September 30, 2012
Q3:2012 U.S. GDP Forecast Update | 9.30.2012
Starting with today’s update of looking ahead to the next quarter’s GDP, I’ll present several forecasts drawn from different methodologies for contrast and comparison on a regular basis. With that in mind, let’s consider how several forecasts for third-quarter U.S. GDP stack up.
The first chart compares four in-house forecasts that will be updated as new data arrives. I’ll briefly explain below how each of The Capital Spectator’s GDP forecasts are calculated. But first, take note that the first chart also includes two widely cited surveys of economists. The average guesstimate for each survey is presented for additional perspective. One source is the Survey of Professional Forecasters (SPF) via the Philadelphia Fed. It’s updated relatively infrequently, however. The current average forecast of real GDP growth of 1.6% for Q3 was published on August 10. The other survey is the September outlook via The Wall Street Journal, which asks several dozen economists for their outlook each month. The Journal's current forecast from dismal scientists reveals an average forecast of 1.9% for Q3 GDP, based on September 7-11 polling.
One rationale for keeping on eye on multiple forecasts and tracking how they change through time is that it gives us an additional layer of intelligence to consider. Point forecasts at one moment in time are fine, of course, but as conditions change, so too should the predictions. How they change can sometimes tell us as much, maybe more, as a specific forecast at one specific moment. Are the forecasts continually rising, falling, or going every which way?
With that in mind, here's how our four in-house forecasts compare in recent weeks:
Next, here's a brief profile of how each of The Capital Spectator's forecasts are calculated:
4-Factor Nowcast. This prediction is based on a multiple regression of quarterly changes for four key economic indicators: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls. This model compares the data on a quarterly basis, looking for relationships with GDP within each quarter from the early 1970s to the present. The four monthly data series are updated monthly and so as new data arrives, the forecast is updated—thus the term "nowcast," which can be thought of as a dynamic forecast that draws on frequently revised inputs.
10-Factor Nowcast. This model also uses a multiple regression framework that's updated as new numbers arrive, but with two key differences relative to the 4-factor model above. First, this model uses more factors—10 in all. In addition to the data quartet used in the 4-Factor model, the 10-Factor nowcast also looks at the following series:
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
The second difference with the 10-factor model is that it analyzes relationships across a longer span of time by considering the average of changes across the trailing one-, two-, three-, and four-quarter comparisons.
ARIMA Forecast.The engine here is known as an autoregressive integrated moving average. The technique is one of using real GDP's history from the early 1970s onward as the raw material for predicting the next quarter's change. As the most recent quarterly GDP number is revised, I re-run the ARIMA forecasts, which are calculated in R software, using Professor Rob Hyndman’s “forecast” package, which optimizes the prediction model based on the data set's historical record.
VAR Forecast. Finally, I forecast GDP with a vector autoregression model, which looks to several data series in search of interdependent relationships to provide some guidance about the future. In particular, I use the four factors in the 4-factor model above to generate VAR forecasts based on the historical records dating back to the early 1970s, using the "vars" package for R.
Okay, so what do all these forecasts tell us? Clearly, there's a mixed bag in terms of the recent trend. Two of our in-house forecasts turned higher, but two slipped modestly. Perhaps it's just the usual noise that comes with updating forecasts. We'll learn more in the days and weeks ahead as fresh numbers are published and we move closer to the government's official release date for the first official estimate of Q3 GDP: October 26.
Meantime, there's a reasonably strong case for expecting that the economy will continue to post slow growth for the July-through-September period this year. There's nothing to contradict that expectation in our latest economic trend analysis, a separate econometric technique for assessing recession risk.
As usual, all this could change if the next batch of data is particularly ugly. Indeed, September's economic news starts arriving this week. Based on what we know at the moment, however, cautious optimism isn't easily dismissed for thinking that the trend will struggle forward.
September 29, 2012
Book Bits | 9.29.2012
● The Signal and the Noise: Why So Many Predictions Fail--But Some Don't
By Nate SIlver
Review by Burton Malkiel via The Wall Street Journal
It is almost a parlor game, especially as elections approach—not only the little matter of who will win but also: by how much? For Nate Silver, however, prediction is more than a game. It is a science, or something like a science anyway. Mr. Silver is a well-known forecaster and the founder of the New York Times political blog FiveThirtyEight.com, which accurately predicted the outcome of the last presidential election. Before he was a Times blogger, he was known as a careful analyst of (often widely unreliable) public-opinion polls and, not least, as the man who hit upon an innovative system for forecasting the performance of Major League Baseball players. In "The Signal and the Noise," he takes the reader on a whirlwind tour of the success and failure of predictions in a wide variety of fields and offers advice about how we might all improve our forecasting skill.
● America the Possible: Manifesto for a New Economy
By James Gustave Speth
Summary via publisher, Yale University Press
In this third volume of his award-winning American Crisis series, James Gustave Speth makes his boldest and most ambitious contribution yet. He looks unsparingly at the sea of troubles in which the United States now finds itself, charts a course through the discouragement and despair commonly felt today, and envisions what he calls America the Possible, an attractive and plausible future that we can still realize. The book identifies a dozen features of the American political economy—the country's basic operating system—where transformative change is essential. It spells out the specific changes that are needed to move toward a new political economy—one in which the true priority is to sustain people and planet.
● The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy
By David Wiedemer, and Robert Wiedemer, Cindy Spitzer
Summary via publisher, Wiley
From the authors who accurately predicted the domino fall of the conjoined real estate, stock, and private debt bubbles that led to the financial crisis of 2008 comes the definitive guide to protection and profit in 2012 and beyond. Based on the authors' unmatched track record of precision predictions in their three landmark books, America's Bubble Economy, Aftershock, and Aftershock, Second Edition (Wiley, 2011), their next book offers what readers have been clamoring for: A detailed guide to how to put Aftershock in action, with 14 new chapters on what investors need to know to survive and thrive in the next global money meltdown. The Aftershock Investor shows readers:
● How Do We Fix This Mess?: The Economic Price of Having it all, and the Route to Lasting Prosperity
By Robert Preston
Essay by author via The Guardian
"How do we fix this mess?" That may be one of the stupidest questions I have ever asked myself, as of course I don't know the answer. What I do know, however, is that few of the structural flaws in how the global economy operates, which took us from unsustainable boom to intractable bust, have been fixed. And that leads me to fear that in the rich west, and perhaps more widely, it will be many years yet before we enjoy the kind of recovery that raises most people's living standards.
● Don't Buy It: The Trouble with Talking Nonsense about the Economy
By Anat Shenker-Osorio
Summary via publisher, Public Affairs Books
Today the term "dismal science" seems almost too kind: too many of today's economic arguments deserve the mantle of mysticism. In the name of appeasing our fickle economy, politicians have slashed services, laid off public workers, and threatened the future of the social safety net. And yet all of these "sacrifices" only make matters worse. In Don't Buy It, political communications expert Anat Shenker-Osorio shows how wrong-headed ways of conceptualizing the economy have led to bad decisions and worse policies. When we call the economy "unhealthy" or "recovering," we give it the status of a living being. Americans must submit to any indignity required to "keep the economy happy." Tread lightly, we can't risk irritating the economy!
September 28, 2012
U.S. Economic Trend Update | 9.28.12
With a full set of July indicators in hand, along with a nearly complete set of August numbers, the data is telling us that the economic trend has weakened. But the decline in the trend is nowhere near the danger zone for recession risk. Nonetheless, the 3-month moving average of the Capital Spectator Economic Trend Index (CS-ETI) has dropped modestly for each of the three months through August and so the potential for trouble down the road can’t be ignored in the current slow-growth climate.
Leaving guesses about the future aside for a moment, here's what the recent past looks like based on the numbers published so far:
August witnessed another indicator that slipped over to the dark side: oil prices rose relative to year-earlier levels last month (based on monthly average prices; price changes are inverted for CS-ETI). That’s the first year-over-year jump since March for crude prices. Even so, the majority of indicators are still trending positive, as the table above shows.
Taking the 3-month average of these indicators and tracking the changes through time still leaves us with a comfortable margin of safety relative to where recession risk has historically become a problem. As you can see in the next chart below, the August reading of CS-ETI (3-month average) fell to 75.5%. In other words, 75.5% of the indicators are trending positive. But the level has been slipping lately? Is that noise, or a sign of a new round of weakness? No one really knows at this point, but it’s clear that a 75.5% reading is still far above levels linked with economic downturns. It’s another story if CS-ETI continues to retreat, but for now it’s premature to argue that the economy is caught in a fatal cyclical swoon.
For some perspective on what the near-term future may bring, let’s turn to ARIMA forecasts for each of the indicators and then aggregate the individual predictions for a read on where CS-ETI may be headed in the near-term future.1 Any one forecast is likely to suffer error, of course, but predicting all the indicators in a robust econometric framework should minimize the risk a bit. With that in mind, the next chart suggests that the trend is set to modestly weaken again in September and then stabilize in October. That's a sign that we should manage our expectations for the economy, but it's still well short of an argument for expecting the worst. (Note: the “forecasts” for September's market numbers (stocks, interest rates, and oil) aren’t really forecasts. Instead, I’ve taken the average prices for each market in September based on available daily data to date. Accordingly, the ARIMA forecasts for market data begins with October. For the economic series, the ARIMA forecasts start with September.)
As for what we do know, it seems clear that August wasn’t the start of a recession, despite what you might have heard elsewhere. Short of a dramatic and broad downward revision in the data for last month, the business cycle managed to eke out another month of growth. But the trend is weakening, which is no trivial matter in a world still struggling with lots of risk factors, including slow growth. Based on what we know today, however, the case for slow growth still looks like a reasonable forecast.
Will September data tell us another story? The first round of clues are scheduled to arrive next week, starting with the ISM Manufacturing Index report for September, which will be released on Monday, October 1. The consensus forecast anticipates a slight decline, according to Briefing.com. If so, that would leave the ISM index just under a neutral reading of 50 for the fourth month in a row. Not good, but not particularly fatal either. (For some perspective on the ISM index for manufacturing, see my report on the August data.)
Finally, a quick update on the methodology for CS-ETI. Starting with this report, I’m taking the average of four employment indicators (the blue cells in the table above) and using that average as the representative variable for the labor market. The adjustment doesn’t change much in terms of CS-ETI’s historical record. Ok, so why the change? Primarily it’s an issue of using one data series to represent the labor market rather than four. As a result, CS-ETI’s fluctuations move a step closer to an equal-weighted measure of the economy’s various signals—a change that should deliver more robust readings of the cyclical trend.
Spending & Income Increased In August
Personal income and spending rose in August, the U.S. Bureau of Economic Analysis reports, although the increase on the income side of the ledger was sluggish in nominal terms (and actually fell last month after adjusting for inflation). Personal consumption expenditures, on the other hand, had a much stronger month, rising the most since February. Some of the higher spending was due to rising gasoline prices. Nonetheless, consumers were willing to spend more on durable goods, which suggests that there's still some capacity to open the wallet for discretionary items. Overall, today’s income and spending numbers suggest that the economy still has forward momentum. If you’re looking for a clear sign that a recession is near (or recently started), you won’t find it here.
Here’s how income and spending compare on a monthly basis. Notably, consumption has been picking up in the last two months. Income, on the other hand, is growing weakly relative to earlier this year.
Month-to-month comparisons can be misleading, however, and so looking at year-over-year changes cuts through the noise a bit. What we find is a relatively encouraging sign: the annual pace of growth for income and spending is no longer decelerating. Both series are rising vs. their year-earlier levels and, more importantly, at slightly faster rates. The growth is hardly stellar, but the trend certainly looks favorable, if only on the margins.
The data tells a similar story after adjusting for inflation, albeit with a somewhat less dramatic turnaround angle. But it’s hard to miss the fact that the annual rates of real income and spending growth seem to be stabilizing around the 2% mark. The implication: the consumer’s contribution to economic growth remains in the net-plus column.
Another signal that consumer spending is holding its own comes from tracking real durable goods consumption on a year-over-year basis. Spending on big-ticket items rose 8.1% in August in inflation-adjusted terms. That's up from July's 7.2% pace and near the highest rates since the recession ended. In other words, last month's spending pop was more than paying higher prices at the pump.
