What the Leading Indicators Tell Us About This Rally

As the market continues to rally the big question becomes: Is this rally for real or is this another one of those dreaded bear market rallies? While I am sure everyone would prefer the former, the leading indicators seem to be painting a different picture. In my last article, I spoke about some aspects of the market that still looked bleak, but many of them are considered to be lagging indicators. Therefore, I decided to look at the leading indicators, to see if they are painting a different picture that could bring some more clarity to the situation. I am going to examine the Index of Leading Indicators and its components to see just where this economy might be headed and figure out whether or not this is a rally to believe in.

The Components of the Index

1. The Average Weekly Hours Worked By Manufacturing Workers - Since March 2008, the average weekly hours worked by manufacturing workers has declined by 4.6% and is still registering declines. The average work week fell from 39.5 to 39.3 hours on a seasonally adjusted basis from Feb 09 to Mar 09. The total number of hours worked in the private sector also declined in March to 33.2 hours (a new low) from 33.3, after not registering a decline in 3 months. This signals that there is still some slack in the labor markets that has yet to work its way through the system. While the unemployment rate is a lagging indicator, the fact that the average hours worked is still coming down is a big concern for the future employment, income and spending outlook in the economy. Bears 1, Bulls 0.

2. The Average Number of Initial Applications for Unemployment Insurance - For the week ending March 28, initial claims for unemployment increased by 12,000 to 669,000. The 4 week moving average, which helps smooth out extreme one time impact shocks, also increased by 6,500 to 656,750, indicating continuing deterioration in the labor market. The drag that this will create on consumers as they continue to deleverage is just going to decrease spending . Furthermore, this will have a positive impact on the savings rate as the economy as a whole tries to adjust to the fact that we can no longer live with the a total debt to income ratio above 140%. Bears 2, Bulls 0.

3. The Amount of Manufacturers’ New Orders for Consumer Goods and Materials - New orders for manufactured goods were up 1.8% in February after 6 straight months of decline. This was one of the more positive reports that has come out of the economy in the past few weeks. Throughout the month of February it seems as though the industrial sector might have seen some type of bottom, but it is going to take more than one month of data to prove that it has truly bottomed out. Bears 2, Bulls 1.

4. The Speed of Delivery of New Merchandise to Vendors from Suppliers - This part of the index, which is the Index of Supplier Deliveries - Vendor performance, has gone from a cycle high of 51.8% in September to 46.7% in February 09, which marks an increase from the January 09 number of 45.3%. It seems as though the industrial sector had a solid month in February, but it still remains to be seen if this was a bounce of the bottom or a one time anomaly. Since the latest number is positive this one goes to the Bulls. Bears 2, Bulls 2.

5. The Amount of New Orders for Capital Goods Unrelated to Defense - New orders for capital goods increased by 7.1% to $52.2 billion in February, from $48.7 billion in January, as the leading indicators for industrial activity saw a broad range of positive data come out. Next month’s data on this front will be very telling in terms of whether or not we have seen a bottom in industrial production and demand. Since this data looks promising, chalk another one up to the bulls. Bears 2, Bulls 3.

6. The Amount of New Building Permits for Residential Buildings - The amount of new building permits for residential real estate has been on the decline for 7 straight months as it has collapsed by more than 50% from its most recent high of 1.138 million in Jun 08 to 564,000 in Feb 09. While there was a slight increase in February, there is no data in the housing market, especially the new sales market, to suggest that this number has bottomed at all. With sales of new homes still taking almost 10 months, I do not think we have seen the bottom and feel as though there is still significant downside pressure to this number. Bears 3, Bulls 3.

7. The S&P 500 Stock Index - Clearly one of the biggest reasons for the most recent optimism is the strong performance in the equity market as it has had a strong bounce from the lows and has rebounded over 20% in the past few weeks. Much of this has been due to the fact that economic data has come out better than expected, while the market ignores increasingly bad payrolls data. Either way, if data keeps coming in better than expected, then it will all depend on earnings season to see if this rally will be a sustained one. But for now, the bulls seem to have the upper hand in the equity market. Bears 3, Bulls 4.

8. The Inflation Adjusted Money Supply (M2) - The M2 money supply has been steadily increasing pretty much since the data started being calculated. Since M1 and M2 have to do with savings, I will turn this one into an analysis on the savings rate. The savings rate currently stands at 4.2%, as it has been steadily increasing throughout the deleveraging cycle as consumers unwind from debt positions that they can no longer sustain. This is an extremely deflationary development for the short to medium term. In addition, it does not paint a good picture for future consumer spending or even the success of the consumer based aspect of some of the government programs as people will be much more averse to spending in the next 6 months. Since our economy depends on this spending and not the savings rate, this one goes to the bears. Bears 4, Bulls 4.

