Single-day rallies of 900 points or more in the Dow Jones Industrials tend to get our attention, in part because they’re the unicorn of market action: Often imagined but never seen. Well, we saw a unicorn yesterday.
In fact, we’ve seen a lot of things lately that just a few months ago were the stuff of dreams–or nightmares. No wonder, then, that this reporter is at risk of losing perspective amid all the chaos. But let’s try to sober up and reassess where we’re at in the economic cycle. Maybe, just maybe, we can cut through the extreme volatility and venture a guess as to what’s coming. It’s a long shot, but let’s go through the motions anyway.
We begin by speculating that all the government’s efforts at stabilizing the financial industry don’t really change the underlying economic conditions that brought us to this point. The government’s intervention was about stopping the bleeding and shoring up the system to avoid implosion. Perhaps it’s time to label that effort successful, although no one quite knows just yet. As for the real economy, the question mark is much bigger. Indeed, the financial crisis over the past year has only recently been making a mark on Main Street, and it’s our guess that the trend has quite a few more months to run, at the least.
We’re talking here of real estate bubbles and the associated fallout. It didn’t start overnight, nor will it end suddenly. No, we still can’t see the future any better today than yesterday or last year. Regardless, we’re not convinced that the cycle gods are done playing with mortals.
We could cite any number of economic numbers to support our still-cautious outlook, but we’ll start by looking at our proprietary measure of economic activity–CS Economic Index. As our chart below shows, momentum still looks biased to the downside, as it has been for some time. This is hardly news. Your editor has been pointing this out for some time now, along with many others observers of the economic scene. For quite a while, we were premature in calling for a material weakening of the general economy, as in this post from last March. So it goes in forecasting generally: you’re either early or late. A few lucky souls enjoy perfect timing, of course, but repeat performances by the same people are rare, and rest assured that yours truly isn’t likely to ever join that celebrated club.
As for the economy, the above chart strongly suggests that there’s more weakness coming. Economic weakness tends to beget more of the same. Until it stops. Even then, recovery may be preceded by lengthy stretches of treading water. Distinguishing one from the other is as much art as science, of course, and on that note it’s every forecaster for himself. As for our index, let’s decipher its design. The black line is our CS Economic Index, an equally weighted measure of 17 leading, lagging and coincident indicators covering such diverse corners of the economy as housing, the labor market, the stock market, consumer spending, and so on. Roughly 47% of the index is weighted in leading indicators, i.e., those metrics that are thought to be forward-looking gauges of economic activity. Building permits, for instance, are considered a leading indicator because they reflect intentions about future construction plans. The remaining metrics are coincident indicators (29.5%) and lagging measures (23.5%). No, it’s not a magic measure, and to some extent its naive and it may even be misleading. Alas, we can only make that determination in hindsight. For now, we’re reasonably sure it captures the basic ebb and flow of the economic trend, and it’s still telling us that more weakness is coming.
The fact that our index of leading components are falling even faster strengthens our view that we’re still looking at a rough patch for the wider economy. Yes, our economic metrics are only updated through the end of August and we won’t have all of the numbers for the September reading until early in November. But the more-recent numbers we do have aren’t providing much reason to expect that a turnaround in our broad economic index is imminent. A few examples: initial jobless claims are still running hot, nonfarm payrolls are still shrinking, and various measures related to consumer spending look weak.
The stock market, as always, is looking ahead, which contrasts with the big-picture economic reports, which are invariably backward looking. Bridging the gap in that statistical chasm is the terrain of speculators. Of course, huge rallies come and go within the broader context of secular bear markets, and so one should be cautious about equating one with the other in real time. Tactical opportunity, in other words, is always waiting in the wings. But so is risk.
Nonetheless, we think it’s premature for investors to buy equities on the assumption that the economic troubles are now passed. Traders have their own reality, of course, and it may differ at times from strategic investors. As one of the latter, we’re still of a mind to nibble on weakness while keeping enough cash on hand to take advantage of future issues. No, we can’t guarantee that last week was the bottom. It may very well prove to be the trough. But we don’t know, and there’s sufficient evidence to support our view, or so we argue. As such, we still favor cautious rebalancing and redeployment of capital, with the assumption that this part of the cycle will take time to unfold in economic terms.
Originally published on Oct 14, 2008 at The Capital Spectator and reproduced here with the author’s permission.