There’s always a danger of reading too much into one data series in the search for clues about the broader economy. But as key factors for divining the general trend, consumer spending and income have no equals in terms of influence for GDP. As such, it’s reassuring to see that these indicators are still growing on a year-over-year basis. History suggests that recession risk is rising when the growth rate of income and spending is persistently slipping on an annual basis. To the extent that’s not happening—and it’s not—there’s one more reason for thinking that slow growth for the economy overall is still a reasonable guesstimate.
But let’s not minimize the risks. With gasoline prices on the rise again, and consumption and income growing moderately at best, there’s little confidence for extrapolating today's numbers deep into the future.
“The consumer is not going to be able to lead the recovery,” says Ryan Sweet, a senior economist for Moody’s Analytics. “We’re headed into a few months of soft consumer spending. Even though gas prices look like they may be peaking for the year, that’s going to weigh on spending for the next month or so.”
Yes, it seems that the income and spending numbers for August dodged a bullet. But that’s still a long way from arguing that all’s well or that the next batch of data won’t bring negative surprises. That said, the consumer doesn’t appear to be intimidated, at least not yet. A measure of consumer sentiment (via the University of Michigan-Thomson Reuters index) jumped to 78.3 for September, up from 74.3 in August. There’s no shortage of things to worry about, but Joe Sixpack (rightly or wrongly) is keeping a stiff upper lip.
September 27, 2012
Contradiction Du Jour: Durable Goods Orders vs. Jobless Claims
There’s good news and bad news in today’s economic reports. In the labor market, initial jobless claims dropped a hefty 26,000 last week—the biggest weekly decline since July—to a seasonally adjusted 359,000. That leaves new filings for unemployment benefits close to the post-recession low of 352,000 from the week ending July 7. But this encouraging news is marred by a steep drop in durable goods order for August. Does one data set trump the other? That’s to be determined in the weeks ahead as more numbers roll in. Meantime, there are two newly minted data points to consider, each one contradicting the other in rather stark terms. The macro truth will out, and probably quite soon. Meantime, today's menu of statistics offer a choice: darkness or light.
Choose wisely, grasshopper... or perhaps not at all, at least not just yet. For perspective, let’s review how jobless claims stack up in recent history. As the first chart shows, last week’s substantial decline in new claims looks fairly decisive in terms of breaking the recent trend of moving sideways or inching higher. One week of data for this series doesn’t mean much, of course, but for the moment the case for optimism is a bit stronger.
Actually, one could reasonably argue that nothing much has changed for the trend in jobless claims, last week’s data point notwithstanding. As I regularly advise, the clearer analysis of jobless claims—an unusually noisy data set—typically arises from looking at year-over-year changes before seasonal adjustment. By that standard, the news is relatively upbeat, as it has been for most of the past 12 months, namely: claims continue to fall by roughly 10% a year. If and when the annual pace starts rising on a consistent basis vs. year-ago levels, we’ll have a dark signal to consider for the business cycle. At the moment, however, we’re nowhere near that turning point, which is to say that the labor market continues to heal, albeit slowly.
But all this happy talk is tarnished with the news that new orders for durable goods dropped 13.2% last month—the biggest monthly decline since January 2009, when the recession’s fury was still raging. There’s no way to sugarcoat this tumble, although it’s worth pointing out that most of the drop is due to the volatile transport industry. Durable goods orders ex-transport was still down last month, but by a considerably milder 1.6% fall.
Take note too that capital goods orders—a.k.a. business investment, or new durable goods orders less defense and aircraft—actually rose in August, climbing a moderate 1.2%. That's the first monthly gain since May. Hmmm....
But there’s no getting around the fact that the trend in new orders has turned negative. As the next chart shows, demand for durable goods is shrinking—for both the top line measure and for capital goods. That hasn’t happened in more than two years. It doesn’t help that today’s third revision of third-quarter real GDP fell to an annualized 1.3% rate, or down from the previous estimate of 1.7%. The slow recovery just got slower in broad terms, according to official numbers.
The critical question now: Will the weakness in durable goods orders spill over into the rest of the economy? Or is the drop in this series just short-term noise? It’s folly to dismiss the risk that today's numbers imply, but it’s also premature to conclude that the business cycle’s fate has been sealed. We’ll need to see more darkness in more data sets before issuing a call to man the cyclical lifeboats and evacuate the passengers. But the possibility of rough seas and worse looks somewhat more plausible—particularly if you ignore the jobless claims data, and quite a bit of the other numbers that collectively add up to the U.S. economy.
Nonetheless, we seem to be at another critical juncture. It's possible that we're being misled by the short-term noise. It wouldn't be the first time, and so it's important to maintain objectivity by looking at a broad cross section of the numbers. On that note, tomorrow we learn how personal income and spending fared in August. Once those numbers arrive, I'll update the Capital Spectator's Economic Trend Index and GDP nowcast for a fresh benchmark for evaluating how the outlook has changed. Stay tuned….
The New Abnormal Is Back (Actually, It Never Left)
Surprise, surprise—stocks and inflation expectations are down. Together. Again. Surprised? You shouldn't be. This abnormal relationship has prevailed for most of the past four years, from roughly that period of economic infamy when a certain investment bank was allowed to collapse and the linkage between markets and macro has been skewed ever since. I call this the new abnormal—the unusually high positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. Whatever you call it, it's still with us, and it's a sign that the crowd still craves higher inflation. That's likely to prevail until something approximating "normal" returns to the economic landscape. Meantime, the new abnormal rolls on.
The notion that the market's looking for higher inflation drives some pundits batty. But it's a prescription that the crowd prefers, at least for now. One reason: money demand is still too high—even after four years, as economist David Beckworth explains. Meantime, we're still in a world where equities and inflation expectations move in tandem.
David Glasner details the theory behind this connection—it's known as the Fisher effect. But theory and empirical fact aren't enough for some folks, who ignore the new abnormal entirely and prefer instead to talk about inflation risks as a real and present danger now, today, this minute. Eventually they'll be right, just as a broken clock tells the right time twice a day.
For now, the new abnormal is still with us until further notice. You can ignore it or accept it, but it's not going away until the economy moves closer to normality. Exactly when that will be is open for debate. But if some of the inflation hawks have their way on matters of the fiscal cliff, the day of macro salvation may be further out than you think.
September 26, 2012
Will The Recent Weakness In Capital Goods Orders Roll On?
If I had to choose one economic indicator that worries me the most, today, in the context of the business cycle, I’d probably choose the sharp decline in new orders tied to business investment—non-military capital goods excluding aircraft, as reported by the Census Bureau each month. Economists generally look to this series as a valuable clue for future economic activity. If so, the data is worrisome, given the recent weakness in demand for capital goods. But is spending on capital goods really a reliable indicator for estimating the business cycle?
“Shipments of nondefense capitals goods excluding aircraft can serve as a proxy for the level of total nonresidential business investment in the GDP report,” writes Bloomberg economist Richard Yamarone in the new edition of his book The Trader's Guide to Key Economic Indicators. Investment in capital “drives economic activity,” he explains. “Only when businesses are confident about the economic outlook and future demand will they make costly investments in new machinery and innovative processes.
In other words, weakness in capital spending may be a sign of trouble brewing for the overall economy down the road. With that in mind, here’s how new orders for capital investment (and orders for durable goods broadly defined) compare on a year-over-year basis for the last two decades:
As you can see, capital investment orders are down roughly 6% for July vs. the year-earlier level (red line). That’s the second negative reading in a row, and July’s descent is quite a bit lower than June’s 2% drop from the year-ago level. Another dark milestone: the 6% fall in new orders for capital investment is the biggest slump on an annual basis since the last recession ended in June 2009.
The August update is scheduled for release tomorrow morning at 8:30am eastern and the consensus forecast calls for another decline, according to Briefing.com. In other words, the annual rate of descent for capital goods spending looks set to go lower still, according to the consensus prediction. How much lower is anyone’s guess at this point, but for some context, let’s crunch the numbers using an ARIMA forecast for an econometric guess.1
The ARIMA model offers some relatively good news by estimating that capital goods orders will actually rise a bit in August vs. July (durable goods overall, however, will dip slightly in August). On a year-over-year basis, the estimate translates into a lesser rate of the decline rate for capital goods orders: less than a 1% drop for August vs. 12 months earlier. That would be an improvement compared to what we've seen lately. But all the usual caveats apply, starting with a fairly large confidence band around the point estimates that leave plenty of room for surprises. Par for the course in forecasting.
Turning back to the historical record, the numbers in the chart above suggest that a negative year-over-year reading in capital goods orders is suspect as a clear sign of business cycle trouble unless the overall trend for durable goods orders is also retreating on an annual basis. For the moment, July’s nearly 5% rise in durable goods orders compared with a year ago offers a welcome counterpoint to the red ink for capital goods orders.
Meantime, the weakness in capital goods orders hasn’t spilled over into the broader set of economic indicators, at least not yet, as I noted in last week’s update of the Capital Spectator Economic Trend Index (CS-ETI). To be fair, CS-ETI's trend has weakened a bit in August, echoing similar readings in other broad measures of the macro trend, such as the Chicago Fed National Activity Index.
It’s too early to jump to conclusions until we see darker numbers in more indicators. After tomorrow’s update on durable goods and jobless claims figures, plus Friday’s August report on personal income and spending, we’ll have a better sense of whether the recent drop in capital goods orders is a sign of things to come or just another batch of short-term noise.
September 25, 2012
Managing Revision Risk
The ongoing potential for data revisions to create chaos in the best-laid plans of analysis is no trivial matter. It’s a perennial challenge and one that requires constant attention. But it needn’t be fatal in the essential task of reading the numbers for clues about where the economy’s headed. There are no complete solutions, but there are techniques to keep this hazard from turning an otherwise reasonably designed forecast into trash.
One approach I use begins by recognizing that there can be a lot more noise in the short term numbers compared with longer-term data. For instance, if you’re analyzing private-sector non-farm payrolls for insight on the business cycle, the potential for getting whipsawed by revisions for, say, 3-month percentage changes can be quite high. That doesn't mean we should ignore shorter-term comparisons, but it's a mistake to rely on them alone.
Accordingly, we can manage revision risk to a degree by focusing on year-over-year changes as well, a technique that also minimizes seasonal distortions. If you’re comparing the latest data point to its counterpart from a year ago, the earlier number is less likely to be revised after 12 months. Even if it is, history shows that the differences between initial estimates and revisions tend to be less volatile through time vs. looking at shorter-term comparisons.
As an illustration, consider private nonfarm payrolls on rolling 3-month percentage-change basis. Let’s compare those changes in terms of the initially reported data (via the ALFRED database at the St. Louis Fed) and the revised data (as reported by FRED).
As you can see in the chart above, the difference between the initial estimate and its revision can be rather dramatic at times. In early 2010, for instance, the initial data was wildly misleading relative to the revised data that was reported later. Such differences tend to less extreme and therefore less troublesome in year-over-year comparisons, as the second chart below illustrates. Yes, revisions can be a minimal problem for short-term comparisons at times, but you never know when a big revision is going to hit you over the head.
The higher level of revision risk in the shorter term applies to many data series, which is why it's important to look at year-over-year changes to keep this problem from spinning out of control. It's not a perfect solution, however. Revisions still bedevil annual comparisons. That inspires adding another layer of defense by combining a carefully selected mix of indicators in order to keep a lid on the noise from any one set of numbers.
A third treatment for managing revision risk is looking at the aggregate of annual changes for a broad set of indicators through the filter of a diffusion index. In other words, focus on the binary signal of the indicators in terms of the annual trend: is the indicator rising or falling? Combining these signals into a single diffusion index, which is the basis for the Capital Spectator Economic Trend Index, provides a valuable signal for assessing the business cycle overall and estimating recession risk in particular.
To be sure, perfection still eludes us. It always does in matters of macro analysis, which is why it's critical to evaluate the business cycle from several perspectives, with different methodologies and different indicators. In sum, developing a solid read on the business cycle, which can only be estimated, takes a fair amount of work.
That said, the various risks that cloud our capacity for looking ahead aren't absolute, at least not always. There are usually partial solutions to consider. That's not always clear when some analysts talk of a given risk in the interest of rationalizing their forecast du jour. Yes, revisions can be a problem—a big problem if you're clueless. Fortunately, there are ways to deal with revisions to keep them from turning an otherwise reasonable forecast into garbage.
