False Signals and Real Hope

Today is the first full day of President Barack Obama’s administration and, as everyone knows, the new commander in chief has his work cut out for him. With a fresh start before us in Washington the question on the home front remains: What’s up (or down) with the economy?

In broad terms, the answer is obvious, and the numbers only lend statistical support. Clearly, tough times lie ahead, with the next 6 months or so looking set to be the toughest. But how does that square with our proprietary measure of U.S. economic activity (CS Economic Index), which bounced sharply higher in November, the last month with the full compliment of data pieces for this benchmark? What’s more, based on preliminary data for December, the November bounce looks set to hold.

Leading Component Indices

Alas, the rise is something of an illusion for the time being since only two factors out of the 17 in our economic index are driving the bounce skyward. Those two lone bullish factors, unfortunately, aren’t likely to spark a recovery of any substance for the foreseeable future. Looking out later in the year offers some hope, but first let’s talk about the immediate future.

The two factors doing all the heavy lifting in our economic index are money supply and the interest rate spread. Both were in overdrive in November in terms of generating pro-recovery fuel to an otherwise shrinking economy. The rate spread was particularly bullish, although the growth-oriented bounce from money supply was robust too. Collectively, the pair overwhelmed the negative energy elsewhere in the economy, at least when measured on an average basis.

By rate spread we’re talking of the difference between the yield on the 10-year Treasury Note less the effective Fed funds. Thanks primarily to the dramatic fall in Fed funds in November, which continued in December, the rate spread widened sharply and thereby moving definitively into positive territory, which generally is a bullish signal for the economy. Why? Because a positive sloping yield curve—rates are higher as bond maturities lengthen—historically accompanies economic growth. By contrast, a negatively sloping yield curve—rates fall as maturities lengthen—is a sign of distress/economic contraction.

Based on the rate spread, this measure went negative in July 2006 and stayed negative until February 2008, when the spread moved back into positive territory. Looking back, it turns out that the recession warning posed by the arrival of a negative yield curve in mid-2006 was an accurate forecast of an approaching recession, which officially began in December 2007.

Fast forward to November 2008 and the rate spread is telling us that it’s now in high gear as an economic stimulus. That is, short rates are extremely low relative to long rates—despite the fact that long rates are also bouncing around at historically low absolute levels. Based on this measure alone, one might be bullish on the immediate future, assuming this was a normal cycle. But as we know, the times are anything but normal and so even the unusually bullish stimulants coming from the money supply and interest rate factors aren’t yet dispensing their usually pro-growth influence. The reason is that the negative drag from everything else is, for the moment, still too much to overcome. Indeed, the lagging and coincident factors in our broad economic index are either flat lining or still declining.

The good news is that at some point all the monetary stimulus will take root and promote expansion. All the money has to go somewhere and eventually it’ll go into corners of the economy other than banks accounts and T-bills. Banks will one day lend and businesses will borrow. In addition, now that the Obama administration is at the helm, we expect a fresh round of fiscal stimulus to compliment the monetary efforts now running at full speed.

Guessing when all this will produce some measurably positive change in the economy proper is the great question. Given the depth and magnitude of the economic headwind, we’re not expecting much for the first half of this year, perhaps longer. Even when signs of growth, or at least stabilization emerge, they’re likely to be tenuous, slipping temporarily back into negative territory and keeping everyone on pins and needles.

Recovery worth the name is going to take time, and perhaps a fair degree more time than we’ve come to expect over the past generation, when growth returned fairly quickly after a downturn.

As such, strategic-minded investors should pace themselves and use the next several quarters productively to restructure their portfolios for the day when the storm passes. As we’ll discuss in more detail in the February issue of The Beta Investment Report, the ongoing economic and financial turmoil is wrenching but it also offers substantial opportunities for dynamic asset allocation strategies.

That said, the next several months are undoubtedly going to be rough, replete with surprises, false starts and lots of noise in the markets. Economically speaking, there are still a number of big unknowns lurking in the near-term future too. Investors should brace themselves for more volatility, and at the same time prepare to take advantage of it.

Risk management, in other words, has never been more important, or potentially more rewarding.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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