Don't Follow the Lemmings

by: Elliott Gue

Economists often use the Latin phrase ceteris paribus, or “other things being equal.” This disclaimer indicates that your analysis or prediction assumes that everything else remains the same. Unfortunately, the real world follows a Heraclitian logic and rarely stands still for our benefit. Change is the only constant in the complex global economy. Relationships between economic conditions and the stock, bond, currency and commodity markets aren’t as straightforward and deterministic as some might imagine.

Plenty of people claim to be able to predict the economy’s ups and downs. In the late 1980s, plenty of newsletter editors made their names forecasting the 1987 crash. If I told you their names now, you probably wouldn’t recognize them, but these gurus were once considered infallible.

More recently, plenty of pundits and formerly obscure economists rose to stardom after they “foresaw” the 2008-09 financial crisis. But here’s a dirty, little secret: Most of these supposed clairvoyants have made the same predictions for years. A broken clock is right twice a day. If you make the same call for long enough, you’re bound get lucky at some point.

I won’t lie to you. I don’t have a crystal ball that enables me to infallibly predict the global economy’s fate. As long-time readers can attest, I readily admit when my forecasts are incorrect. I also regularly revisit my assumptions when conditions on the ground change.

To stay ahead of the market, my economic outlook hinges on a handful of economic indicators that have proved their worth time and time again. These indicators aren’t infallible, but I’ve found that a consistent approach to monitoring economic trends is far more effective than cherry-picking data series to support a preconceived notion. Economic forecasting is an exercise in probabilities. The global economy’s interrelationships are too complex to be distilled into any series of equations.

Fortunately, you don’t have to time inflection points in the economy or stock market precisely to succeed as an investor. The market is a forward-looking system that comprises a mass network of human emotions and decisions - needless to say, its outlook is often cloudy.

The recent boom-and-bust cycle is a case in point. If you failed to position your portfolio against the Great Recession until six months after it began in 2008, you still would have avoided the brunt of the subsequent market implosion. If you were three or four months late calling the market bottom and economic rebound in 2009, you still would have caught the meat of the bull-market rally.

In short, the challenge isn’t to predict economic inflection points. The real money is made by recognizing these changes once they occur and positioning your portfolio accordingly.

During this earnings season, management teams from many of the companies we follow have stated that their outlook remains positive - provided that the economy doesn’t slip into recession. Management teams remain cautiously optimistic about their business prospects, but the big picture remains a cause for concern.

Here’s my updated economic outlook.

The U.S. and other developed economies have been mired in a soft patch since April or May. Incoming economic data have yet to provide concrete signs that this malaise has dissipated.

Some of this weakness stems from temporary factors: Oil and commodity prices spiked in early 2011, adverse weather weighed on business conditions in parts of the U.S., and the magnitude-9.0 earthquake that hit Japan’s Tohoku region in March disrupted global supply chains. These transitory factors should recede in August or September, setting the stage for a welcome uptick in economic growth.

Despite the recent spate of weak economic data, there’s only a 10% to 20% probability that the U.S. will slip into recession. Inflation appears to have peaked in emerging markets, enabling China, India and other fast-growing nations to stop hiking interest rates in an effort to cool their overheated economies. Strong global growth should support rising energy demand.

Moreover, many pundits have confused weak economic growth with an outright contraction. Many of these commentators are repeat offenders who in summer 2010 warned that the U.S. would spiral into a double-dip recession.

In July the Institute for Supply Management’s Purchasing Managers Index (PMI) for Manufacturing slipped to 50.9% and the Non-Manufacturing version fell to 52.7, suggesting that activity slowed in both the service and non-service segments of economy. At the same time, PMI readings above 50 suggest expansion. Historically, levels of 45 to 47 have indicated an outright contraction.

Meanwhile, the market ignored the better-than-expected automobile sale data released this week. This rebound in sales suggests that the manufacturing PMI may have bottomed now that the supply-chain constraints stemming from the Tohoku earthquake have abated.

