A Perfect Storm For Lead Economic Indicators?

by: Bruce Pile

I like what Harry Truman once said to his advisers - "Give me a one armed economist". He was tired of hearing them say on the one hand we have this good indicator agreeing with that good indicator, but on the other hand, blah, blah.

We currently have the most reliable and beloved of indicators slapping us in the face with both hands, leaving many of us dazed and confused. These are indicators with decades of good track record that usually agree with each other that now are pointing in opposite directions.

Probably the highest profile indicators in the news lately are the improving employment numbers. There is controversy about changes made in how they tabulate this and the quality of the new jobs being added, but the direction is positive. But keep in mind that employment is a lagging indicator. It is the caboose, in fact, of any economic move; and it is the last thing you want to look at for predictive power.

When you look at leading indicators, perhaps the finest is The Conference Board Leading Economic Index (LEI) which has been getting it right for decades. Right now it is climbing to new highs out of the recession indicating an ongoing recovery gaining momentum. But you also have the very reliable Baltic Dry Index, which has a habit of foreshadowing major turns in the economy and stock market by about 3 to 6 months; and it is forecasting a very sharp fall: (click on graphs to enlarge)

The sharp moves the BDI made last year show a striking similarity to what the S&P 500 did, only phased a few months ahead. Much has been made of the fall off a cliff it apparently shows coming up next.

But the BDI has been severely distorted by the massive ship overbuild. The index is based on shipping rates, and too many ships depresses rates. Back in 2007 when commodity demand was off the charts, way too many new ships were ordered. Then the economy tanked, but the orders are being filled. So there has been a glut of ships to carry dry bulk (iron ore, etc.) and it is this dry bulk that offers the best lead indicator of economic activity because it is actual orders to build stuff based on real demand (no speculation here) and it takes awhile to build stuff out of powder - so there's a nice forward lag.

Many want to dismiss the BDI entirely now because of the ship oversupply. But keep in mind that this oversupply is coming through gradually, greatly suppressing the absolute value of the index. But for the shorter term moves, it still may be trying to tell us something. You can filter out the ship count problem by simply looking at the container rates for the individual containers loaded onto ships. Harper Peterson & Co. has been tabulating an index for this since 2004, and data has been put into the model that calculate it back to 1986. This index is showing the same forecast as the BDI:

As Louis Basenese noted in The Blame Game: Revisiting The Most Alarming Chart I've Seen All Week:

And don't even try to blame this drop on supply!

In the last six months, the number of container ships only increased 0.3% and capacity only increased by 1.9%. Meanwhile, the HARPEX Index is down 46.9% over the same period.

Bottom line: Don't be so quick to dismiss the sudden and severe decline of the Baltic Dry Index. Although shipping capacity is increasing, it's not the only culprit.

The Harpex has declined overall much less than the BDI since early 2010 because there's no big oversupply; and it is more of a coincident indicator (the stuff has already been made and put together at the container stage) but the forecast since last May's market top looks the same as the BDI - very bad.

You get the same take if you look at overall world trade charted:

The 6 month smoothed average has us crossing into negative ground just as in each of the two previous recessions.

But, to irritate Truman, on the other hand, the retailers have been doing very well and, in fact, the XLY consumer discretionary ETF has blasted to a new high leading all the major indexes. This is an important leader group that has been signalling an ongoing bull market since early '09. But if you look at gasoline demand as a gauge on the consumer you see this:

Egad! Truman's two handed economist again. Gasoline usage has plummeted way below the depths of the '08 crisis, falling off precipitously from the track of last year as the lower EIA chart shows. Are we switching to electric cars or ethanol this fast? Maybe this is saying that frivolous trips are being severely cut as the first wave in a consumer squeeze. It's easier to do internet substitutions for physical trips than to give up your favorite electronic devices or your favorite clothing and food.

A squeeze is also suggested by the recent spike in consumer credit in the face of poor consumer confidence. This spike is steeper than the run-up to the 2000 top, which was done by a supremely profligate consumer. If this squeeze trend continues, it may have an impact, not just on gas, but on all of retail.

But what about the raised forecasts from USB, and several of the major bank analysts, the good Conference Board outlook, the improving GDP, Larry Kudlow's prediction of a melt-up? Well, I don't know if I would use analyst upgrades and downgrades as a predictive tool. Squawk Box used to show them as penguins jumping in and out of the water with the herd of dumb money. And improving GDP, like employment, is not a leading sign. But how can you go against Kudlow?

Well, Larry doesn't always get it right like the Conference Board does. Which brings us to the big battle of the two major leading indicators, the Conference Board's LEI and the Economic Cycle Research Institute or ECRI. These two have been like two peas in a pod through past economic cycles even though their methods are not the same. But since 2008, they have sharply diverged to the point where ECRI's Lakshman Achuthan has been predicting a new recession since September. I have a theory as to why these two trustworthy indexes have gone their separate ways. I wrote an article on it back on August 22, 2011 "Is 'Zero Hour' Debt Saturation Upon Us?"

Let's look at a map of these two indexes consisting of the debt saturation chart of Marc Faber superimposed on an LEI/ECRI side-by-side comparison from "The Great Leading Indicator Smackdown: New Update" by Doug Short (with some notes added):

The marvelous track record of these two indexes is readily apparent. They both establish pretty clear trends out of a recession, and when they turn out of those trends, you are within a few months of a new recession. Why have they gone separate ways since '08? The make-up of the ECRI index is proprietary, but I think it is simply that the LEI factors in monetary policy much more heavily than the ECRI.