September 24, 2012
Chicago Fed: US Economy Weakned In August
U.S. economic momentum weakened in August, according to today’s update of the Chicago Fed National Activity Index (CFNAI), a weighted average of 85 indicators. But the weakness fell short of signaling that a recession started, a warning that requires a reading of -0.70 or below for the CFNAI’s three-month moving average. As of August, the index’s three-month average is -0.47, down from -0.27 in July. There's weakness in the trend, but it's not yet fatal.
Nonetheless, CFNAI’s decline isn’t easily dismissed these days. As the Chicago Fed advises in a press release today, the three-month reading for August is the “lowest level since June 2011 and its sixth consecutive reading below zero. August’s CFNAI-MA3 suggests that growth in national economic activity was below its historical trend.”
It’s been clear for several months that economic growth overall, while still positive, has retreated a bit recently, as noted in last week’s review of a broad range of leading and coincident indicators that comprise the Capital Spectator Economic Trend Index (CS-ETI). The in-house benchmark can be thought of as an early read on CFNAI's changes. In any case, the broad profile of macro data via CS-ETI implies that a recession didn’t begin last month. Why? There were too many indicators still trending positive (primarily on a year-over-year basis) to make a strong case that the cycle had slipped over the edge in August.
But the full set of August numbers isn’t yet complete, and there's the revision risk to consider. In addition, on Thursday we’ll learn how durable goods orders fared last month, and Friday brings word of personal income and spending for August. The consensus outlook via Briefing.com expects more weakness in durable goods while income and spending will continue to post moderate gains for August, according to economic forecasts. Once these numbers are released, I’ll post an update of my GDP nowcast for this year’s third quarter. The government’s first official estimate of Q3 GDP arrives on October 26. Meantime, my current nowcast for Q3 GDP is roughly 1.9%, or slightly above the current official estimate for Q2. A key issue for the week ahead: how will Friday’s income and spending numbers change the nowcast? Stay tuned.
The bigger question is where September’s data is headed in general? The major indicators for this month don’t start arriving until next week. But as today’s CFNAI news suggests, it’s getting harder to dismiss the idea that we may be at or near the tipping point for the economy. If the recent weakness extends into September on a broad basis, that would be a distressing sign. Even so, it’s going to take several weeks at a minimum before we can confidently distinguish between what may be noise vs. a clear sign that economic weakness will extend into the rest of the year. For now, the jury’s still out, although the case for optimism has deteriorated a bit in the last several weeks.
Yes, it may be put-up-or-shut-up time. As I've been discussing for months, the case for arguing that a recession had recently started or was imminent has looked overbaked, based on the numbers (see this post from June 2012, for instance, which reviews a precursor index to CS-ETI). Three months on, it's somewhat less compelling to maintain the same level of optimism. But it's still premature to argue that a new recession is fate, even though the trend isn't necessarily improving at this point. In any case, deeper perspective is coming as the updates roll in.
Tactical ETF Review: 9.24.2012
The global economy may be struggling, but bullish sentiment in the capital and commodity markets prevails. All the major asset classes via our list of ETF proxies are sitting on tidy gains over the last several weeks. Ditto for the year so far through September 21. Red ink, in other words, is nowhere in sight these days.
Momentum has the upper hand in nearly every corner, for now. Can it roll on? Yes, of course. But reversion to the mean has a habit of stealing momentum's thunder at times, and vice versa. How can we recognize when one is giving way to the other? Watching prices in relation to moving averages is one approach. But market action alone isn't everything. And there's that old problem of human error. The great challenge in financial and macro analysis is calling turning points in real time.
How to hedge this risk? If your asset allocation has dramatically changed this year, it's probably time to rebalance, if only modestly. No one likes to trim the winners and redeploy capital to the relative laggards, but history suggests a bit of contrarianism on the asset class level is the foundation for earning decent and probably above-average risk-adjusted performance through time. Alas, bucking the crowd almost always looks like a dog in the here and now. No wonder that only a minority of investors are able to take advantage of what some call the rebalancing bonus.
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
FOREIGN DEVELOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
FOREIGN GOVERNMENT INFLATION-LINKED BONDS • SPDR DB International Inflation-Protected Bond (WIP) •
Benchmark: DB Global Government ex-US Inflation-Linked Bond Capped
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
Charts courtesy of StockCharts.com
September 22, 2012
Book Bits | 9.22.2012
● Paying the Price: Ending the Great Recession and Beginning a New American Century
By Mark Zandi
Interview with author via Bloomberg TV (Sep 17)
U.S. Economy Doesn't Need More Stimulus, Zandi Says: Mark Zandi, chief economist at Moody's Analytics Inc., talks about federal stimulus programs and the impact on the U.S. economy. Zandi also discusses the U.S. budget deficit and Federal Reserve monetary policy. He speaks with Trish Regan on Bloomberg Television's "Street Smart."
● Automate This: How Algorithms Came to Rule Our World
By Christopher Steiner
Review via USA Today
Christopher Steiner's new book, Automate This: How Algorithms Came to Rule Our World, is a fascinating exploration of how the mathematics behind automated trading revolutionized business worldwide. But it is also a cautionary tale of how automated trading can get completely out of hand. As an example, he points to the "flash crash" of May 6, 2010. "At 2:42 PM on the East Coast, the markets began to shudder before dropping into a free fall. By 2:47 PM -- a mere 300 seconds later -- the Dow was down 998.5 points, easily the largest single-day drop in history. Nearly $1 trillion of wealth fell into the electronic ether." He continues, "Some share prices crashed to one penny -- as in $0.01 -- rendering billion-dollar companies worthless, only to bounce back to $30 or $40 in a few seconds. Other stocks swung wildly up. At one point, Apple traded at $100,000 a share (up from about $250). The market had been gripped with violent turbulence and nobody knew why."
● What's the Use of Economics: Teaching the Dismal Science after the Crisis
Edited by Diane Coyle
Summary via publisher, London Publishing Partnership
This book examines what economists need to bring to their jobs, and the way in which education in universities could be improved to fit graduates better for the real world. It is based on an international conference in February 2012, sponsored by the UK Government Economic Service and the Bank of England, which brought employers and academics together. Three themes emerged: the narrow range of skills and knowledge demonstrated by graduates; the need for reform of the content of the courses they are taught; and the barriers to curriculum reform.
● Free Market Revolution: How Ayn Rand's Ideas Can End Big Government
By Yaron Brook and Don Watkins
Q&A with co-author via Washington Times
Q: Today, many people tend to confuse the concepts of free markets, free trade, and fair trade with one another. How would you describe each?
Watkins: “Free markets” refer to the economy of a capitalist system. A market is free when the government outlaws force and fraud but otherwise leaves individuals free to produce and trade. In other words: no regulation, no wealth redistribution, just freedom.
“Free trade,” broadly speaking, is the activity that individuals engage in on a free market. In common usage, however, the term refers to measures that reduce or eliminate coercive restrictions on international trade, such as government-imposed tariffs, subsidies, and quotas.
“Fair trade” is an invalid term made up by those who want us to view free trade as unfair. But if fairness means justice, then free trade is fair trade. What could be more fair than an interaction that is voluntary and mutually beneficial? All of the actual problems and injustices commonly attributed to free trade are in fact the result of restrictions on freedom. The actual solution is more freedom—and not, as “fair trade” supporters advocate, less.
● The Financial Domino Effect: How to Profit Now in the Volatile Global Economy
By Ben Emons
Summary via publisher, McGraw-Hill
Originated during the Vietnam War era, the Domino Theory has been used to describe how political unrest becomes contagious, resulting in a chain reaction of events—events that the most knowledgeable and astute observers can predict. The Financial Domino Effect gives you the insight you need to spot political and financial events that signal an impending fall of dominoes—and use this knowledge to direct your investing decisions for maximum profit and minimum risk. The book covers the disintegration of the European Monetary Union, liquidity traps, financial repression, complacency, and debt dynamics.
● Intelligent Commodity Indexing: A Practical Guide to Investing in Commodities
By Robert Greer, Nic Johnson, and Mihir Worah
Summary via publisher, McGraw-Hill
In the mid-1970s, when Bob Greer scrolled through miles of microfilm in the basement of a public library in order to record commodity prices in his yellow legal pad, the idea of commodities being an investable asset class was way outside the mainstream. Now, it's a multibilliondollar vehicle for achieving portfolio diversification and inflation hedging--and he and his colleagues have written the book on earning better returns than the indexes themselves! In Intelligent Commodity Indexing, Bob joins his fellow leaders of PIMCO's Commodity Practice, Nic Johnson and Mihir Worah, in opening up commodity indexes. Never before has there been a more thorough explanation of how a commodity index works coupled with a powerful set of strategies for making it work for you.
● Regulating to Disaster: How Green Jobs Policies Are Damaging America's Economy
Review via The Weekly Standard
Diana Furchtgott-Roth, former chief economist at the Department of Labor and now a senior fellow at the Manhattan Institute (as well as a former colleague of mine at the Hudson Institute), likes to tilt at windmills, and in her latest book she has an opportunity to do so—and at actual windmills, no less.... She attempts, successfully, to show that the concept of “green jobs” is a fiction, that the 3.1 million such jobs the Obama administration claims to have created include a reclassification of employees at bicycle shops, drivers of hybrid buses, and manufacturers of paper cups with a “Save Energy” logo (but not of those without that imprint).
September 21, 2012
Expected Equilibrium Risk Premiums | 9.21.12
After asset allocation and rebalancing, one of the tasks on the short list of strategic-minded portfolio design and management is developing reasonable assumptions about risk premiums. In fact, all three are intimately linked. You can hardly make informed decisions about any one without spending some time analyzing the other two. Forecasting is challenging, of course, to say the least. But it’s also necessary and inevitable. Investing by nature is a process of making decisions about the future, and so the price of doing business in the money game is developing assumptions.
There are, of course, many ways to proceed. My preference is to begin by estimating equilibrium-based risk premia for all the major asset classes and my Global Market Index, or GMI (a passively weighted mix of all these asset classes). As I’ve written before, both on The Capital Spectator and in my book Dynamic Asset Allocation, this is a sound methodology for generating benchmarks for expectations. It’s not perfect, but nothing is. In any case, every thousand-mile journey starts with a first step, and this is a prudent way to put your foot forward while minimizing the potential for stumbling.
The basic idea is to reverse engineer expected risk premia by making assumptions about the overall market’s price of risk, the volatility of each asset class and the correlation matrix for all of the above.1 With that data in hand, we can estimate the implied risk premia.
The critical issue, of course, is developing respectable estimates for each of the inputs. Once again, there are numerous methodologies to consider. It seems prudent, however, to start with a basic, transparent approach, if only as a baseline.
For instance, let’s allow the data to “speak” to us for estimating the inputs in a rather intuitive way. For the market price of risk overall, I calculate the rolling 3-year annualized Sharpe ratio for GMI and then take the average of the annualized data as a long-term estimate for the future. I do the same to estimate volatility and correlation for each of the asset classes. Before we review what the numbers tell us, let’s take a brief tour of where we’ve been for some perspective.
First, here’s how GMI and the major asset classes stack up in terms of realized risk premia over the past 3- and 10-year periods (remember, here and throughout we’re referring to risk premia, or returns before adding in a “risk-free” rate, such as the yield on a 3-month T-bill):
Next, let’s compute realized Sharpe ratios in recent history for a simple comparison of risk-adjusted performance:
For a richer view of how risk premia have fluctuated, consider the graph below, which compares rolling 3-year annualized risk premia for GMI and U.S. stocks and bonds:
Now let’s look ahead by estimating equilibrium risk premia for the long-run future, which is computed for each asset class as follows:
Plugging in estimates based on the methodology outlined above dispenses the following:
What can you do with this information in the table above? You might start by considering if the expected risk premia are satisfactory or not. For instance, if GMI’s expected risk premia of 5.3% strikes you as insufficient for your financial objectives, you might consider how to engineer a higher rate of performance. One possibility: reweighting the major asset classes. GMI’s implied risk premia is based on a market-value weighted mix of the major asset classes. In theory, that’s the optimal asset allocation for the average investor with an infinite time horizon. Unless you’re a foundation or pension fund, that’s wildly impractical, of course, and so there’s a reasonable case for modifying Mr. Market’s asset allocation to suit your particular needs.