We also continue to monitor the Conference Board’s Index of Leading Economic Indicators (LEI). Three consecutive monthly declines usually indicate that the U.S. economy may be slipping into recession. Thus far in 2011, the LEI has posted only one month-over-month decline.

The Bureau of Labor Statistics’ June Employment Situation report fell well short of analysts’ expectations, and the disappointment weighed heavily on investor sentiment. But initial jobless claims have trended lower since May, and figures from ADP Employer Services estimate that the U.S. economy added 114,000 jobs in July.

Global credit markets remain a concern, though the EU sovereign-debt crisis has yet to affect the U.S. corporate bond market. As I discuss in my article, No Recession Looming: Buy Stocks Into the Summer Shakeout, the EU has demonstrated a willingness to take any steps necessary to prevent fiscal conditions initially - and, to a lesser extent, Spain - from deteriorating to the point that they have in Greece, Portugal and Ireland.

Although Italy’s debt-to-gross domestic product (GDP) ratio is 120%, in 2010 the government ran a deficit that amounted to 4.6% of GDP - well below Greece’s deficit of 10.5 of GDP or the U.S. deficit of 9.1% of GDP.

Moreover, Italy continues to make headway on reducing its deficit. A new austerity budget that includes roughly EUR45 billion ($65 billion) in cuts has the support of both the center-right government and its main opposition. In fact, the size of the budget cuts increased to EUR45 from EUR40 as the proposal was debated in the Italian senate.

The package calls for reductions to housing and alternative energy-related credits, additional payments for healthcare services and changes to the retirement age. If Italy enacts these measures and follows through with their implementation, concerns about the country’s ability to service its debts should subside.

Italy aims to balance the budget by 2014, but some critics have lambasted the government for pushing back the most onerous cuts and tax increases until 2013.

Because Italy runs a smaller budget deficit than its troubled peers, any reductions in government spending won’t damage the economy to the extent that Greece, Ireland and Portugal’s austerity programs have devastated their domestic economies.

For example, Greece’s efforts to reduce government spending and increase tax revenue enabled the country to secure much-needed bailouts from the EU and International Monetary Fund. But this tough medicine also mired the economy in a severe depression. Economists expect Greece’s GDP to shrink by almost 4.5% in 2011, further pressuring the government’s tax receipts.

Meanwhile, Italy’s economy continues to grow, albeit at a snail’s pace. The nation’s GDP expanded by about 1.3% in 2010 and should increase by another 1% in 2011. If the recent global economic slowdown proves temporary, Italy’s economy should be able grow by 1.25% in 2012. Check out Jim Fink’s article, Italy Debt Crisis: Best Italian Stocks for a Rebound, to see which Italian stocks Jim thinks represent the best bargains.

Italy can also access the public bond markets - admittedly at elevated interest rates - a privilege that Greece no longer enjoys. In mid-July, the Italian government placed EUR5 billion worth of new debt, including 15-year bonds that yielded 5.9% - 3% more than the yield on an equivalent bond issued by the German government. At the same time, the higher yields attracted 1.5 times more bids than the amount of bonds that the Italian government issued.

Let’s turn our attention to the hullaballoo surrounding U.S. debt ceiling. Although the media presented the situation as a crisis that would have wreaked havoc on the global economy, the incident, as Jim Fink points out in the S&P downgrade of U.S. Credit Rating, was politics as usual. The Aug. 2 deadline crated a heightened sense of urgency, but the U.S. was never in real danger of a default - no matter what the editorials said. If this political theater raised legitimate questions about U.S. credibility, then why are the yields on U.S. Treasury bonds near multi-month lows?

The recent patch of economic weakness is part and parcel with the halting economic recovery that began in mid-2009. If economic growth picks up in August and September, this is an excellent opportunity to buy well-placed energy stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.