In a previous article on the merits of Zimmer, I followed a clear and precise format for the selection of the stock through criteria based investing. A company had to be a leader in its industry, have the largest percentage market share in its niche, maintain strong international revenue, possess a low historical relative valuation, maintain strong dividend growth, and a clarified new revenue source. When analyzing the prospects of the economy, I follow the same "criteria based" approach.
Quantitatively, no single economic index is foolproof. Many economists will prefer one economic statistic over the next, and have sufficient evidence to back his or her story. In my mind, building evidence of an eminent turndown in the economy is very difficult. You should not be worried about accurately predicting each recession on the horizon. You should let the evidence inform you on the "odds" of a potential recession.
In building a case for a recession, I concentrate on six key indicators. These indicators also allow me to make prudent long only selections in the most beneficial sectors of the economy. For example, if my criteria list indicates a possible recession in the future, I might not only be less inclined to remain at a market weight, but also I will overweight defensive equity positions in the heathcare and consumer staples sectors.
Indicators (click to enlarge images):
- Copper: I consistently measure the price of copper to gauge the health of the global economy. This is a very popular indicator, also known as Dr. Copper, for the metal's ability to predict future economic growth. China now has a very large impact on the price of copper, as it controls over 40% of the global market. To track the metal, I follow the London Market Exchange. My primary focus is on the trend of the price in copper, especially looking for any breakdown. Despite the slowdown in China and the economic problems in Europe, copper's price has been holding steady. In fact, Copper just rose to its highest price in nearly four months, no doubt driven by China's new approval of a multi-billion dollar infrastructure program, the European Central Bank's recent positive commentary, and the hope of QE3. Verdict: POSITIVE
- My second indicator is also tied to economics. Chicago Fed National Activity Index (CFNAI): Diffusion Index. This index is produced monthly and measures overall economic activity. I prefer the more obscure CFNAI as it measures a weighted average of 85 existing monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one. It is also measured through a diffusion index, which is also preferable. A diffusion index is created by measuring the number of indicators that are rising and taking this as a percentage of the number under observation. For example, if five out of the ten indicators turn up during a given period, the diffusion index is 50%. If seven turn negative, the index is 30%. The index is currently trending sideways, but holding above the critical -0.2 reading. Verdict: NEUTRAL
- One of the more abstruse economic indicators I track is the DAT Trendlines Index. The DAT Trendlines Index is a weekly updated report highlighting key freight trend and industry indicators from the DAT U.S. Freight Index. It tracks 68 million loads and trucks listed each year on the DAT Load Board Network. I specifically look at the Freight Trend of the Month data. For the month of August 2012, freight volume increased 4.5% compared to the previous month, and was up 17.5% compared to August 2011 on their load boards. Verdict: POSITIVE
- Any investor worth their salt will follow the Dow Jones Transportation Index.
The transports follow what is known as the Dow Theory. In technical analysis, the Dow theory states that when the Dow Jones Industrial Average and the Dow Jones Transportation Average both hit a new high or a new low for a period of time, it can confirm a previous, bullish or bearish signal. It is important that both the averages must reach a new high (or a new low) in order to confirm the trend. Otherwise, you have a negative divergence. The index has a very long term track record of predicting ultimately where the economy and markets are heading. However, the timing is not always perfect. In 1999, the transports set the high in May of that year. The market did not finally top out until nearly a year later, a recession did not begin until 2001. At this juncture, the transports have not confirmed last week's market breakout. However, the transports have not yet broken down yet, and with the more recent positive DAT freight numbers, this indicator could turn upwards. Verdict: NEUTRAL
- Another of my favored economic indicators measures builder confidence. NAHB-Wells Fargo Housing Market Index (HMI) is based on a monthly survey of National Association of Home Builders designed to measure the health of the single-family housing market. The survey asks questions on the sales of new homes and more importantly the view of the members on the next 6 months. The survey also measures the traffic of prospective buyers of new homes. The August survey indicated a fourth consecutive month of gains in the survey, up to 37. In fact, the index is at its highest level since February of 2007. We are at a much different juncture than in 2006, when the HMI index topped out. Current reading: POSITIVE
- Credit spreads. I actively follow the credit spreads of the 10-yr U.S. corporate A rated bonds vs. Treasury bonds of the same maturity. Many analysts will prefer non-investment grade credit spreads, but any diversion from risk will show up in this spread. In the chart below, the spread between corporate A rated bonds and Treasuries started to widen dramatically in the last few months of 2007, ultimately reaching a spread of over 300 basis points within six months. Currently, the spreads continue to be quite tight. Verdict: POSITIVE
Overall, four of my six favored indicators are demonstrating a healthy U.S. economy. Especially positive are housing starts, freight traffic, and investment grade corporate spreads. The price of copper, which is a better harbinger for global growth, is remaining above the 2011 level. The transports have not confirmed the upwards move in the Dow Industrials, but also have not broken down as of yet. My investment strategy, based upon these indicators, is to not get too defensive despite the noise surrounding the election, eurozone troubles and low GDP growth. The odds of a recession before the end of 2012 looks very unlikely at this juncture. I remain overweight those sectors that will benefit from a continued recovery including energy and materials.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.