Along those lines, you might decide to leave off one or more asset classes. You might also estimate risk premia with alternative methodologies for additional insight about the near-term future. For instance, let’s say that you have a lot of confidence in the dividend-discount model (DDM) for predicting equity market performance over the next 3 to 5 years. After crunching the numbers, you find that DDM tells you that the stock market’s expected performance will be considerably higher than the equilibrium-based estimate for the long run. In that case, you have some tactical information. As such, you may decide to overweight equities relative to the market weight as a device to raise your portfolio’s expected return.
What you can’t do is get blood out of a stone. No one really knows what risk premia will be in the months and years ahead, which is why relying on forecasting alone (particularly for the short-term future) is asking for trouble. In other words, you should deviate from Mr. Market’s asset allocation carefully, thoughtfully, and for reasons other than assuming that you’re smarter than everyone else (i.e., the market).
That said, looking ahead by making assumptions about risk (as opposed to forecasting return directly) is a reasonable framework for developing intuition about the future. Forecasting risk isn't easy, but there's quite a lot of theoretical and empirical support for thinking that we can generate a better read on this data vs. trying to figure what performance will be. The real value here is less about any one round of estimating. A better approach is to routinely forecast risk premia and track how your expectations change through time. This will provide an additional layer of insight in the delicate art of formulating expectations for designing and managing portfolios.
It’s also important to keep in mind that relatively few investors end up adding value over GMI (or comparable portfolios) without taking on substantially more risk. Remember too that it's easy to assume more risk, but it doesn't easily translate into higher return. Even the pros tend to fall short overall vs. a simple multi-asset allocation strategy, as I discussed a few months ago. That’s not terribly surprising, but it offers essential guidance that should keep us wary in the matter of overconfidence.
Nonetheless, it’s important to run the numbers regularly and make a habit of looking forward in a systematic way using various methods. Mr. Market’s asset allocation isn’t likely to be ideal for many, if any, investors, which is why estimating risk premia is crucial. Indeed, everyone needs context for deciding how to customize the portfolio. But there are limits to our capacity to improve on a passive mix due to the one constant you can count on: uncertainty about the future. As a result, too much of a good thing on the analytical front can and does bite back at times.
1. ^ The original methodology for generating equilibrium expected returns was outlined by William Sharpe in “Imputing Expected Returns From Portfolio Composition,” Journal of Financial and Quantitative Analysis, June 1974. For a more recent treatment, see the "Reverse Optimization" section in Thomas Idzorek’s monograph via Morningstar.
September 20, 2012
Q3:2012 U.S. GDP Nowcast | +1.92% | 9.20.12
After today's update of jobless claims, The Capital Spectator's revised nowcast of third-quarter GDP slipped by the smallest of margins to real annualized growth of 1.92%. That's down ever so slightly from the previous 1.93% estimate. Once again, it adds up to effectively no change, which is a clue for thinking that the outlook for sluggish growth rolls on. That said, the current nowcast still represents a small improvement over the 1.7% growth rate for Q2, as reported by the Bureau of Economic Analysis.
The current nowcast incorporates today's update on jobless claims for last week, along with data through yesterday on the three market indicators in our nowcast GDP model: the stock market, oil prices, and the Treasury yield spread for the 10-year Note less the 3-month T-bill. (For a list of the model's 10 factors and a briefing on the methodology, see this post; for a look at the model's in-sample history, click here.)
Here's how the latest nowcast compares with officially reported GDP data in recent history:
And here's the evolution of the Q3:2012 U.S. GDP nowcast since the model's launch earlier this month:
The official Q3:2012 GDP report is scheduled for release on October 26.
Are Jobless Claims Treading Water Again?
New filings for jobless benefits slipped a bit last week, but the bigger story is that new claims appear to be stuck in neutral again. It’s hard to say for sure, however, since the weekly numbers are quite noisy. But if the last few months are an indication, progress in paring claims has slowed to a crawl if not ceased altogether. Even so, it’s too soon to assume the worst: the year-over-year change in unadjusted claims is still falling.
Let’s back up a minute and consider today’s news. New claims fell 3,000 to a seasonally adjusted 382,000 last week. That’s near the highest levels since May and quite a move up from the post-recession low mark of 352,000 in July 2012.
The annual percentage change in unadjusted claims provides a clearer read on the trend, however, and by that measure there’s still a decent signal of progress in the data. New claims last week were a bit more than 7% below the year-earlier level. That’s leaning toward the upper range of the annual pace of decline lately, but it’s still a respectable fall… if we can keep it.
But let’s not jump the gun here. When and if jobless claims—a key leading indicator—are flashing red, it won’t be a gray area. Yes, the expansion’s momentum has weakened lately (see our Economic Trend update from earlier this week, for example). For now, however, the numbers still don’t look ominous overall. A bit worrisome, perhaps, but still well short of acute in terms of slipping over the edge. New, unadjusted claims continue to retreat on an annual basis, a measure that strips out the seasonal and short-term distortions that can and do mislead us. Until we see this indicator's annual change consistently move closer to zero and above, it’s premature to read too much into the last few weekly data points.
"We've seen a little move upward in jobless claims over the last few weeks, but nothing to suggest the economy is in trouble, Gary Thayer, chief macro strategist at Wells Fargo Advisors, tells Reuters. “It's more the case that we are still in a period of slow growth."
Keep in mind too that weekly claims have suffered a dry spell before without leading to a recession. Not surprisingly, in those cases when the weekly data was stagnating (late-2010, early 2011, for example), the economy continued to expand. In fact, there was a good reason for expecting no less back in late-2010/early 2011 via the ongoing drop year-over-year drop in new claims.
When there’s a clear and conspicuous change in the trend, revealed by jobless claims and other indicators, you’ll read it about here. That’s not to say that all’s well, or that there’s a high confidence that the economy will keep growing over the next six months or a year. But we shouldn't go off the deep end in searching for trouble either. When the warning bells are ringing loudly, the shift in the cycle's direction will be obvious, or at least substantially more compelling than what we're seeing today.
In short, don't confuse cloudy weather with a hurricane. The former may lead to the latter, but you need more than a hunch to know when the risk is truly rising.
September 19, 2012
Q3:2012 U.S. GDP Nowcast | +1.93% | 9.19.12
The Capital Spectator's latest nowcast of third-quarter GDP pares the outlook ever so slightly to real annualized growth of 1.93%, or down a touch from the previous 1.95% estimate. That's effectively no change from the earlier nowcast, which implies that the outlook for the economy remains in a holding pattern of sluggish growth. That said, the current nowcast represents a small improvement over the 1.7% growth rate for Q2, as reported by the Bureau of Economic Analysis.
The current nowcast incorporates today's update on housing data for August, along with fresh numbers through yesterday on the three market factors in our nowcast GDP model: the stock market, oil prices, and the Treasury yield spread for the 10-year Note less the 3-month T-bill. (For a list of the model's 10 factors and a briefing on the methodology, see this post. For a look at the model's in-sample history, click here.)
Here's how the latest nowcast compares with officially reported GDP data in recent history:
Here's how the Q3:2012 U.S. GDP nowcast has evolved since the model's launch earlier this month:
The official Q3:2012 GDP report is scheduled for release on October 26.
Housing Starts Rise In August As New Building Permits Slip
The housing recovery was a bit sluggish in August, although perhaps today’s monthly update is more noise than signal. Nonetheless, the latest residential construction figures from the Census Bureau are a mixed bag: newly issued building permits for housing retreated modestly (-1.0%) in August vs. July while new housing starts in August rose 2.3% over the previous month. It’s not a terribly encouraging batch of numbers, but it doesn’t look especially troubling either. But if we strip away the short-term changes and focus on the annual trend, the numbers still suggest growth will prevail in the months ahead.
For some perspective, let's start by looking at the monthly stats in recent history:
The trend looks somewhat better with the year-over-year percentage changes:
The housing recovery, which started to resonate back in December, still appears to have some legs, or so the annual pace implies. With starts and permits continuing to increase in excess of 20% vs. year-earlier levels, it’s hardly convincing to argue that the August numbers alone are a sign of trouble. If future updates show permits and starts flat-lining or worse, month after month, well, that's a different story.
Meantime, it’s no trivial factor that mortgage rates are at or near all-time lows. The combination of lower prices for houses and a high degree of financing affordability are “actually quite favorable right now,” Jim O’Sullivan, chief U.S. economist for High Frequency Economics, tells Bloomberg. “There’s a lot of room for housing to go up over the next few years.”
For the moment, that’s still a reasonable forecast. The population keeps growing and quite a lot of the excess has been purged in the home-building industry. As a result, the revival of late is partly fueled by simple supply and demand factors. Even so, it wouldn’t be surprising to see the rate of growth in starts and permits slow in the months to come. Expecting something more ominous can’t be ruled out entirely, but a darker outlook doesn’t have much quantitative support at this point.
Consider, for instance, yesterday’s upbeat news on builder confidence:
Builder confidence in the market for newly built, single-family homes rose for a fifth consecutive month in September to a level of 40 on the National Association of Home Builders/Wells Fargo Housing Market Index (HMI), released today. This latest three-point gain brings the index to its highest reading since June of 2006.
“This fifth consecutive month of improvement in builder confidence provides further assurance that the housing market is moving in a positive direction, but there’s still a long way to go on the road to recovery and several obstacles are slowing our progress,” said NAHB Chairman Barry Rutenberg, a home builder from Gainesville, Fla. “In particular, unnecessarily tight credit conditions are preventing many builders from putting crews back to work – which would create needed jobs -- and discouraging consumers from pursuing a new-home purchase.”
The more impressive gains in the housing market’s recovery may be behind us, but the recovery, perhaps downshifting a bit, is still with us. Overall, that's a positive for the economy, considering the housing market's influence. At the very least, housing (until further notice) is no longer a drag on macro conditions. That's hardly the last word on looking ahead for the broader economy, but it's one more plus in the positive column of variables.
September 18, 2012
U.S. Economic Trend Update | 9.18.12
Several analysts are warning (again) that we’re in a recession now, today, this minute. They may be right, or not. It’s hard to say for sure, of course, because we have minimal economic data about what’s happening now, today, this minute. Septermber's economic profile, in other words, remains a mystery for the most part for a few weeks longer. But we do have most of the data through August, and it’s always worthwhile to review a broad measure of the numbers as a benchmark for thinking about where we've been in the business cycle, and where we seem to be headed.
Tallying up the stats so far suggests that recession risk was still low for August. That’s based on updates for 13 of the 17 indicators that comprise our Economic Trend Index, a collection of leading and coincident variables that have a reasonably good record overall for quantifying the ebb and flow of the business cycle. There are signs of weakening in the last two months, but it’s not yet clear if this is short-term noise or the start of something more ominous. We'll have a better read on what's happening in a few weeks. Meantime, for some perspective of what we know today, let’s turn to the numbers proper.
As the table below shows, the warning signs are still in the minority. Several data points for August are still missing and so it’s possible that the incidence of red ink may rise on the ledger below. But for the moment, the case for arguing that August slipped over the cyclical edge still looks fairly weak.
For a review of how our 17 indicators compare through the decades with the arrival of recessions, consider the next chart, which tracks a 3-month moving average of the monthly data listed in the table above to smooth the short-term volatility. History suggests that when the risk of a new slump is high, the percentage of these indicators trending positive (on a trailing 3-month basis) will be falling persistently. As a rough guide, when we slip under the 60% mark, that’s a strong warning sign; if the tumble takes us below 50%, well, it’s a virtual certainty that a new recession has started.
But with the August reading at roughly 78%, there’s still a fairly large comfort zone for debating if growth is dead. Yes, the August reading is down a bit from July, which is down slightly from June, but it’s premature to assume that the cycle’s fate has been sealed. To be sure, revisions may further lower the readings for July and August. But it's unlikely that we'll see sufficiently negative revisions that show clear signs that a recession started in the recent past.
For some guidance on where we may be going, let’s turn to ARIMA forecasts for each of the 17 indicators and then aggregate the individual predictions for a read on where our trend index may be headed in the near-term future.1 Any one forecast is likely to suffer error, of course, but predicting all 17 indicators in a robust econometric framework will minimize the risk a bit. With that in mind, the next chart suggests that the trend is set to weaken further in the months ahead, if only slightly. That's a sign that we should manage our expectations for the economy, but it's still well short of an argument for expecting the worst.