9. The Spread Between Long and Short Interest Rates - While credit spreads have improved over the past month, spreads are still at extremely high levels relative to historical norms as the economy goes through the deleveraging process. The TED spread is still at levels that are three times the norm of about 30 bps. The one that the Leading Indicator Index focuses on is the spread between the 10 year Treasury and the effective federal funds rate. As you can see from the chart below, while this has eased up from the highs that were established after the Lehman collapse and the credit freeze, this spread is still extremely high relative to historical levels. Even relative to July 2008, these levels are higher. So there still seems to be significant improvement that is necessary in the credit markets before we can consider ourselves out of this mess. Hopefully the Fed’s program of buying treasuries will help lower this spread and the spread between treasuries and corporate bonds, but the credit markets still have a lot of thawing to do. Bears 5, Bulls 4.

10. Consumer Sentiment - While consumer sentiment improved slightly in March versus February, ticking up to 57.3 from 56.3, it is still at extremely depressed levels. Furthermore, it has shown no consistency in terms of the development of a bottom, as it seems as though consumers are still extremely mixed on how they feel about the economy going forward. If consumer sentiment does not improve, there is no way we will see the spending necessary to get out of this recession. As the chart on the right shows, this has been one of the worst recessions in terms of consumer sentiment. In addition, there has been no bottom that has formed, even though it looked like there might have been one earlier on in the year, only to collapse again later. Clearly, the consumer is still unsure, but the score does not lie. Bears 6, Bulls 4.

Outlook

While it seems like the bulls are making a little bit of a comeback, I would have to wait and make sure that all the industrial numbers are not just some type of one time anomaly before even considering the fact that the bulls look good in the Leading Indicator Index. I would love to turn bullish right now, but nothing is compelling me to do so, especially with earnings season coming up. That is going to be the biggest driver going forward, as we listen to what the CEOs have to say about the rest of 2009 in terms of their expectations. I would not expect them to be all that rosy, but I for one hope they are. At this point, nothing is compelling me to turn completely bullish with this market.

Disclosure: None

Comments

[Larrysyr:]

Thanks for the straight-forward analysis.

I think the real recovery will have to rely on something other than consumer spending. (If I thought I knew what, I'd take up punditry.) There's no particular reason I can think of that we should go back to a consumer-driven illusion of prosperity. Long-term, readjusting the economy to more productive pursuits is a good thing. Short-term, it's very uncomfortable.

The stimulus and monetary policies can cushion the shocks, but I don't see how they can restore what came before.

Apr 09 04:05 PM

[msgtb:]

Agree with your caution, if this market reverses and hits new lows think of all the retail investors who will lose their shirts as well as their retirements. This is still a trading market and not a buy and hope and don't drink the cool aid.

Dave

Apr 09 04:10 PM

[BigJake:]

this guy is 19 and still in business school! I'm not sure whether that means he's really smart or I'm just really dumb because when I was 19 I was feverishing figuring out the best way to be buying beer not stock!

Apr 09 04:48 PM

[BigJake:]

I wish they would let you go back and edit your comments when you make a typo on this site. I meant "feverishly"

Apr 09 04:49 PM

[CJJ:]

So I'm a bit confused why we have become SOOO caught up with items like:
We can't go back to being a consumer driven economy? Huh? What is an advanced economy driven by? Once you build the ballpark you don't need the builders anymore you need people to buy tickets to the game.
We went from 63-65% consumer driven economy to 70%. Okay, so we need to come down 3 or 4 or 5%, that can be replaced by a new industry. Or have inventions become a thing of the past?
Housing went up from 65% to about 70%. Again we are talking 5% as if the world is coming to an end.
Add the 5% of housing and 5% of consumer spending and you have the magical 10% depression number.
Except much of the consumer spending 5% will go to saving and paying down debt(a long term net positive)
Much of the 5% housing number will go to saving and much of it will be used to rent.

Apr 09 06:44 PM

[RiskReturnO...:]

Another factor to consider is the latest irrational market behavior. For example, TGT stock up, when sales are down. WMT stock down, when sales are up. Let's see what happens to Chevron and Boeing next week, as both reported bad news. If these stocks can trade up next week, I think the market has discounted all the bad news there is, so perhaps time to go long.

