Trader’s Narrative

This is a guest post by Tyler S. Lang:

The US and world economies are transitioning from the initial recovery phase (which usually lasts a few months) to the early upswing phase. Typically, this latter phase persists for at least a year and often several years if the output gap closes slowly. The textbooks tell us the early upswing phase is characterized by rising short term interest rates, stable long term interest rates and an upward trending stock market. In general, consumer confidence rises and unemployment starts to fall.

The two key questions are: is the recovery self-sustaining and, how long until inflation is a problem. Ideally, we want the recovery to walk the line of being strong enough to avoid a double dip recession (the frying pan), but not too strong, which has the nasty habit of resulting in inflation (the fire). In order to monitor this we need to look at indicators that give us timely insight into whether or not either of these pernicious scenarios is taking shape.

Accordingly, I’ve have compiled the following 11 economic and financial indicators to help provide this insight. Eight of the eleven indicators are positive, two are negative and one is neutral. Taken as a whole, we believe these indicators currently paint a picture of a sustainable recovery in the economy, which implies a continued upward trending stock market.

Consumer Confidence – Neutral (turning positive):

This indicator is important because it is correlated with consumer spending, which is a critical component to an economic recovery. Consumer confidence has improved, but only marginally from the extremely low reading of 55, seen at the end of 2008. A reading over 80 would turn this indicator to positive.

Personal income less transfer payments - Positive:

This is the value of income received from all sources stated in inflation-adjusted dollars to measure the real salaries and other earnings of all persons. It excludes government transfers, such as Social Security. Income levels are important because they help determine both aggregate spending and the general health of the economy. This indicator is currently positive because posted a gain for four months in a row.

Employees on Non-Agricultural Payrolls – Negative (turning neutral)

This series from the Bureau of Labor Statistics (BLS) reflects actual net hiring and firing of all but agricultural establishments and the smallest businesses in the nation. It is one of the most closely watched series for gauging the health of the economy.

The rate of decent has slowed and another month of moving sideways (as opposed to down) turns it neutral. However, in order to turn positive we are waiting for two months of payroll growth.

Temporary Hiring – Positive

Temporary Hiring tends to precede growth in Payrolls and, consequently, improved employment. This has turned up sharply and that is positive.

Industrial Production - Positive

Although the industrial sectors (manufacturing, mining & utilities) contribute only a small portion of GDP, they are highly sensitive to interest rates and consumer demand. Thus, it is a good measure of the economy. This indicator has moved up strongly and that has positive implications for the sustainability of the recovery.

Manufacturing & Trade Sales - Positive

This data is released by the US Census Bureau and is intended to provide timely measures of changes in domestic retail trade, wholesale trade and manufacturer’s activities. The rapid improvement in this indicator is positive and augurs well for domestic economic activity.

Commercial and Industrial Loans - Negative

This series measures the volume of business loans held by banks and commercial paper issued by non-financial companies. This is a lagging indicator because it tends to peak after an expansion peaks as declining profits increase the demand for loans. On the flip side, troughs are typically seen more than a year after a recession ends. Despite this being a lagging indicator, we are at a stage in the cycle where a turn in this indicator would be an important indication that the recovery is becoming broad based and sustainable. If the rate of change on this indicator moves above 0, that would turn this neutral.

Long Term Inflation Expectations – Positive

There is a lot of concern right now about runaway inflation or devastating deflation. We don’t want either of these extremes as they both have negative effects on asset prices (particularly equities). Thus, in an ideal world we walk the line between solid real economic growth and low, stable price increases. Right now long term inflation expectations are in the sweet spot and this is positive for the stock market.

30 Year Mortgage Rates - Positive

This is Freddie Mac’s national average on a 30 year fixed rate with 20% down. Low mortgage rates have numerous positive implications for the refinance market and for purchases. Additionally, low mortgage rates have important implications for the cost of other consumer loans. It is true that Mortgage purchases by the Federal Reserve are holding these rates artificially low and it doesn’t tell the whole story because many banks have tightened lending standards, thus, making this low rate more difficult to obtain. Nonetheless, rates this low are on-balance positive.

S&P 500 Index – Positive

The direction and strength of the stock market is important as a leading economic indicator and because it has critical implications for the level of wealth. As the stock market rises from its March, 2009 bottom investment accounts are reflated, 401(k)’s are restored, and confidence slowly seeps back into the populace. All of these factors are important for consumer spending and the level of economic activity. Despite the relatively minor correction since mid-January the stock market is still positive. If it breaks down to make fresh lows, then that would flip this at least to neutral and perhaps negative.

South Korea stock market (KOSPI Index) – Positive

One of the best “canaries in the coal mine” is South Korea, because this economy is exposed to consumer demand in the US and infrastructure spending in China. This economy is on the pointy end of the economic cycle and, similar to our S&P 500, it is still holding up relatively well, which is positive.