Deciding if the recent wobbles in the economic trend is a sign of deeper trouble, or just more noise, is still the great unknown at the moment. Some economists insist that the die is cast and so the cycle is destined to fall into darkness. Maybe, but if that’s true we’ll soon see more convincing evidence in the numbers. As usual, a fresh batch of data is on its way. Meantime, there’s still a case for expecting slow growth until the economic and financial indicators tell us otherwise.
September 17, 2012
Q3:2012 U.S. GDP Nowcast Update | 9.17.12
Friday's update on industrial production and retail sales for August, along with the ongoing changes in the market indicators, provides an opportunity to run fresh numbers on the Capital Spectator's 10-factor GDP nowcast (see this post for an overview of the methodology).1 The current nowcast anticipates Q3:2012 GDP rising at nearly 2.0% in real annualized terms—down from the previous +2.3% nowcast. (The government's first estimate of Q3 GDP is scheduled for release on October 26.)
For the moment, the current nowcast still represents improvement over the official 1.7% real annualized growth rate for the second quarter. The key question: Will the nowcast continue slipping between now and the scheduled release of the official Q3 estimate next month? The answer, of course, depends on the data updates in the weeks ahead. Meantime, cautious optimism prevails, but there's a lot of data to digest between today and the end of October. If the nowcast falls further in the updates to come, that would be a worrisome signal.
Here's where we stand today: A nowcast for the third quarter that's above the previous published growth rate:
But the combination of updates in the economic and market factors over the past week has pared the outlook.
It's likely that we'll see further declines in the nowcast as we move closer to the official release of the Q3 estimate from the Bureau of Economic Analysis. The economy isn't strong enough to inspire expectations that a substantial upturn in the growth rate. But it's also premature to rule out a Q3 that more or less matches the pace in Q2.
Predicting is risky business, however, and so the main value of nowcasting (computing a series of forecasts as new data arrives) is providing a benchmark on the directional trend of estimates through time. In theory, a robust model will become more accurate as the release date of the data point in question approaches. Why? Because the model will process more timely data that influences the number we're trying to forecast. On the eve of the Q3 GDP report, forecasting that number should be relatively easier vs. forecasting two months in advance.
It's important to keep in mind that every prediction model will suffer the indignity of error. That's simply the cost of doing business when uncertainty about the future dominates. But within that broad caveat lies quite a lot of variation. As for the Capital Spectator's model, here's a brief look at how it stacks up in terms of its in-sample history.
As the chart above shows, the nowcast (the red bars) has provided a reasonable benchmark of the actual GDP data. It's hardly perfect, but nothing is in the precarious realm of forecasting. The next chart looks at the same in-sample prediction record going back to the early 1970s.
Eyeballing the track record can only tell you so much. For a quantitative assessment of the model's record, I analyzed the nowcasting history from several statistical perspectives in the software R. The basic result: the numbers are encouraging. For instance, I compared the model with an ARIMA forecast that's optimized for the GDP data set (to be precise: ARIMA (2, 1, 0) with drift). The Capital Spectator's model suffered a moderately lower root-mean-square error (RMSE) rating vs. the ARIMA model (40.2 vs. 59.3), which means that the nowcast errors were lower by about one-third. (The errors here are defined as the dollar amount of deviation, in billions, from the actual GDP data.) I also compared the model against a naïve forecast, which is simply assuming that the previous quarter's GDP will repeat in the next quarter. Not surprisingly, the naïve prediction's RMSE was higher still: 87.1
Although the GDP nowcasting model looks relatively robust on these and other tests in terms of its in-sample history, the true test is how it performs on an out-of-sample basis. In other words, the model's performance in the run-up to the next release of GDP data is the only test that matters. Perfect accuracy, of course, isn't possible. Instead, I'm looking for a benchmark that, through time, offers guidance on thinking about the next GDP report. In particular, I'll be closely watching the evolution of the nowcasts between now and the official publication of the Q3 GDP report. Are the updates rising, falling, or holding steady? Stay tuned….
1. Although real personal consumption expenditures is one of the nowcast model factors, real retail sales is available earlier and so it's used as a proxy each month until updated PCE data is published. ^
September 15, 2012
Book Bits | 9.15.2012
● The Value Investors: Lessons from the World's Top Fund Managers
By Ronald Chan
Summary via publisher, Wiley
Investing legend Warren Buffett once said that “success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” In an attempt to understand exactly what kind of temperament Buffett was talking about, Ronald W. Chan interviewed 12 value-investing legends from around the world, learning how their personal background, culture, and life experiences have shaped their investment mindset and strategy. The Value Investors: Lessons from the World’s Top Fund Managers is the result. From 106-year-old Irving Kahn, who worked closely with “father of value investing” Benjamin Graham and remains active today, and 95-year-old Walter Schloss (described by Warren Buffett as the “super-investor from Graham-and-Dodsville”), to the co-founders of Hong Kong-based Value Partners, Cheah Cheng Hye and V-Nee Yeh, and Francisco García Paramés of Spain’s Bestinver Asset Management, Chan chose investment luminaries to help him understand the international appeal – and success – of value investing. All of these men became strong advocates of the approach despite considerable age and cultural differences. Chan finds out why.
● The Measure of a Nation: How to Regain America's Competitive Edge and Boost Our Global Standing
By Howard Steven Friedman
Review via Examiner.com
The prose—simple, largely matter-of-fact and boldly stated—is not what makes The Measure a compelling read. The spare literary device may actually be one of the more compelling aspects of the book, which reduces it heft to an easily digested 226 pages liberally interspersed with graphic visualization of the points made. What makes the book compelling is the sense many have that America is losing its competitive edge in a global economy at a time economic collapse. Essentially, Friedman—who is a prominent American statistician, health economist, writer poet and artist is currently employed at the United Nations Population Fund, and as an adjunct Associate Professor at Columbia—has done what Adam Smith did for The Wealth of Nations to outline those attributes that contribute to the greatness of nations when measured against the performance in the global marketplace.
● Advanced Technical Analysis of ETFs: Strategies and Market Psychology for Serious Traders
By Deron Wagner and Ed Balog
Excerpt via publisher, Wiley
In our first ETF book, Trading ETFs: Gaining an Edge with Technical Analysis, we focused on the use of very basic technical indicators including trend lines, moving averages, support and resistance levels, volume, and price action (swing highs and swing lows).Although it is not necessary, you mayfind it useful to read that book because it lays the groundwork for the advanced technical strategies covered in this book.
In this follow-up book, we will introduce several new technical indicators and strategies that enhance the effectiveness of our proven “top-down” trading strategy detailed in the last book. While the merits of our initial top-down strategy can certainly stand alone, applying additional technical indicators, strategies, and concepts only serves to improve the profitability of ETF traders.
● The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything
By Jason Kelly
Video interview with author via Yahoo Finance
In the accompanying video, I discuss the state of the industry with Jason Kelly, a Bloomberg reporter and author of The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything. Thanks to Mitt Romney's run for the White House, private equity has come under intense scrutiny. Kelly says the industry's track record is much more complicated than is commonly portrayed. "Romney made it very much about jobs," but most private equity firms "never set out to be about jobs," Kelly says. "Private equity guys say 'we do sometimes [create jobs], sometimes we don't. It's not really what we set out to do.'" What is clear is that when private equity firms get involved "it does tend to have an impact on workers," he says. "Things are going to change if a private equity company buys the firm you work for. They don't tend to do nothing."
● Guesstimation 2.0: Solving Today's Problems on the Back of a Napkin
By Lawrence Weinstein
Summary via publisher, Princeton University Press
Guesstimation 2.0 reveals the simple and effective techniques needed to estimate virtually anything--quickly--and illustrates them using an eclectic array of problems. A stimulating follow-up to Guesstimation, this is the must-have book for anyone preparing for a job interview in technology or finance, where more and more leading businesses test applicants using estimation questions just like these. The ability to guesstimate on your feet is an essential skill to have in today's world, whether you're trying to distinguish between a billion-dollar subsidy and a trillion-dollar stimulus, a megawatt wind turbine and a gigawatt nuclear plant, or parts-per-million and parts-per-billion contaminants. Lawrence Weinstein begins with a concise tutorial on how to solve these kinds of order of magnitude problems, and then invites readers to have a go themselves. The book features dozens of problems along with helpful hints and easy-to-understand solutions. It also includes appendixes containing useful formulas and more.
● The Digital Flood: The Diffusion of Information Technology Across the U.S., Europe, and Asia
By James Cortada
Summary via publisher, Oxford University Press
No technology seems to have spread so fast around the world in such a short period of time as computers. It was a phenomenon that predated the arrival of the Internet and that began to change how businesses, governments, and whole societies functioned. The diffusion of information technologies occurred in dozens of countries all over the world with fascinating similarities and differences. In this book, historian James W. Cortada provides the first world-wide history of how computers appeared and were used in North America, all of Europe, and in most of Asia in barely a half century. He explores the causes of diffusion, arguing that more than the technology itself, other conditions were required for the spread of computers, such as standards of living, education, the Cold War, and globalization of the economy. He argues that these technologies are the glue that hold together today's economies and are propelling increases in the quality of life of over a billion people moving into the middle class.
● Exchange Rate Regimes in the Modern Era
By Michael W. Klein and Jay C. Shambaugh
Excerpt via publisher, MIT Press
The dollar–euro exchange rate, perhaps ‘‘the world’s single most important price,’’ is determined by market forces, and changes day to day, and even minute to minute. In contrast, each of the countries of the European Union that uses the euro as its national currency experiences no exchange rate changes with the other members of the eurozone because they share a common currency. Why is it that the United States allows its currency to float, while Germany, France, and the other members of the eurozone have abandoned their national currencies and, effectively, have set a fixed exchange rate across Europe? Similarly, why does the government of China fix the value of its yuan to the US dollar, while the world foreign exchange market determines the daily value of the Brazilian real? The overarching policy of the government toward the exchange rate—to allow it to float or instead to fix or peg its value to another currency—is called the exchange rate regime. What are the economic and political implications of these different exchange rate regimes for these nations?
September 14, 2012
Retail Sales Strengthen In August As Industrial Production Slumps
Retail sales continued to rebound in August, the Census Bureau reports. Industrial production, however, tumbled sharply last month—the most, in fact, since 2009. But Hurricane Isaac may be to blame for most of the weakness in industrial production, according to today’s update from the Federal Reserve. If so, the strong report for consumer spending in August offers a clearer profile of the general trend last month.
Let’s take a closer look at both indicators. First up: retail sales. As the chart below shows, consumer spending rose 0.9% last month—the biggest monthly rise since February.
More importantly, the year-over-year percentage change in retail sales continues to rise. In the next chart, it’s clear that the trend is improving. For the second month in a row, the annual pace of spending increased, climbing to 4.7% vs. the year-earlier level. Fears that consumption is about to collapse look a bit more overbaked with today’s data in hand.
Some pessimists may be quick to point out that gasoline sales also surged last month, thanks to higher prices at the pump. In turn, that raises questions about what’s really behind the gains in retail sales. But that’s a straw man for analyzing August: After stripping out gasoline sales from the top-line number, retail sales were still up 5% on an annual basis in August--a modest improvement over July’s tidy 4.7% year-over-year change ex-gasoline.
Auto sales, which are notoriously volatile in the short term, were also strong last month. Is this corner artificially skewing the headline results? No. Reviewing consumption ex-motor vehicle and parts data doesn’t change the big picture either. Retail sales less autos rose 0.8% in August, or just below the headline 0.9% increase for the month. More importantly, the annual change in retail sales less autos improved in August, rising 3.4% from the year-earlier level--up from July’s annual increase of 3.2%.
Overall, the August retail sales report is encouraging. Industrial production, however, is another matter, thanks to the sharp 1.2% drop last month. But the Fed advises that “Hurricane Isaac restrained output in the Gulf Coast region at the end of August, reducing the rate of change in total industrial production by an estimated 0.3 percentage point.” Nonetheless, August’s decline is quite striking relative to recent history, as the next chart shows. It's also quite disturbing--if this weakness rolls on.
