowered food prices, therefore 1% inflation rate should be considered very good.

figure 4 consumer price index
Figure 5: Consumer price index (1984 = 100). Source: FRED.

Issues With The Above Data

With all of the favorable data, it might be tempting to pay higher prices for riskier assets, but that is exactly the biggest trap such economic indicators create.

A closer look at the above data shows that current indicator levels are similar to those from 2007, so even though they are all positive it might not be the best time to be heavily invested. Keeping in mind the essential investing quote of “being greedy when other are fearful and being fearful when others are greedy,” this might be the time to be fearful and wait for a future recession to be greedy.

figure 6 sandp gdp
Figure 6: S&P 500 and GDP since 2007. Source: Yahoo.

The market is far more volatile than the economy because investors tend to be overoptimistic in good economic times—as is the case now—and overly pessimistic in a recession. As all indicators are at their best levels, it is time to be fearful.

The issue here is that this is contrary to human nature as we are social creatures. Doing things differently than the rest of the pack makes us very emotional, but investors have to learn how to set emotions aside as markets and money have no emotions.

Valuations

Except for the fact that the market is finding it very difficult to grow and all economic indicators are more likely to worsen than improve in the next few years, another important indicator—which is the result of the positive economic developments—are valuations. Simply put, relatively high valuations increase the risk of holding stocks and minimize long term returns.

With 7 years of positive economic developments, investors should carefully analyze growth and clearly separate the growth coming from the general high liquidity artificially created by the FED, and real business qualities. A good way to do that is to look at debt levels. If revenues increase slower than a company’s debt level it means that the return on capital is lower than the cost of capital. Such a situation can be sustainable in an economic growth cycle but comes to an abrupt end at the first signs of a recession.

Conclusion

One has the be foolish to look only at the positive economic indicators and assume that everything is good and being long stocks is the best option. Stocks will be the first to react if any of the forecasting economic indicators turn negative, so careful stock selection is the only option to preserve capital in these uncertain times. Other risks come from exuberant optimism which inflates asset prices as well as low yields, which pushes investors toward stocks in search of higher yield, but which also comes with higher risk.

As we do not know when the economic winds will change, the current market volatility gives great opportunities to increase portfolio returns with well placed trades and a more active investing strategy.