Apr 09 08:00 PM

[Duderonomy:]

Point #8-steady increase in the M2 money supply. Steady increase? Seems to be pretty drastic increase. From steady state of about plus one to minus one percent for about a year to positive 20 percent in about a month? Bear vs. bull number kinda seems nebulus. Sounds like a bear that did not wake up fast enough to catch the rally. I may not know much about the stock market but I think a gain of more than 20% constitutes a bull market rally.

Apr 10 03:33 AM

[behalcyon:]

Your manufacturing indicators omit inventory changes which are also a key indicator of demand.

Apr 10 09:37 AM

[Stone Fox C...:]

Couple of issues with this article. First, all indicators aren't equal. Isn't the stock market and money supply more important then consumer sentiment? Second, shouldn't the numbers be absolute versus your opinion of the interpretation of the numbers? Consumer sentiment was up. That is bullish. Money supply is up that is bullish. You said that New Building Permits is up so that is bullish as well. So based on facts, the leading indicators should be around Bulls 7, Bears 3. The whole brillance of these indicators is that its based on solid numbers and not human emotions.

Agree with your outlook though. The key is always multiple months of positive numbers. For the most part though, so many of those numbers such as building permits and consumer sentiment are at such lows they pretty much have to reverse. Again the brillance of these indicators. On an absolute basis they look horrible, but being better then last month shows the turn. And once the trend turns, and investor doesn't want to be stuck looking at absolute numbers.

Apr 10 04:26 PM

[David Van K...:]

The state of the economy is but one of a number of factors that stock investors take into account in making decisions whether to buy, hold, or sell. And it is the future state of the economy, not the current state, that is most important. In most recessions, the market turns back upwards about 6 months before the economic numbers improve. Often the latter are still worsening even as the market hits bottom and starts back up again.

I like the author's use of the Conference Board's Index of Leading Economic Indicators..."leading" meaning looking ahead. Historically, it has a pretty good (but not infallible) track record. I also like his simple Bulls-Bears point system. It's easy to understand, and as Warren Buffett says, it's better to be approximately correct instead of precisely wrong.

I use the Leading Index in my own Timing Outlook (explained here: www.sensiblestocks.com... ). It's one of ten indicators that I employ in a rather simple short-term market outlook. With respect to Stone Fox Capital's comment about the importance of multiple months, I agree, and I require the Leading Index to be going in the same direction for three months in a row before I consider it to be positive or negative...otherwise I consider it neutral.

Apr 10 09:30 PM

[Alphameister:]

The LEI are intended to preview economic trends, not the stock market which is itself one of the best leading indicators. And for a market that had discounted Armageddon, a good case can be made that today's leading indicators are remarkably bullish on a relative basis. Anyone waiting for the LEI to sound a loud and clear bullish signal is likely to miss the most robust stage of the bull market.

Apr 10 09:41 PM

[friar tuck:]

people who are laid off will find something to do. there's a lot of unused skills and talents out there and this little recession will provide a new road to wealth. there are now people who are buying stocks to come to the aid of their country. there is no military draft but there are other ways to support the troops and the country. one way is to buy stocks in american and foreign companies. president Obama has not said it yet but the old quote from president Kennedy should be heeded at this time in our history. we are americans and we have the american spirit that emerged through some very hard times in our lives and we will do it again. some of the authors here obviously do not know the history of this nation as a people bound and determined to not only survive but to thrive. believing in that spirit of determination and will, i would be bullish on america itself, and that tips the scale. bulls 50 bears 0.

Apr 11 07:56 AM

[Larrysyr:]

I object to mixing ideas of public service and investing or consuming. I use my money based on my assessment of my own micro-economic forces - i.e. what will give me the best return. For public service, I donate to charities doing work I find helpful to the community at large, and I volunteer for similar organizations in ways I think I can be most helpful.

Private companies do not look out for my interests (nor do I think they necessarily should), and I do not look out for theirs. If my interests coincide with theirs, great. If not, I look elsewhere.

Apr 11 11:35 AM

[E Nuff Sed:]

Cetin Hakimoglu, do not let these bearish comments get you down. .

Lots of smart people know this is the time to buy stocks; like Ken Fisher, Warren Buffet and Doug Cass. Most of the commentators on this site were too late in selling their positions in 2007-2008 and will again be too late in buying into the recovery. This cycle repeats again and again - prices are never too high and never too low for them.

According to Doug Cass we hit a generational low in March. When will you find companies like 3M, P&G and J&J selling at half their intrinsic values? These companies operate everywhere and even if you do not believe in America and Europe, you cannot wish away Brazil, China, India.

Apr 11 12:33 PM

[Hmm?!:]

Friar Tuck,

The character you state is of little use, until integrity is returned.