How has August’s slump affected the annual trend for industrial production? It’s taken a toll, of course, but only modestly. Industrial production still managed to rise by 2.8% in August vs. a year ago. That’s a decent growth rate, as the final chart below reminds. The question, of course, is whether it can hold?
It remains to be seen if last month’s weakness in industrial production is merely a temporary setback related to Issac vs. an early warning of something more ominous brewing. We'll know the answer soon. If industrial production's annual pace weakens further in the months ahead, we'll have a genuine warning signal on our hands. Given the potential for storm-related mischief in August, however, it's premature to say if last month is true clue of what's to come. In fact, given today’s robust retail sales report, the worst you can say about today's numbers is that the jury’s still out.
As for clear and obvious signs that the economy’s caving, there’s nothing in today’s to feed that beast in the data du jour. Cautious optimism is still the path of least resistance based on the numbers release for August so far. That's been the message all along when you take a broad read of the economy's various indicators. Yes, it’s still a precarious expansion, but that's the point: it’s still an expansion. The numbers may tell us different in the days and weeks ahead, but considering what we know so far, it’s still hard to argue that the business cycle has slipped over the edge.
A New Round Of Fed Stimulus & The New Abnormal
Yesterday's announcement by the Federal Reserve that it will embark on a new and open-ended bond-buying program until job growth is stronger has many implications for the markets and the economy. One is deciding what the latest chapter in monetary stimulus means for the new abnormal.
That's my phrase for the unusually high positive correlation between changes in the stock market and inflation expectations, as defined by the 10-year Treasury’s yield less its inflation-indexed counterpart. Higher inflation doesn’t normally correlate tightly with equity buying, but the standard relationship was turned on its head after the financial crisis in late-2008 and the Great Recession. The positive link between the market’s inflation outlook and the stock market is abnormal in the grand scheme of history, but it rolls until the economy returns to something approximating a “normal” state. (For the theory behind the empirical fact of late that binds the equity market with the inflation forecast, see David Glasner's research paper on the so-called Fisher effect.)
At some point, the new abnormal will die an ignominious death, but there's no sign in the latest numbers that mortality is near. As the chart below shows, the stock market (S&P 500) and inflation expectations have taken wing lately, moving in virtual lockstep once more. The S&P has again risen above 1400 in recent weeks and the market's outlook for inflation has climbed to 2.47% as of yesterday, based on the yield spread between the nominal and inflation-indexed 10-year Treasury notes.
That's the highest level for the inflation outlook since May 2011 and Mr. Market is clearly ecstatic. Par for the course in the new abnormal. Rising inflation expectations will eventuallyl be a problem for equities. But based on Mr. Bernanke's comments yesterday, it seems that abnormality will be with us for some time. The stock market, at least, is on board with that view.
September 13, 2012
Jobless Claims Rose Last Week, But The Annual Trend Is Still Encouraging
Initial jobless claims rose 15,000 last week to a seasonally adjusted 382,000--the highest since July. But the Labor Department advises “that several states have reported increases in initial claims (approximately 9,000 in total) for the week ending September 8, 2012 , as a result of Tropical Storm Issac.” Does that mean that last week’s rise is temporarily skewed with storm-related noise? Possibly, although only time will tell. Meantime, one reason for thinking positively: the unadjusted claims data on a year-over-year basis is still falling by 10% as of last week, a rate that’s in line with recent history. That’s a sign that it’s premature to read too much into last week’s seasonally adjusted jump.
Putting the potential for statistical mischief via Ivan aside for a moment, let’s review how the seasonally adjusted history stacks up with last week’s data point:
Even if the latest pop reflects deeper trouble in the labor market beyond Issac’s nefarious influence, the worst you can say of the seasonally adjusted weekly numbers of late is that they're treading water. That’s hardly productive at a time of sluggish growth overall, but it’s still well short of a smoking gun for arguing that the labor market’s growth phase is dead. Even if you think otherwise, we should still be suspicious of the last several data points for this volatile series. The tendency for being mislead is high with weekly claims when we focus on the last several weeks.
A clearer picture of the true trend for initial claims can be found in the annual percentage changes of the raw numbers—before seasonal adjustment. By that benchmark, not much has changed with today’s update, which is a good thing. As the next chart reminds, new claims continued to fall last week by roughly 10% a year. That’s generally in line with the track record over the past 12 months, and overall it’s a healthy trend—if it continues.
When the tide truly turns to darkness for the business cycle, as it one day will, history implies that it’s likely that we’ll see a warning sign relatively early via increases in the year-over-year percentage change in claims data, in both the seasonally adjusted and unadjusted numbers. For now, however, claims continue to retreat each week relative to a year ago. That suggests that the labor market’s expansion, modest though it is, hasn’t yet run out of steam.
September 12, 2012
Is The Decline In Positive Payrolls Revisions A Warning Sign?
Most economic reports should come with a warning: the data is subject to revision. Today's glowing number that's the toast of the punditocracy is tomorrow's statistical detritus. But if the world is always eager to move on to the next number du jour, and forget yesterday's news, informed analysts recognize that monitoring the initial estimates of a data series, and tracking its path through time, offers another layer of intelligence. For example, a recent study by the Philadelphia Fed found a "small positive (but statistically significant) association between the revision to job gains and the level of job gains."
With that in mind, let's review the trend in revisions for private nonfarm payrolls through the decades, courtesy of the St. Louis Fed's archival database (ALFRED). Specifically, I'm looking at the monthly revision as defined by last reported number (the final data point in most cases other than for the last several months) less the initially reported estimate. The chart below tracks this monthly difference since the early 1970s.
As you might expect, positive revisions tend to be associated with periods of economic growth. But it's not a hard-and-fast rule. Sometimes the changes are negative (revisions are lower than the initial estimates) and the economy is expanding, although this condition tends to prevail in the early stages after a recession has ended.
The question these days is whether the recent fade in positive revisions is a sign of trouble for the business cycle? For a better view of what's been happening lately, the next chart summarizes the last 12 months.
It's clear that the strong run of positively revised estimates for private payrolls has dried up lately. The average revision for the six months through July (we don't yet know how August's initial estimate will change) is a slim +21,000. By comparison, the six-month average through February 2012 was a dramatically higher +219,000.
How should we interpret the recent stumble in revisions? History suggests trouble ahead for the economy if the monthly updates turn significantly lower than the initial estimates in the months ahead. That alone wouldn't be enough to generate a reliable recession warning, but it wouldn't help either.
You still can't tell much from cherry-picking the data in search of deeper insight about the broad trend in the economy. Context and perspective, by analyzing a broad spectrum of indicators, is essential. In other words, darker signals from payrolls revisions may, or may not be, a smoking gun. Much depends on how the numbers look overall. On that note, the trend signals from most other key indicators remain positive, based on the latest data through July. August is a mixed bag so far, but we only have a few numbers at this point. But if a tipping point awaits in the near future, it'll be obvious in the numbers, including revisions to payrolls.
Correction: Previous versions of the two charts above included titles that reversed the order of the differencing between revised and initial data for employment. The corrected charts now include titles that reflect the data: revised payrolls estimates less initially reported data. Sorry for the confusion.
September 11, 2012
It's The Government's Shrinking Payrolls, Stupid
Mark Perry, an economics professor at the University of Michigan, writes that the weak labor market "can be traced to the biggest loss of government jobs since WWII." The evidence is certainly damning if we compare government payrolls with private payrolls, which have been rising at nearly 2% a year over the past two years.
Perry crunches the numbers and finds that
the contraction of government jobs starting in 2009 (almost 700,000 through August) is the largest contraction in public sector jobs since the 1945-1947 period following WWII when government jobs contracted by 770,000 jobs, and almost twice the 392,000 government jobs lost in 1981-1982.
Comparing the numbers for the past five years on the basis of the annual percentage change clearly shows that government payrolls are indeed shrinking these days.
Once we add private payrolls to the chart, the difference becomes obvious. In the next chart below, private employment (the yellow line using the left scale) has been consistently advancing by ~2% a year over the past 24 months. By contrast, federal, state and local government jobs have been shrinking recently. (The spike in Federal employment in 2010, by the way, was due to the temporary hiring of workers linked to the decennial census.)
How does the 1.8% annual rise in private jobs in August compare with history? It depends on the historical period you choose, of course. Relative to the best annual rate during the years just before the 2008 financial crisis, 1.8% looks pretty good. The fastest annual rate of private employment growth was in March 2006, when jobs growth peaked at 2.4%. But it's another story if we take a longer view. Compared with the broad sweep of history, going back to the 1940s, 2% job growth looks like weak tea. In the late-1970s, for instance, the private sector was minting new jobs at roughly a 5% annual rate for a sustained period. And for much of the 1990s, 2% to 4% year-over-year growth was typical.
It's clear that private sector employment growth has slowed in historical terms. That was obvious before the Great Recession. That's a problem, of course, and one that's being exacerbated by an across-the-board decline in government employment.
Politics ultimately infects the analysis these days, but it's hard to argue with the numbers. Perry sums up the situation: "Private sector jobs have been increasing at 91,000 per month since the recession ended in June 2009. Government jobs have contracting by 18,000 per month on average over that period, which is bringing down the overall monthly job increases to only 74,000 on average."
We can debate the finer points of whether the shrinking payrolls in government is productive or part of the problem, but let's at least recognize the facts as reported. Unfortunately, even that basic standard is too high for some folks. Yes, we need to promote policies that will enhance private sector job growth. The question is whether cutting government jobs further in the here and now will advance this cause?
September 10, 2012
A Model For GDP Forecasting
The government's first estimate of the nation's economic growth for the third quarter doesn't hit the streets until October 26. Meantime, the burning question: Does the sluggish 1.7% annualized pace in Q2 for GDP imply more of the same during for Q3? Or will see a stronger reading in the next quarterly report? The world is awash in guesses, and now there's one more. Today marks the start of a new feature on The Capital Spectator: a regularly updated "nowcast" of the next quarter's GDP using standard econometric techniques.
I call it nowcasting because as the variables behind the forecast are updated, the forecast will be revised too.. Over time, I'll publish a chart that compares the evolving forecasts in real time relative to the actual data and so you'll be able to see for yourself how the forecasts compare with reality.
There's more to evaluating the economy than dissecting GDP, of course. But as the broadest measure of U.S. economic conditions in a single data point, and one that receives a fair amount of attention, it's only natural to develop a statistically robust estimate of this influential number for the period ahead. Like every other economic report, GDP should be considered in context with a range of indicators. But the case for starting with this metric has obvious appeal. It's only a beginning, however. In the weeks ahead, I'll introduce a broader suite of data estimates for developing additional perspective on risk premia and the broad economic trend. But I'm getting ahead of myself.
The Capital Spectator's model currently projects a 2.3% real annualized growth for GDP in Q3, up moderately from Q2's 1.7% rise. The forecast draws on analyzing the last 40 years for relationships among individual factors in terms of how it correlates with quarterly GDP changes. The model uses that historical relationship for making predictions, based on the latest data points for each of the underlying variables. I'll get into a few of the details of how the model works, but first some graphical perspective on how the forecast stacks up vs. recent history:
In other words, the model's predicting an improvement in economic growth relative to the last published report for Q2. What's behind this forecast? The engine is a multiple regression of the quarterly percentage changes in GDP with the changes in 10 key economic and financial variables:
• nonfarm private payrolls
• real personal income excluding current transfer receipts
• real personal consumption expenditures
• industrial production
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
Each of these data series plays a role in economic growth, or the lack thereof, of course. If we're looking to model the ebb and flow of the economy, the 10 indicators above are a reasonable short list. For running the regressions and estimating the coefficients, I used the historical period 1971 through the present. As a complete set of quarterly data becomes available, I'll re-estimate the relationships, although the changes will likely be small from quarter to quarter.
There are, obviously, many more indicators to consider. Alternatively, one could argue that a shorter list is a better way to go. The search for the optimal tradeoff of parsimony vs. a richer read on the economy is a struggle with no obvious answer, but the list above, I believe, is a sensible compromise.
I didn't choose the list lightly. After spending a considerable amount of time crunching the numbers, I settled on the indicators above. The list isn't terribly surprising; any basic economics text will make the case for each of the data series for econometric and theoretical reasons.
Here's a quick overview of what's going on behind the scenes. First, for those who are interested in the technical details, I'm modeling the data via R, the statistical software environment. The first task is transforming the daily, weekly, and monthly data into a quarterly dataset so that it's directly comparable to GDP.
