Ahead Of The Curve Business Cycle Indicators

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Includes: DIA, IWM, QQQ, SPY
by: Charles Bolin

Summary

This article describes Joseph Ellis' book, Ahead Of the Curve and the leading characteristics of indicators along Mr. Ellis' Chronology of the Economic Cycle.

Short Term and Coincident Indicators are following Long Leading Indicators downward.

The impact of low profits and production may be unfolding on Labor and Income indicators in the coming quarters.

INTRODUCTION

I have enjoyed reading articles on Seeking Alpha and the comments on the few articles that I have written. The Seeking Alpha Editors critiqued "Profits As a Leading Indicator Of the Stock Market And Economy" and wanted more information about why I always optimized my indicators six months into the future. For that article, I created a couple of charts showing the correlations of indicators compared to my Corporate Health Indicator by month 10 months leading and lagging. This article looks at correlations further and segregates my indicators into long leading, short leading and more coincident indicators.

CHRONOLOGY OF THE ECONOMIC CYCLE

The first book that I read that interested me about forecasting business (and other) cycles was "Ahead Of The Curve" written by Joseph Ellis and published in 2005. Mr. Ellis shows his Chronology of the Economic Cycle to be that Inflation influences interest rates and real hourly wages which effect changes in 0 to 9 months in Consumer Borrowing and Spending followed by reactive changes in 0 to 6 months in industrial production and services which are followed by changes in capital spending in 6 to 12 months. There is a feedback loop through corporate profits which in turn has an impact on Employment in 6 to 12 months. The charts in the book are great.

In "Using Economic Indicators To Evaluate The Investment Environment", I describe my Allocation Model that uses over a hundred indicators to help me set my allocations. In this article, I look at the inter-relationship between these indicators. I use k-median clustering described in "Data Smart: Using Data Science to Transform Information into Insight" to segment the 37 composite indicators into four groups which are loosely long, short and coincident indicators. The distinction in names between the two short leading indicator groups is their correlation to my Recession Indicator. The average of the four indicator groups is shown below.

The Long Indicators consists of Robert Dieli's " Mr. Model", Potential GDP, Monetary, Valuation and Margin Debt Indicators. Potential GDP is my indicator that determines how much slack there is in the economy based on the "CBO's estimate of the output the economy would produce with a high rate of use of its capital and labor resources." My Margin Debt Indicator is created based on a description from Doug Short and as used by Lance Roberts. As seen below, these long leading indicators are not positive for outlook over the next two years.

The next chart shows the two groups of short term indicators which performed similarly except during the high valuation of the Technology Bubble. These two groups of indicators are showing weakness similar to periods preceding recessions. The indicators in these two groups are:

Short-Hi: Corporate, Recession Alert Weekly Leading Indicator, Interest, Investment, Orders, Leading, Household, Labor, Coincident, and Services.

Short-Lo: Confidence, Financial Risk, Housing, Effective Demand and Banking.

Below, I show the short leading indicators along with the more coincident indicator which consists of Final Sales, GDP, Spending, Income, Technology, Production and Construction. None of the three are giving encouragement for the short term.

Below is my Investment Index which I use to create my Allocation Model. It is a weighted average of about 100 indicators to maximize returns for an individual investor with most funds in a tax advantaged account and low trading fees. The outlook for stocks began to deteriorate in Q3 2014 and is now on the edge of being negative with some wiggle room for optimism.

But back to Mr. Ellis and "Ahead of the Curve". I did not build my Allocation Model according to how Mr. Ellis looks at the Chronology, but did follow his general concepts. Below are my indicators that most closely match his. From my grouping of indicators, Corporate Health, Interest, Orders, Labor, and Services are from Short-Hi group. Spending, Income, and Production are from the more coincident group. My Spending Indicator consists of Total Business Sales which have been declining, Retail Sales, Real Personal Consumption Expenditures, and Merchant Wholesalers Sales.

While the indicators follow the same general trend, even within some groups, some are more leading than others and the leaders change depending upon the number of months of lead time. With a 12 month lead time, Corporate Health leads Labor (0.54 correlation), Production (0.55), Income (0.64) and Services (0.53). Investment leads Labor (0.53). Orders leads Production (0.53). Spending leads Income (0.59). Services leads Income (0.65). In other words, one year out there is some leading relationships, but the correlations are not strong.

For 6 months of lead time, Investment leads Labor (0.76 correlation), and Production (0.63). Orders leads Spending (0.62), Labor (0.69), Production (0.77) and Income (0.72). Spending leads Income (0.84). Corporate leads Labor (0.71), Production (0.76), and Income (0.65). Labor leads Income (0.78). Production leads Income (0.75). Correlations increase significantly looking at 6 month lead times instead of 12 month.

Looking at only the strongest correlations for a 3 month lead time, Investment leads Labor (0.80). Orders lead Spending (0.74), Labor (0.79), and Production (0.81). Spending leads Production (0.80), Income (0.83) and Services (0.71). Corporate Health leads Labor (0.74), Production (0.79). Production leads Income (0.78). Correlations are higher for shorter term looks at the economy.

Three of the indicators with high correlations to others in the 3 to 6 month range are my Diffusion Index of falling indicators, Recession Alert Weekly Leading Indicator, and my composite index of leading indicators. For 6 months, the Diffusion leads Recession Alert (0.66) and Leading Index (0.56). For three months, the Diffusion Index, has a leading correlation of (0.81) to Recession Alert and Leading Index (0.74). All three have good 3 month future correlations to Orders (~0.7), Spending (~0.7), Labor (~0.85) and Production (~0.8).

Shown below, Corporate Health and Production are leading other indicators like Spending, Income and Services down as they often have done in the past. Corporate Health and Production have made the headlines often during the past several months while Services and Labor are sometimes offered as strength to the outlook. The trends in all have been weakening since 2014.

Banking is from my Short-Lo group of indicators. Some of the components are shown below. It can be seen that Banks are tightening lending standards and the delinquency rate is starting to increase as it does before many recessions. This will make it harder for some businesses to expand.

I like to validate my Indicators with data. Below is the declining Industrial Production and increasing Inventory to Sales Ratio does not bode well for the Chronology of the Economic Cycle, particularly Labor and Income.

Below is my Household Indicator which is a composite of Net Worth, Net Worth As a Percentage of Disposable Income, and Personal Interest payments. I don't believe the consumer is going to charge to the rescue of this economy in the next year or two.

CONCLUSION

Here is a link to a great article on Profits Growth by George Bijak at GB Capital which shows the correlation of Profits as a long leading indicator to the markets and economy. More coincident indicators are trending negative as supported by a May 2016 Press Release from Challenger, Gray & Christmas which points to planned job cuts announced by employers to be 24 percent higher compared to the first four months of last year. They point out that job cuts extend to retailers and technology and is not confined to the energy section. My suspicion is that low profits and production will result in more negative impacts to labor markets in 2017 due to the lag in the budgeting process.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment advisor. Investors should do their own research or seek the help of investment professionals when making investment decisions.