The Durables Data Predicts Doom

by: Markos Kaminis

The latest in the stew of mixed economic data came in a spoiled Durable Goods Orders Report Tuesday. What it may say about the economy should be concerning, and might contribute to that turn in stocks I've been anticipating would accompany this year's market comprehension of new economic trouble.

Durable Goods Orders were reported down 4.0% for January, the steepest month-to-month decline in three years. That's how the popular press is telling the story today, but truth be told, the decline follows three consecutive monthly increases, including December's 3.2% rise. Taken in that context, the slip in January would not seem so bad. However, that's not the context I believe will prove material to investors through the year. This decline may indicate the beginning of a new trend, one in which slumping European consumption of American exports and rising gasoline prices weigh on our vulnerable economy. Indeed, durable goods orders look ahead, and if they offer a clear perspective this time, the insight is troubling.

The 4.0% decline in durables matched against economists' expectations for a more modest 0.7% drop. Durable Goods Orders vary widely due to the big ticket prices attached to airplanes and other transportation goods. Because of this, the tally takers screen out transportation and also defense goods to get a smoother read of general business and consumer driven economic activity. When transportation orders are removed from the January data, new orders still decreased 3.2%, compared to a 2.1% increase in December. Excluding defense, new orders also decreased 4.5%, so any way you cut it, orders declined.

That said, there was one notable synthetic driver of January's decline in ordering activity, but its affects also lifted the three months that preceded January. A tax-incentive intended to drive capital goods purchases at cautious businesses expired at the end of the year in 2011. Its expiration drove a burst of acquisitions into the close of 2011, but in its absence, January misfired. I would expect more of the same in the months ahead.

Lower confidence in a March decline would be kindled by a nascent trend of last minute buying among managers. The last few tough years exhibited cautious purchasing patterns due to the uncertain economic environment. The result led managers to refrain from spending capital until they were certain of its availability, perhaps to best manage capital against working capital needs and debt obligations or to manage earnings in an uncertain environment. So, they end up making all their purchases in the last month of each quarter. Well that's March this quarter.

Closer inspection of the durables data shows Non-Defense Capital Goods Orders fell precipitously, dropping 6.3% in January. This data point in particular is indicative of the expiration of the tax-incentive for businesses to acquire capital goods. I am finding many optimists noting this point, while leaving out the fact that Q4 2011 benefited greatly from a rush of businesses taking advantage of the expiring incentive. I believe that a smoothing of the fourth quarter of 2011 and the first quarter of 2012 will offer much less reasoning to believe in economic recovery. For informational purposes, I note the month's weakness extended to Manufacturing (-5.8%), Primary Metals (-6.7%), Machinery (-10.4%), Computers and Related Products (-10.1%), Transportation (-6.1%) and Defense Aircraft and Parts (-5.6%).

Those ignoring what could be a shift from Q4 2011 to Q1 2012 are basing their view on some recently contradicting data. I even heard one gentleman expert guest on Bloomberg Radio say that we should take the Durables Report with a grain of salt, due to the evidence he's seen in other reports lately. I would suppose he is speaking to the improvements seen in several Regional Federal Reserve Branches' manufacturing surveys. This Tuesday, for instance, the Richmond Fed published its report showing its index rose to a mark of 20 in February, up from 12. Monday, the Dallas Fed's index improved to 17.8, up from 15.3. Last week, the Kansas City Fed's report showed improvement to a reading of 13, from 7. The week before that, the New York Fed's index gained to 19.53, its best reading in over a year. The Philadelphia Fed's index also gained to 10.2, up from 7.3. It's hard to argue against such broad reaching data.

Since the regional indexes are measuring February, versus the January Durables data point reported Tuesday, I can understand why the majority of institutional investors seem to be discounting it today. The broad equity indexes were all higher Tuesday on the news. The SPDR S&P 500 ETF (NYSEARCA:SPY), SPDR Dow Jones Industrial Average (NYSEARCA:DIA) and the PowerShares QQQ Trust Series (NASDAQ:QQQ) had all etched gains from their morning starts on the news. Looking forward, economists surveyed by Bloomberg see the ISM Manufacturing Index, which is the national measure, gaining to a mark of 54.6, from 54.1 in January. Based on the regional data, it would appear it may even be understated.

Despite the generally positive report, industrial sector ETFs were lower. I surveyed the Focus Morningstar Industrials ETF (NYSE:FIS), Vanguard Industrials ETF (NYSEARCA:VIS), PowerShares Dynamic Industrials ETF (NASDAQ:PRN), noting that each was in the red while the broader indexes were in the green through morning trade Tuesday. That was certainly due to the importance of the transportation and defense sector stocks within the group. Other leaders like Caterpillar (NYSE:CAT) and General Electric (NYSE:GE) were fractionally higher.

The important wisdom investors must discern today, considering current data, is what it may say about tomorrow. It takes some daring to venture out in a different direction than the trend says to, and so you will hardly ever hear a Wall Street voice sounding out against the tide, except perhaps in the rare cases of brazen genius or foolishness. I continue to look towards the factors that should prove important and detrimental to economic activity this year, including European demise and gasoline price rise. Europe cannot be written off, not just for the 20% of American exports sold into the deteriorating marketplace, but for the risk it poses to the entangled American financial institutions and other multinationals doing business there. Then there's the third point, call it the third rail even, because it's the one Wall Streeters will never touch. The exogenous factor many call unpredictable, which is of course predictable, but just not so for financial focusers. It is the Iran trigger, the event to top all events of the last 25 years, if not longer. It threatens to disrupt not only oil flow, but global trade, and it is greatly misunderstood and underestimated by the market today.

For these reasons, people like me will point to the Durables Report as supportive of a bearish argument, which it is in absolution anyway. February seems to offer hope given the regional data points, but if it should fall short, it would be that much more damaging. So while stocks may rise today and even into March, the Ides of that mythical month draw near, and with tangible risk factors full of sharp tentacles.

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