Next, there's the decision of how to measure the changes in the data. Is a quarter-over-quarter change superior to looking back two quarters vs. four quarters in searching for a "good fit" with quarterly changes in GDP? In the end, no one can really say for sure when it comes to deciding what'll work best in the future. As a result, I take an average of the percentage changes for the past one-, two-, three-, and four-quarter comparisons. Two exceptions: the yield curve and ISM Manufacturing Index. The former is calculated as the average spread for each quarter; the ISM Index is evaluated in terms of its difference relative to a neutral reading of 50 and translated into quarterly averages.
Some of the inspiration for this comes from the literature on nowcasting and mixed data sampling (for example, see Evans (2005), and Lahiri and Monokroussos (2011) and their bibliographies). To be sure, the model I'm using is relatively simple, but that's by design. The goals here include transparency and parsimony.
On that note, you may be wondering at this point if I tested various mixes of the ten datasets above? I did. The results? Without going into too much statistical detail, the 10-factor model above compares quite well with a dozen or so alternative combinations of the ten factors. Still, the 10-factor model doesn't exhibit the best fit. But simply choosing the model that does the best job of predicting in the past—i.e., the model with the lowest in-sample errors—isn't necessarily going to be the best model going forward. In fact, there's quite a lot of reasoning for avoiding what worked best in the past when searching for an economically robust model for the future.
The pitfalls of overfitting and other statistical traps are well known, but the key issue comes down to uncertainty. It's never clear which indicators will be relevant (or irrelevant) in the period ahead. As a first approximation of choosing a superior model, there's a strong case for favoring equal weighting and its equivalent in the design of forecasting models. The true optimal set of parameters are always unknown, and it's not obvious that analyzing all the various permutations of variables and model types will lead to better results on a regular basis.
One quick example in the extreme. After analyzing more than a dozen combinations of indicators for the model, I found that one of the strongest possibilities is simply using personal consumption expenditures by itself to forecast GDP. Its F-stat, for instance, is far higher relative to the other multi-factor models I reviewed and its median error residual is considerably smaller. This is hardly a shock, considering that consumer spending represents about 70% of GDP.
But here's the question: do you want to bet the farm on developing intuition about GDP based exclusively on consumer spending? If you could only choose one factor, that's probably the first choice. History reminds, however, that other factors sometimes play a role, perhaps a big role, in driving economic fluctuations. Consumer spending is important, but its influence varies from quarter to quarter. No one knows exactly which factor (or set of factors) will dominate next week, next month, etc., and so there's some logic to modeling a broader set of indicators that are known to have a strong relationship with the economy. The assumption here is that a broad set of relevant indicators will, in the aggregate, dispense useful information about where GDP is headed. The tool for extracting this information, which may not be obvious in any one indicator, is the workhorse of econometrics: the multiple linear regression model.
Still, let's be realistic: the perfect forecasting model in macro doesn't exist—or if it does, its designer is keeping it to himself. As for the Capital Spectator's 10-factor model, it has a reasonably good fit with GDP: the adjusted R-squared is 0.588, for example. But a look at a wider array of statistical metrics reminds that balancing simplicity against complexity in the search for a strong model is as much art as it is science.
Remember too that the goal here is the process rather than a single point forecast. As the 10 indicators are updated with new data, the GDP forecast will change. Once the official estimate is published, we'll move on to the next quarter. Monitoring how these estimates change, and how they ultimately compare with actual data, will provide valuable information for thinking about GDP going forward. But you can't learn much from one forecast at a single point in time.
For now, the obvious question to ponder: Will the 2.3% GDP forecast hold up as new data comes in? Stay tuned....
September 8, 2012
Book Bits | 9.8.2012
● The Price of Politics
By Bob Woodword
Review via the Associated Press/Newsday
A combination of miscalculations, ideological rigidity and discord within the leadership of both political parties brought the U.S. government to the brink of a catastrophic default during the 2011 showdown over the federal debt ceiling, according to a new book by journalist Bob Woodward. "The Price of Politics," Woodward's 17th book, chronicles President Obama's contentious and still unresolved fiscal policy battle with congressional Republicans that dominated the White House agenda for nearly all of 2011. The book is scheduled for release on Tuesday. Woodward is a Washington Post associate editor. As the nation's leaders raced to avert a default that could have shattered the financial markets' confidence and imperiled the world's economy, Obama convened an urgent meeting with top congressional leaders in the White House. According to Woodward, House Speaker John Boehner pointedly told the president that the lawmakers were working on a plan and wouldn't negotiate with him.
● A Nation of Deadbeats: An Uncommon History of America's Financial Disasters
By Scott Reynolds Nelson
Review via The Seattle Times
Four years ago, as Wall Street plunged, Virginia historian Scott Reynolds Nelson posted on Facebook a comparison of the events of 2008 to the Panic of 1873. His posting startled readers and led to "A Nation of Deadbeats," a book he subtitles "An Uncommon History of America's Financial Disasters." The crises were alike in some ways. All had to do with uncertain financial promises, "whether personal notes in 1792, bills of exchange in 1819, bank drafts in 1837, railway mortgages in 1857, or second- and third-mortgage railway bonds in 1873," Nelson writes. Most panics of the 1800s came after too-loose lending by the English. The 1929 crash came after Americans undertook to lend to Europe and Latin America.
● Crisis in the Eurozone
By Costas Lapavitsas
Q&A with author via The Guardian
Lapavitsas: It is likely that the eurozone will begin to unravel, although it is impossible to anticipate the form that the unravelling might take. There could be a complete dissolution, or the creation of a "hard" euro surrounded by variants of national currencies. There could also be individual exits by countries in the first instance. Whatever its form, the unravelling of the monetary union would have enormous costs. It is absolutely vital to have a Europe-wide public debate on how to manage the process.
● The Quest for Prosperity: How Developing Economies Can Take Off
By Justin Yifu Lin
Review via Publishers Weekly
In the 1960s, conventional economic thinking was that Africa had “better conditions and opportunities for economic development” than did East Asia. Lin, the chief economist and senior vice president for the World Bank from 2008 to 2012, tackles prevailing shibboleths in this provocative and challenging work. Lin argues that “different countries... require different policy choices to facilitate growth”; indeed, developing nations that progressed industrially and technologically “rarely followed... the dominant development paradigm of the time.” Lin concludes that the Soviet Stalinist model of modernization through industrialization provided a poor precedent for subsequent leaders whose zest for large capital-intensive projects was inappropriate, especially since developing nations rarely have abundant available capital. Lin focuses on the concept of comparative advantage, which indicates that nations should concentrate on “what they can produce best” and trade with other nations that do likewise.
● Aftermath: The Cultures of the Economic Crisis
Edited by Manuel Castells, Joao Caraca and Gustavo Cardoso
Summary via publisher, Oxford University Press
The crisis of global capitalism that has unfolded since 2008 is more than an economic crisis. It is structural and multidimensional. The sequence of events that have taken place in its aftermath show that we are entering a world that is very different from the social and economic conditions that characterized the rise of global, informational capitalism in the preceding three decades. The policies and strategies that intended to manage the crisis-with mixed results depending on the country-may usher in a distinctly different economic and institutional system, as the New Deal, the construction of the European Welfare State, and the Bretton Woods global financial architecture all gave rise to a new form of capitalism in the aftermath of the 1930s Depression, and World War II.
● The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall
By James Hagerty
Summary via publisher, The History Press
In 1938, the administration of Franklin Delano Roosevelt created a small agency called Fannie Mae. Intended to make home loans more accessible, the agency was born of the Great Depression and a government desperate to revive housing construction. It was a minor detail of the New Deal, barely recorded by the newspapers of the day. Over the next seventy years, Fannie Mae evolved into one of the largest financial companies in the world, owned by private shareholders but with its nearly $1 trillion of debt effectively guaranteed by the government. Almost from the beginning, critics repeatedly warned that Fannie was an accident waiting to happen. Then, in 2008, the housing market collapsed. Amid a wave of foreclosures, the company’s capital began to run out, and the U.S. Treasury seized control. From the New Deal to the administration of President Obama, author James R. Hagerty explains this fascinating but little-understood saga. Based on his reporting for the Wall Street Journal, personal research and interviews with executives, regulators and congressional leaders, Hagerty charts the course of Fannie Mae.
September 7, 2012
A New Old Story For Jobs: Slow Growth
Today’s employment report for August from the Labor Department is a disappointment, but not enough to sink the case for expecting slow growth for the economy overall. Nonetheless, after yesterday’s 201,000 increase via ADP, this morning’s weak 103,000 gain for private nonfarm payrolls is a wet rag.
Even so, August’s tepid increase is enough to keep the year-over-year percentage change for payrolls at 1.8%. That's basically unchanged from July’s annual pace. It's also a sign that the labor market isn’t caving, even if looking at the latest monthly numbers suggests otherwise.
Then again, given the current climate, arguing that the glass is still half full tends to fall on deaf ears. “This is definitely a setback for the labor market and the economy,” Michael Feroli, chief U.S. economist at JPMorgan Chase, tells Bloomberg. “This clearly validates Bernanke’s concern. We have Europe, the fiscal cliff, and it is a generally cautious business environment.”
Fair enough. But if you’re looking for clear signs that the economy is tanking, today’s jobs report still falls short of a smoking gun. Private employment continues to rise at roughly 1.8% a year, today’s report advises. That’s down a bit from the 2.0% rate in this year’s first quarter, but the annual pace is still in line with the trend over the last several years. That implies that more of the same is on tap for the immediate future, namely: slow growth, perhaps spiked with some upside surprises along the way.
Yes, it’s an old forecast, not to mention an increasingly frustrating one. But it’s been an accurate forecast for some time and there’s little in the August payrolls report to suggest that we're going to see much in the way of change, for good or ill. That leaves us with pondering what the Fed might do next, and when.
"This weak employment report, in jobs, wages, hours worked and participation is probably the last piece the Fed needs before launching another round of quantitative easing next week,” opines Joseph Trevisani, chief market strategist at Worldwide Markets. “QE will boost equities, damage the dollar and do little for the economy, but what else can an activist Fed do?”
September 6, 2012
Two Encouraging Updates For The Labor Market
We have two new updates on the labor market today and both sets of numbers are encouraging. The ADP Employment Report advises that nonfarm private payrolls rose a respectable 201,000 in August, up from July's 173,000 increase and the highest since March. Meanwhile, initial jobless claims dropped last week, falling by a seasonally adjusted 12,000—the biggest weekly decline since July. You still can't assume much in economic analysis these days, but for the moment we're batting a thousand when it comes to the data points du jour.
Let's take a closer look at today's employment numbers, starting with the ADP estimate. As the chart below shows, the latest figures suggest that tomorrow's official payrolls report for August from the Labor Department will also bring news of stronger job growth. Running a regression analysis on the past 10 years of monthly changes for both series spits out a handsome forecast: a 200,000-plus increase (excluding government jobs) in private-sector employment for August. If so, that would represent a substantial upside surprise. Indeed, the consensus forecast among economists via Briefing.com is looking for a slowdown in the pace of growth in the Labor Department's numbers: 144,000 for August private payrolls, down from July's reported 172,000.
Turning to initial jobless claims, new filings for unemployment benefits fell 12,000 last week to a seasonally adjusted 365,000, or near a four-year low. Recent history suggests that the pace of the decline has slowed if not hit a wall. But for the moment, there's no sign that this indicator is trending higher, which would be a dark signal.
Looking at the year-over-year change in new claims (before any seasonal adjustment) looks a bit better. Last week's number shows that claims dropped in unadjusted terms by nearly 12% vs. the year-earlier level. That's in line with recent history and a strong signal that new filings will continue to drift lower in the weeks and months ahead.
It all adds up to an encouraging profile for the labor market. But we'll need a good number from the government to seal the deal. For now, it's easy to think positively.
Today's ADP update is “good news for the economy if it turns out to be correct,” Joel Naroff, president of Naroff Economic Advisors opined in an email to clients, according to Bloomberg. “We may not be seeing a deluge of new jobs but it clearly looks like firms are hiring again.”
