Spinning A Consistent Yarn

By: Michael Ashton | Mon, Mar 1, 2010
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It is true, the economic data is not singing harmoniously. Employment not only remains weak, but seems as if it may be weakening again; housing was temporarily pumped up by government action but it appears that nothing permanent was occurring as a consequence of "Cash for Cottages." There are three ways to resolve divergences (1. the stronger returns to the weaker; 2. the weaker catches up to the stronger; 3. they meet in the middle), but rather surprisingly - since the preferred method in this case is (2) and (3) is the most common way - it appears that in the case of the housing data the huge surge last year in Existing Home Sales relative to New Home Sales (see chart, source Bloomberg) is being resolved in favor of weakness-for-all after Friday's surprising continued plunge in Existing Home Sales.


Big divergence of Existing and New Home Sales is being resolved.

All, of course, is not bad news. The Chicago Purchasing Managers' report made economists 0-for-2 on the day by coming out stronger than expected, a point which augurs well for Monday's ISM national report (Consensus: 57.5 from 58.4, although the consensus would probably be higher if they had taken the survey after Chicago PM).

But non-synchronous data is nothing new. Rarely are all the data singing from the same hymnal, except for that reasonably brief period in the middle of the expansion or contraction when almost everything is pointing the same way (and by then, you may already have missed the meat of any market move...which is not to say that that the market anticipates correctly with a very good batting average, but it does anticipate and sometimes it is right!). The challenge for the analyst is to discern the consistent story that explains the data in the clearest and cleanest way possible.

The consistency of the story is in the eye of the beholder, to be sure. Dad's explanation in the dialogue below (taken from this link) is consistent, if wrong:

Calvin: How come old photographs are always black and white? Didn't they have color film back then?
Dad: Sure they did. In fact, those old photographs are in color. It's just that the world was black and white then. The world didn't turn color until sometime in the 1930s, and it was pretty grainy color for a while, too.
Calvin: But then why are old paintings in color?! If the world was black and white,
wouldn't artists have painted it that way?
Dad: Not necessarily. A lot of great artists were insane.
Calvin: But... But how could they have painted in color anyway? Wouldn't their paints have been shades of gray back then?
Dad: Of course, but they turned colors like everything else did in the '30s.
Calvin: So why didn't old black and white photos turn color too?
Dad: Because they were color pictures of black and white, remember?

So when we look at the data and see employment growth weak/negative and perhaps stalling, while manufacturing surveys are quite strong, one simple narrative (that we see a lot) goes like this: "Employment always lags the economy. We are in an expansion, but jobs haven't caught up yet." Some analysts will even go a bit further and by calling it a "jobless recovery," assume away the weakness in employment altogether.

But the narrative that says the economy is enjoying normal recovery and jobs are just lagging runs into problems when we start adding data points from other sectors such as an abrupt re-weakening of housing and a drop in consumer confidence. It cannot simply be that employment is lagging. Something more is happening (or, rather, something less than a normal recovery is happening).

I think that we need to be careful about getting too cheerful about things like Philly Fed, Empire Manufacturing, the Chicago PM, and the ISM. One reason that caution is due is that all of these reports share the characteristic that they are surveys of relative measures. That is, in each case respondents are asked how business is shaping up this month relative to last month. When things are near normal, then a comparison to last month is easy, and not a bad way of taking the economy's temperature. When things are coming off a deep recession, I can certainly imagine that it is somewhat difficult to ascertain just how much better things are now than they were last month, and probably any improvement at all tends to be noticed. Also, since the surveys are diffusion measures, a broad but weak recovery will register high on the surveys. This isn't a problem in normal times since a broad recovery tends to also be a strong one; coming out of a crisis, though, any company which hasn't failed has a decent chance of doing better from one month to the next.

These are very different from surveys of absolute measures. In the Conference Board's Consumer Confidence survey, one of the questions concerns whether jobs are "hard to get" or "plentiful," and the economic environment is graded as "good" or "bad." It is very easy for me to create an understandable narrative here: high surveys of relative measures, combined with low surveys of absolute measures (and weak enumerative data reports like Initial Claims and Housing) suggest that things are getting better, but they're still pretty bad and, I suspect, vulnerable to further setback.

In addition to the aforementioned ISM, on Monday we also see Personal Income (Consensus: +0.4%) and Spending (Consensus: +0.4%), which report also includes the Core PCE index. The ISM is for February and Personal Income is for January, so ISM is probably more important near-term for the market.

It looks like it will actually be a 5-day workweek. President's Day and then the blizzard have conspired to give us only about seven tradeable days over the last couple of weeks, and now that the Olympics are over CNBC can go back to talking about the day's markets instead of their afternoon programming, which briefly led me to believe that CNBC stood for "Curling, Nothing But Curling." (Not that I wait breathlessly for CNBC's analysis. I strongly suspect that they will be bullish on stocks).

Last week ended with 10y yields are 3.61%, and the inflation market pricing forward calendar-year CPI as follows:

2010: 1.2%

2011: 1.7%

2012: 2.1%

2013: 2.5%

2014: 2.7%

2015-2020: 2.9%-3.0%

This seems darn optimistic to me. If this pattern of inflation actually obtains, along with reasonable growth, then stocks might not be as overpriced as I think they are. But that's a narrow branch, and there are lots of ways to fall off it. Maintain a healthy margin of safety, as always!

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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