You have a congress that stopped banking oversight of Fannie and Freddie, now using taxpayer dollars to cover their tracks. You have private banks that tried to keep the cash flowing by also making bad loans and then trying to pawn them off as a basket of triple A.

And all are claiming it will somehow be Armagedon if they don't? As if no one would step in and take deposits of money! Or buy homes at any price! Or issues mortgages to good credit, or with a down payment!

There is a bank on practically every corner in this country! I am not worried about banking survival, but I wonder how everyone else could be?

The requirement of restoring integrity to a guilty congress that has only gotten stronger. That scares the hell out of me!



On Apr 11 07:56 AM friar tuck wrote:

> people who are laid off will find something to do. there's a lot
> of unused skills and talents out there and this little recession
> will provide a new road to wealth. there are now people who are buying
> stocks to come to the aid of their country. there is no military
> draft but there are other ways to support the troops and the country.
> one way is to buy stocks in american and foreign companies. president
> Obama has not said it yet but the old quote from president Kennedy
> should be heeded at this time in our history. we are americans and
> we have the american spirit that emerged through some very hard times
> in our lives and we will do it again. some of the authors here obviously
> do not know the history of this nation as a people bound and determined
> to not only survive but to thrive. believing in that spirit of determination
> and will, i would be bullish on america itself, and that tips the
> scale. bulls 50 bears 0.

Apr 11 12:54 PM

[CJ-49:]

This article was great for housewife worrying about her husband's job stability. It provides further coffee time conversation for the Stepford girlfriends.

But if you have an etrade account like Cetin then you need to get back in there yesterday. By the time all the indicators are pointing up the market prices will have moved up 4 times or more. Most of the sweet trades are up over 60% already. and whatever Roubini and his fellow pretend to know-it-all say they are not going down.

Apr 11 03:21 PM

[dcb:]

mach low was correct, market is overbought at this point. Alas, I have gone against my gut a number of times listening to the pro's and it has been a mistake. look at what bonds did, everyone flocked to them. being patient is the way to go right now and pick your entry point.

Apr 11 03:38 PM

[Teutonic Kn...:]

Hmm?

I respect your comments and I appreciate your candor. As writings neither convey any voice tone nor intent of sincerity, I hope you would view my following comments with reciprocity.

Wow, integrity, my gosh! When will it return to our Congress?

My answer: When you have the two parties virtually locked in to their self-serving positions and presenting candidates that are image manipulators who, in my opinion, are more interested in perpetuating their terms and jockeying for power, the timing for integrity to return to our Congress is -- Till Kingdom Come.

Teutonic

On Apr 11 12:54 PM Hmm?! wrote:

> Friar Tuck,
>
> The character you state is of little use, until integrity is returned.
>
>
> You have a congress that stopped banking oversight of Fannie and
> Freddie, now using taxpayer dollars to cover their tracks. You have
> private banks that tried to keep the cash flowing by also making
> bad loans and then trying to pawn them off as a basket of triple
> A.
>
> And all are claiming it will somehow be Armagedon if they don't?
> As if no one would step in and take deposits of money! Or buy homes
> at any price! Or issues mortgages to good credit, or with a down
> payment!
>
> There is a bank on practically every corner in this country! I am
> not worried about banking survival, but I wonder how everyone else
> could be?
>
> The requirement of restoring integrity to a guilty congress that
> has only gotten stronger. That scares the hell out of me!
>

Apr 11 09:38 PM

[Al-USA:]

I am concerned about the low volume climb up to resistance of 860 on S&P 500.

Even so, if you're nimble, you can still make some cash. For example, on the rally this past Th (April 9, 2009), I was able to cash out of my IWM May 43 calls for a very decent % gain. Of course, that meant that I held on Wed, where my swing trade lived up to its "swinging" phrase.

Good luck to all, use the volatility to your advantage, using Technical Analysis, but don't "rent" them for too long.

Apr 12 02:34 AM

[jse17:]

I carry with me selected pearls of investing wisdom e.g., “I know of no investor that consistently made money applying technical analysis,” Sir John Templeton. I recently added a gem to the collection.

Lazlo Birini recently reviewed the predominant significant market bottom indicators including the ever popular VIX, today’s indicator of the month. Yes as you may have guessed, NONE of the perceived indicators consistently provided assistance. The operative word between the above paragraphs becomes consistently.

Ben Graham stated, “Inevitably when I find the key to any market, they change the lock!” A second sentence regarding the preceding sentence exists that is almost never published. “Buy value and weather the storm.”

Apr 13 09:10 AM