September 5, 2012
A Primer On Defining Indexing Methodologies
Indexing used to be simple. In the old days, a representative sample of securities was rolled into a portfolio, weighted by the respective market values, and left to drift with the market's tide. This methodology—market cap indexing—is still used, of course. In fact, most of the planet’s assets linked to indexing reside under this conceptual framework. But it has plenty of competition these days. The challenge is figuring out which indexing methodology will be superior, given a particular set of investor expectations, goals, risk tolerance, etc. Before you can even begin to answer, however, you need a clear understanding of what’s on the menu. Where to start? A new research note from the folks at 1741 Asset Management sorts out the basics: "Alternative Beta: Catergorisation of Indices -- Do All Roads Lead to Rome?"
The road to Rome is littered with dark alleys and potholes, but if there’s any hope of reaching your destination you need a solid understanding of the available options. Reviewing the various index-design choices is crucial, the paper reminds, for one rather obvious reason: The different indexing rules can lead to different expected return and risk results, particularly over the short term. The good news is that virtually all the primary indexing methodologies fall into one or more of five buckets:
Beta 1: Price-focused beta
Beta 2: Price-agnostic beta
Beta 3: Fundamental-focused beta
Assets weighted by fundamental criteria, such as book value, sales, etc.
Beta 4: Risk-focused beta
Assets weighted by optimizing and/or minimizing "risk", such as volatility
Beta 5: Return-focused beta
Assets weighted based on return expectations
The real work, of course, is deciding how to choose from the list above. One possibility is to not even try. In theory, equal weighting all five methodologies has appeal if we're unsure of how to identify a superior indexing process. But that's impractical. The idea of owning five index funds for each slice of an asset allocation plan means that the rebalancing process will incur substantially higher transaction and tax costs. That's a non-starter--indexing is supposed to be tax and cost efficient.
That leaves us with the task of evaluating the strategy choices with an eye on choosing the one or two that best suits our investment goals. But that may not be so easy. Each of the beta replication methods above has a set of pros and cons, which can vary across asset classes. As a result, different investors with different goals and circumstances may come to difference qualitative and quantitative conclusions.
Some of the details about the indexing rules are well known. For example, the only truly passive indexing process is the market-cap design, which implies that expenses for this strategy will be the lowest compared with the other four choices. But there’s a sea of debate about whether market cap indexing will deliver superior return and/or risk results compared with the competition. In other words, does the simplicity and lower cost of market cap indexing come at the price of lower return expectations and/or a higher risk?
The short answer: it’s hard to generalize. Beyond the necessary work of dissecting each indexing strategy and understanding how it works, there are other variables to consider for choosing one over another. Time horizon, for instance, may alter the results. What’s expected to be an ideal indexing strategy under one set of assumptions may not hold up under another.
Ultimately, deciding if the new indexing strategies represent progress depends on crunching the numbers. As the 1741 Asset Management authors explain:
Rather than focusing on semantics, more emphasis should be put on scrutinising the underlying characteristics of these indices. For instance, do the indices provide a targeted and sustainable exposure to common risk factors – such as fundamental indicators or risk measures – that would allow for a characterization of the various indexing methods along different dimensions? Are the beta sources distinctive enough to provide for a diversified pool of passive strategies? Finding the answers to these questions is not only an academic exercise, but of uttermost importance for practitioners. A deep understanding of the distinct qualities of the various indices may help investors to better assess how and when to diversify an existing portfolio with what alternative indices.
The paper offers a good start on defining the basic indexing strategies and reviewing how they compare on a quantitative basis. Still, there’s much more to do. The bottom line: choosing an index fund, or a series of funds to round out an asset allocation, is getting complicated.
There’s a certain amount of irony here. Indexing, after all, was invented in part to simplify investing. But the finance industry isn’t prone to letting simplicity linger (or letting the lowest-cost investment products dominate). Yes, adding nuance to the money game can help, but not always.
September 4, 2012
ISM Index: Manufacturing Is Sluggish For 3rd Straight Month
Manufacturing activity in the U.S. contracted for the third month in a row in August, the Institute for Supply Management reports. That’s a sign that economic growth has been sluggish and is likely to remain so. The ISM Manufacturing Index dipped ever so slightly to 49.6 last month vs. 49.8 in July. Any reading under 50 implies that manufacturing, a key sector of the economy, is contracting. But the below-50 reading is shallow, which suggests that manufacturing is closer to treading water rather than shrinking per se. That’s hardly an encouraging reading. But given the ongoing growth elsewhere in the economy (assuming it holds up), it’s not yet clear if the moderately weak readings for this indicator are the last word on what happens next for the broader economy.
What is obvious is that manufacturing has been on the defensive since June, according to the ISM index. But it’s also true that this so-far subtle slump has yet to spill over into the broader economy, based on the numbers published to date.
Consider the economic profile for July, the last month with all the major economic reports in hand. Manufacturing have been weak in July, but it didn’t seem to infect other corners of the economy. From personal income and spending to retail sales to private nonfarm payrolls, July overall appeared to contradict the darkness in the ISM report. Most of the discouraging news for July is limited to a mixed bag of numbers for durable goods orders.
But we can't dismiss the fact that the manufacturing trend remains weak, if only marginally so. That raises the obvious question: Will the data for August prove to be a turning point for the economy? Or are the ISM manufacturing numbers of late misleading us about the darkness on the edge of town?
One reason for reserving judgment that the business cycle’s about to tank: the ISM index is less than infallible as a recession indicator. This data series has been known to slip under 50—sometimes well under 50—without a follow-up economic slump soon after. Then again, the same caveat applies to every other indicator, which is why it’s crucial to monitor a broad set of economic and financial data series and strip away the short-term noise by looking at the trend. On that note, here’s how the numbers through July compare:
The table above suggests that July wasn’t a tipping point. But the first entry for August is again telling us to beware. Will this be an outlier once more? Or might the full boat of numbers for August reveal a change in the macro weather? The next installment in search of an answer arrives on Friday, with the release of the August payrolls report via the U.S. Labor Department. The consensus forecast (via Briefing.com) calls for a modest gain of 144,000, down slightly from July’s 172,000 jump.
Predictions are a dime a dozen, of course. But this much you can bank on: Given today’s ISM update, the crowd’s capacity for digesting a negative surprise in the all-important news on the labor market is virtually nil. Stay tuned....
Major Asset Classes | August 2012 | Performance Review
Most of the major asset classes posted handsome returns in August, delivering another strong month for multi-asset class portfolios along the way. The Global Market Index (GMI), an unrebalanced, market-weighted mix of all the major asset classes, climbed 1.6% last month. For the year so far through August, GMI is ahead by a solid 7.2%.
Last month's big winner: foreign corporate bonds, which rose 3.2% in unhedged dollar terms. At the opposite end of the spectrum: emerging market stocks slipped 30 basis points in August, based on the MSCI Emerging Markets Index.
This month we've added a new benchmark to our monthly asset class review: a U.S. 60% equity/40% bond benchmark, which is rebalanced back to that mix at the end of each calendar year. The case for a domestic 60/40 strategy in the real world is rather thin, given broad menu of global asset classes available in low-cost ETFs these days. It may have been state of the art for investing during, say, the Nixon administration, but it's fallen on hard times in the 21st century. Yet the legacy of the 60/40 benchmark as a talking point still resonates. It also performs rather well at times, as the latest numbers above remind.
So, why not simply own a 60/40 domestic stock/bond strategy and forget the rest? Several reasons, starting with the fact that this portfolio will fly (or dive) based primarily on U.S. equities. If you're willing and able to budget the lion's share of your portfolio risk to one asset class, the 60/40 portfolio is probably your idea of strategic nirvana.
In fact, if you're highly confident about the superiority of U.S. stocks on an ex ante basis, now and forever, why not hold a U.S. equity fund alone and be done with it? Well, you might be thinking of the trouble that can arise when you bet the farm on a relatively small opportunity set in a world where the future's always uncertain.
In case you're wondering, a 60/40 portfolio doesn't always win the horse race. Over the last 10 years through last month, for instance, a 60/40 domestic stock/bond mix posted a 6.6% annualized total return vs. GMI's 6.9%. Rebalancing GMI did even better, earning a 7.8% total return per year. And equal weighting GMI's asset classes and rebalancing back to equal weights every December 31 generated a 9.4% annualized total return. Adjusting those returns for risk (volatility) further reduces a 60/40 strategy's competitive edge.
Can you count on those return premia going forward? No, of course not. But unless you're supremely confident that U.S. equities will shine for as far as the eye can see, a globally diversified portfolio across the major asset classes still looks like a reasonable strategy for an uncertain world.
September 1, 2012
Book Bits | 9.1.2012
● The New New Deal: The Hidden Story of Change in the Obama Era
By Michael Grunwald
Review via The Washington Independent Review of Books
If the Obama campaign sent The New New Deal to the 5 or 6 percent identified in polls as undecided, the investment might produce more votes than all the megamillions spent on attack ads. Not that Michael Grunwald has written a mash note to the incumbent. The New New Deal inflicts some deserved lumps on the president, his staff and his ostensible supporters in Congress. But Grunwald argues, persuasively, that Obama also deserves credit for two critical accomplishments: saving the country from a depression and setting in motion much-needed major changes in the fields of health care, green energy, education and transportation. He also explains why so many Americans missed the news.
● The Best Business Writing 2012
Edited by Dean Starkman, et al.
Summary via publisher, Columbia Journalism Review Books
In the wake of the financial crisis of 2008, Damian Tambini, a professor at the London School of Economics, wrote a paper that asked a pretty basic question: “What Is Financial Journalism For?” As it happens, Tambini found that no one could really agree what business and financial journalism is for, or even who it’s for: Is it for investors? Markets? Or is it for everybody, the public? We believe we know the answer: Yes. Welcome to Best Business Writing 2012, the first in an annual series that will collect the best English-language writing on business, finance, and economics.
● Volcker: The Triumph of Persistence
By William L. Silber
Review via The Economist
Alan Greenspan may be the most famous central banker of the modern era, but Paul Volcker has been the most influential. He played a crucial diplomatic role during the death of the Bretton Woods financial system in the early 1970s, which severed the link between money and gold and ushered in floating exchange rates. As head of the Federal Reserve from 1979, Mr Volcker then tamed the inflation that ensued, bringing monetary stability in the face of political opposition to the very high interest rates required. In doing so, he set the template for modern economic management, built around an independent central bank with an implicit, or explicit, inflation target.
● Health Care for Some: Rights and Rationing in the United States since 1930
By Beatrix Hoffman
Summary via publisher, University of Chicago Press
The 2010 Affordable Care Act is a sweeping reform to the US health care system. Despite the fact that nearly every other developed country in the world considers health care a right, the passage of the act in the United States was hard fought because of a staunch and vocal opposition to universal health care among many American lawmakers. Why has the United States been so continually divided on this issue? In Health Care for Some, Beatrix Hoffman offers an explanation in the form of an engaging and in-depth look at America’s long tradition of unequal access to health care.
● The Nature of Risk
By David X. Martin
Summary via author's web site
The Nature of Risk is a short, entertaining story designed to help readers face one of modern life’s most important and difficult tasks—confronting risk. Free of complicated theories or formulas, The Nature of Risk relies instead on a cast of familiar, forest-dwelling animals, each of which embodies a different approach to risk management. At least one of these approaches will seem familiar to every reader—whether they knew they had an approach to risk management or not. Then, as the narrative unfolds, the strengths and weaknesses of each approach will be put to a series of natural tests. Finally, at the conclusion of the story, readers will find a short review section designed to help them frame their first attempts at managing risk—with or without professional help.
● The Crises of Capitalism: A Different Study of Political Economy
By Saral Sarkar
Review via Kirkus Reviews
Sarkar (Eco-Socialism or Eco-Capitalism?, 1999, etc.) casts himself as not merely a reformer of capitalism, but rather a radical who believes no amount of tinkering will prop up a capitalist system that’s come up against the twin killers of global warming and the imminent depletion of vital, nonrenewable natural resources. Neither of these developments, he insists, could have been foreseen either by the defenders of capitalism or its fiercest critics. Focusing primarily on the 20th century, the author engages in a critique of the theories of prominent economic commentators, carefully distinguishing the historical crises in capitalism—the Great Depression, the mid-’70s stagflation, the disruptions caused by globalization, the Great Recession of 2008—from the crisis of capitalism, the system’s inevitable collision with the newly appreciated fact of finite resources.