An Investor's Look at Early Cycle Indicators

There is no argument about the current economic situation. We’re in a recession and it is fairly deep. Investing, though, is about the future - not the present or the past. Investors will want to keep their eye on indicators which can give early signals of recovery. A number of these early cycle indicators have recently turned positive.

Monday morning, the manufacturing portion of the ISM was reported and it was up for the first time since June of last year:

This is important because in past recessions, the market has bottomed coincidentally with the ISM (I wrote a detailed post about this in November). More importantly, the indicator does not have to rise back above 50 (signaling expansion) for the market to improve. One month does not make a trend, but the ISM has to bottom somewhere and last month may have been it. Take a look at the ISM at the bottom of the 1974 recession:

And the stock market performance off that low:

The stock market bottomed in December 1974, just as the ISM was hitting bottom, and then rallied 35% by April 1,1975.

Looking at the 1980 recession:

Again, the stock market bottomed at the same time as the ISM manufacturing index. The 1981, 1990 and 2000 recessions show similar patterns with the stock market and the ISM bottoming within 3 months of each other. The 2000 recession was somewhat unusual in that 9/11 interrupted what was likely a bottom in stocks and the economy. While the post 9/11 period didn’t evolve into a full blown recession, there was a period of volatility in the economy that affected the market. The market tracked the ISM quite well bottoming with the ISM right after 9/11. The market and the ISM then peaked in early 2002 and both bottomed in early 2003. The bottom line here is that the ISM is a very good coincident indicator for the stock market.

Another place to get early signs of recovery is the commodity market. Obviously, as demand picks up from the depressed levels of the recession, commodity prices should respond. One caveat though: commodity prices can and do move independently of economic effects. We saw this last year as oil soared even as the recession unfolded. This can happen in an individual commodity due to a supply disruption or some other factor. It can also happen more generally in commodities as an asset class if the dollar is rising or falling rapidly. If we see general commodity prices rising (Gold and Silver are not as economically sensitive) it may mean inflation or it may mean future growth. Ideally what we would like to see as a sign of economic recovery is for commodity prices to rise without a significant move in the dollar.

Copper has bounced off its low:

Oil has also rallied some from the lows:

Neither of these commodities can be said to be in bull markets yet, but they do seem to have found some kind of bottom. Certainly they bear watching for clues about future growth. The Goldman Sachs Commodity Index also bounced from its low, but is now testing it again:

Obviously, the jury is still out on this, but if GSG holds the low, that would be a good sign about the future of the economy. The dollar has been rising of late, so the move in copper and oil may say something about future growth:

One last early cycle indicator to watch is the Baltic Dry Index. It has recently bounced off a low as well, but is still down a lot from its high:

I don’t know if the economy has hit its nadir yet and I am not making any investments based on that idea - yet - but these early cycle market indicators should give us a heads up when the time comes.

Comments

[Tradememe:]

Thanks for that perspective. By comparing with past recessions and recoveries, we can have an idea about the near future.

Feb 03 04:20 AM

[Steven Hansen:]

Manufacturing contracted in January as the PMI registered 35.6 percent, 2.7 percentage points higher than the seasonally adjusted 32.9 percent reported in December. This is the 12th consecutive month of contraction in the manufacturing sector. A reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally contracting.

i would not read to much in an upward tick of the PMI.

Feb 03 04:34 AM

[Child Psych...:]

This is a helpful post, as it contains data rather than just speculation, which is the meat usually offered by perma-bulls. As the bear side seems incleasingly complacent on these pages, it is valuable to see the other side of the trade.

Feb 03 08:00 AM

[jayjayjay1212:]

Thanks for the info.

What has me worried is that inventory levels at firms are still incredibly high. Stockpiles contributed 1.3 % to the GDP growth in the fourth quarter, which basically means firms are not selling what they are producing. Hence many firms will continue with the layoffs and try to liquidate their inventories before starting to produce and hire again.

The savings rate is also on the rise, home prices continue to tumble and job cuts are announced daily, so this indicates that consumers (who represent the biggest portion of GDP) are nowhere near feeling as 'confident' about the future.

In this recession I would be looking mainly at the NAR (National Association of Realtors) data. When home prices stabilize, consumers will cease to see the value of their main source of wealth fall, not to mention the positive effect it will have on the MBS market. Of course, signs of stabilization in the financial sector (in terms of delinquency rates at banks, tier 1 capital ratios, etc.) will also have tremendous effects on the market.