The original projection for zero hour was 2015, but in my article in 2010 "Is The Era of the Fed Closing", I took the liberty of adding some data and fitting a curve that pointed to it occurring in '09 or '10. Sure enough, an updated chart (shown above) has it arriving in 2010. And if you agree with Faber that we are past zero hour, where the diminishing economic bang for the debt dollar goes negative, you understand the divergence. The ECRI, which looks more at what's happening in the real world, is going south while the LEI, which looks at the world we've just left, where the Fed could regulate the cycle, may just be illustrating Faber's point and aligning the LEI into a perfect storm for the lead indicators.

What's really disturbing in the above chart is the similarity of the ECRI pattern coming out of '08 to what it did coming out of the first recession of the early '80s. That wound up being back-to-back recessions. That same pattern was present coming out of the '01 recession, and here we see the first significant difference between the LEI and ECRI. The LEI with its dependence on the Fed shot straight up out of the '01 recession, as in the past, while the ECRI languished a bit, perhaps reflecting the diminished effectiveness of the Fed at this point on Faber's curve. The '01 recovery was particularly weak with by far the slowest postwar employment recovery - except for now. The Fed induce housing boom saved the day (or did it?) If the similarity to the early '80s holds, we are in for the second of back-to-back recessions with the next one worse than the first. This would not be good.

The LEI is more transparent about their index make-up, and we know that it's based on many things related to Fed easing moves. Mike Shedlock recently discussed this in Stock Market Not a Leading Economic Indicator. Here he relates John Hussman's concerns that about half of the LEI index is weighted with monetary factors. Hussman feels that the recent run up in the LEI is related to distortions with interbank flight-to-safety money flows out of Europe into US banks. He says the LEI leans heavily on maxed out variables and that "these variables are essentially detached from economic activity".

The Conference Board may be coming to grips with this. They have announced a major reconfiguration of the index components, the first big change since 1996. And in Shedlock's opinion:

At least a portion of the enormous discrepancy between the LEI and the ECRI weekly leading index (WLI) will be resolved to the downside of the LEI.

If we know that the LEI is heavily biased toward Fed intervention, how can we know that the ECRI is any different since their components are locked away in a secret black box?

An article was written here at SA back in December by Hale Stewart Examining The Model For ECRI's Black Box. This was a follow-up on his earlier piece "A Peek Insight ECRI's Black Box". It is some intelligent guessing as to the black box ingredients based on published thoughts by the founder of ECRI, Geoffery Moore. In looking over these ingredients, you don't get the impression it is anywhere near 50% weighted on Fed intervention.

I also did a little sleuthing on the black box and ran across a telling conversation Lakshman Achuthan, ECRI's chief, had with Margaret Brennan of Bloomberg. In discussing economic cycles and "medicine", this exchange took place that gives us a peek into the ECRI position on Fed intervention:

Brennan: "To take your analogy, there's a worry that we've taken every kind of medicine there is on the market, the Fed doesn't have anything else"

Achuthan: "There's a point where you take too much medicine. I would go one step further..."

Brennan: "You want to see a pull back on QE"

Achuthan: "Yeeeah! I think if you pile on the medicine, too much of it, you can actually do damage, in particular if you're behind the curve"

Brennan: "And you think the Fed is behind the curve?"

Achuthan: "I think they have been behind the curve...I hope they consider easing it. Because if they don't, if you're behind the curve with a lot of medicine, you actually are encouraging boom, bust cycles. And you don't want that...There are reasons why
employment is stubbornly high that don't have to do with some policy,QE. OK? There are structural reasons for half of the unemployment"

From these comments and other anecdotal evidence, I get the distinct impression the ECRI has a low opinion of Fed intervention and probably relies on it very little if at all in their black box. This all suggests that the LEI has gone astray past Faber's zero hour, and the horrific signs of the BDI and all the rest above are actually right.

Having said all that, I'll be yet another two handed economist, and say on the other hand, the best and most comprehensive index is the market itself. As a technical analyst, I have a great respect for the discounting ability of the market, and I believe it knows more than you or I or Larry Kudlow or Marc Faber or all the indexes ever conceived or any perfect storm thereof.

So what is the market telling us now? The current technical condition of stocks is mixed and is anything but a perfect storm. You have important leader groups like XLY mentioned earlier and also technology leading as they have done since '09. But you also have a big Dow Theory problem with the transports right now. The transport indexes are heavily laden with the rails. Because of the dive in the natural gas price, there is a big switch from coal to gas, and this is somewhat artificially depressing the rails which transport the coal. So let's look at comparison between the Dow and the Nasdaq transports, with little weighting in rails:

Here we see, with or without the rails, a big non-confirmation of the new high the Dow is making, which by Dow Theory, makes it suspect.

The next sell-off in the market that visits the 50 day ema moving average area may tell us a lot. Even in good bull markets, sell-offs come in to test this up-sloping support about every 2 or 3 months. It's been about 2 months since the first test back in mid-December. So we are due for one out of the presently overbought condition in a month or so.

Also, we have the typical lead time of the lead indicators to consider. If you examine the LEI/ECRI chart above closely, you see that the LEI usually gave more advance warning of each turn into recession. But if we can't go by it now, we must look at the typical advance warning the ECRI has given. It's lead time has run around 6 months. That's also about what the BDI runs. So, with the ECRI warning of recession beginning last September and the Harpex/BDI also turning about 4 to 6 months ago, the next market pull back to its 50 day ema will coincide with crunch time in their perfect storm.

If the next 50 day ema visit behaves like a bull market correction and finds support near there, it stands a good chance of making all the bad signs anomalous and will probably pull the transports into line with the other leader groups. But if it behaves badly there and goes on to take up residence below the 140 ema, all the bad signs may prove to be right.

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