Bottom line is I don't see a sign to buy yet. I don't necessarily see a general sign to sell either. Perhaps the best idea for the risk/reward focused investor would be to wait for some more favorable economic signals. Trying to bottom-pick stocks is a bad idea in this market.

Feb 03 08:04 AM

[petervankan:]

My gutfeeling is that it will take years to recover from this depression. And the reason is that the main driving force behind the US economy is people buying things. Materialism got us into this, and the quickest way out is enhanced materialism. But half of what is being produced nobody really needs. With the mood swinging toward a more spiritual approach to life, it may take a decade to reach a stable, green and ethically acceptable kind of economy. Too bad for my shares, but ultimately good for mankind.

Feb 03 08:15 AM

[The Pragmat...:]

ISM rebounded throughout all of 2001 before falling off a cliff again in 2002. Anyone who invested in 2002 knows it was just as bad as the second half of 2008. The market deteriorated throughout the ISM's rebound and you were obliterated if you didn't get out before 2002.

This recession is unlike anything this country has ever seen. I don't really think you can apply past history to it. There is no playbook for what we're confronted with....

Feb 03 09:07 AM

[Joseph Calhoun:]

A couple of quick points. In the past, the ISM has not had to return to expansion (over 50) for the market to make a bottom. It is enough for the index to bottom and start rising toward 50. I don't know if this is the bottom. It may be and it may not be. I certainly wouldn't invest based on one data point.

2001 is a somewhat special case. The ISM bottomed right after 9/11 and rebounded until May of 2003. The market rebounded right along with the ISM. The Dow moved from roughly 8000 to 10500. After the ISM peak in the spring of 2002, it fell back and bottomed in November 2002. The market moved in lockstep with the ISM. As I remember it, there was a lot of talk about a double dip recession at the time. The point is that the ISM bottoming was still a good coincident indicator.

One last point. In order for this to be a bottom for the market, the ISM will need to rise over the next few months. It isn't enough just to hit bottom. In the 1982 recession (the second half of the double dip recession of the early 80s) the ISM fell, hit bottom and just went sideways for a year. The market fell the entire time and the bull market didn't start until the ISM started rising in August 82.

Feb 03 10:08 AM

[ROLEX18:]

All indicators will look different, same as all major announcements if DJIA or SP 500 would look different, the stock market is the only one REAL indicator, if you know how to get around it not as a meal for the market, but as a hunter then you don't need to occupy your brain with Copper or ISM.
First is the market, everything else follows.
I expect some kind of false rally developing as big guys have to sell you some more of paper stock, but in general the trend is down, down, down.
The crash will stop finally at DJIA 2000.

Feb 03 10:17 AM

[P. Kalven:]

I think you make a valid point about Housing Prices and the need for them to stabilize, but you may be putting the chicken ahead of the egg. The general consumer is beyond nervous at the present and in the US and other world markets real property owners are feeling very vulnerable and uncertain.

I suspect more people are paying attention to the economy than ever before, housing will start to stabilize as media reports positive developments in the economy, and it all starts with investing, be it stocks or real estate, my gut says stocks will lead because the information moves into the arena faster.

We need to get past the state of shock and grief, to acceptance and response.



On Feb 03 08:04 AM jayjayjay1212 wrote:

> Thanks for the info.
>
> What has me worried is that inventory levels at firms are still incredibly
> high. Stockpiles contributed 1.3 % to the GDP growth in the fourth
> quarter, which basically means firms are not selling what they are
> producing. Hence many firms will continue with the layoffs and try
> to liquidate their inventories before starting to produce and hire
> again.
>
> The savings rate is also on the rise, home prices continue to tumble
> and job cuts are announced daily, so this indicates that consumers
> (who represent the biggest portion of GDP) are nowhere near feeling
> as 'confident' about the future.
>
> In this recession I would be looking mainly at the NAR (National
> Association of Realtors) data. When home prices stabilize, consumers
> will cease to see the value of their main source of wealth fall,
> not to mention the positive effect it will have on the MBS market.
> Of course, signs of stabilization in the financial sector (in terms
> of delinquency rates at banks, tier 1 capital ratios, etc.) will
> also have tremendous effects on the market.
>
> Bottom line is I don't see a sign to buy yet. I don't necessarily
> see a general sign to sell either. Perhaps the best idea for the
> risk/reward focused investor would be to wait for some more favorable
> economic signals. Trying to bottom-pick stocks is a bad idea in this
> market.

Feb 03 01:31 PM

[Cam Hui:]

I agree, see my SA article: seekingalpha.com/artic...

Feb 03 07:47 PM