lighthouse macro report - 2012 - december

7/30/2019 Lighthouse Macro Report - 2012 - December

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Lighthouse Investment Management

Macro Report - US economic indicators - December 2012 Page 1

Macro Report

Economic Indicators - US economy - December 2012

Contents

Introduction .................................................................................................................................................. 2

The past: Oil & Fed ........................................................................................................................................ 3

The Lighthouse Recession Probability Indicator (LRPI) ................................................................................. 4

LRPI: Recession probability (long-term) ........................................................................................................ 5

LRPI: Recession probability (short-term) ...................................................................................................... 6

Interpretation of latest LRPI.......................................................................................................................... 7

Fed Funds Rate .............................................................................................................................................. 8

Crude Oil ....................................................................................................................................................... 9

Building permits .......................................................................................................................................... 10

Non-Farm Payrolls (new) ............................................................................................................................ 11

Consumer Sentiment: University of Michigan survey ................................................................................ 12

Total Credit Outstanding ............................................................................................................................. 13

Electricity Usage .......................................................................................................................................... 14

Consumer Confidence: Conference Board survey ...................................................................................... 15

Retail sales .................................................................................................................................................. 16

Manufacturing: Hours Worked ................................................................................................................... 17

Manufacturing: Orders ............................................................................................................................... 18

Miles Traveled ............................................................................................................................................. 19

Orders: Capital Goods ................................................................................................................................. 20

Electric and Gas Output .............................................................................................................................. 21

Manufacturing: Supplier Deliveries ............................................................................................................ 22

Gasoline ...................................................................................................................................................... 23


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Introduction

Recessions are bad for company profits and hence stock prices. Knowing when an economic slow-down

looms can give important clues about asset class selection. Knowing it early is crucial for investmentperformance.

In the US, recessions are "declared" by the NBER (National Bureau of Economic Research). The NBER

defines recessions as a "significant decline in economic activity spread across the economy" (not, as

often believed, as two consecutive quarters of negative GDP growth. Theoretically, a recession could

happen without negative GDP growth, but it practically never has).

The NBER takes it's time to date the beginning and the end of a down-turn; it announced the beginning

of the last recession (December 2007) only on December 1, 2008 - one year later. By that time, the S&P

500 Index had fallen from 1,575 points to 741.

Similarly, the end of the recession in June 2009 was announced on September 20, 2010 - more than one

year later. By that time, the S&P 500 had already soared from 940 points to 1,142.

Waiting for the NBER to declare beginning and end of recessions would have led to inferior investment

results (the NBER is correct in taking it's time, since many economic indicators are being revised multiple

times as preliminary data gets updated).

Traditional leading indicators include values such as the stock market and the slope of the yield curve.

However, the stock market does not seem very good at anticipating recessions, as the S&P 500 index

marked an all-time high in mid-October 2007, a mere six weeks before the most severe recession of thelast 8 decades began.

The yield curve has historically been a very good warning sign of recessions, as the Federal Reserve Bank

was forced to increase short-term rates in order to cool an overheating economy (thereby triggering a

recession). However, with short-term interest rates near zero for the foreseeable future, the yield curve

could only invert if long-term yields dipped into negative territory. While not entirely impossible

(negative yields for up to 2 year maturities have been observed in German, Swiss, Danish and other

government bond markets) it is very unlikely to happen in US Treasuries. Therefore, the slope of the US

yield curve is unlikely to give any hints about a recession occurring under ZIRP (zero-interest-rate-

policy).

Indicators published by other institutions, such as ECRI (Economic Cycle Research Institute), are

proprietary and not transparent, giving investors only the choice to "believe-it-or-leave-it".

The Conference Board Leading Indicator includes questionable values such as the S&P 500 Index, the

slope of the US yield curve and M2 money supply (which we have found to have little correlation with

economic cycles).


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As most recessions last rarely longer than a year, the economy usually had already exited a recession by

the time the NBER declared it to be in one.

Revisions to GDP growth render it useless for investment purposes; On August 28, 2008 (already 8

months into the "great recession"), Q2 2008 GDP growth was revised upwards from an initial +1.9% to+3.3%, triggering a 2% stock market rally. Later, growth was revised down to 1.3%, with the following

quarters delivering -3.7%, -9.2% and -5.4% (quarter-on-quarter, annualized). The S&P 500 Index didn't

see its level attained that day for another 2 1/2 years.

Finding a reliable indicator for identifying recessions "real-time" would already be a great improvement

over waiting for the NBER.

The past: Oil & Fed

Over the past 50 years, every recession was easily explained by two factors: oil and the Fed.

Unfortunately, this does not have to be the case going forward. Due to impotence of monetary policy at

the lower zero bound and rapidly increasing government debt the Fed might not be able to raise rates in

the foreseeable future. A recession might hence happen without prior tightening by the Fed.


4/23



The Lighthouse Recession Probability Indicator (LRPI)

We looked at many indicators from every angle; some have to be smoothed to cancel out short-term

"noise" in order to prevent false signals (we used mostly 3-months moving averages).

Some data does not give good signals unless you look at decline from recent peaks. Other data needs to

be trend adjusted (number of miles driven, for example, benefits from rising number of cars and

population).

The following indicators have been tested for false positives (calling for a recession when there was

none), missed recessions, the confidence it will work in the future and possible lead time:

Rules for each indicator define levels indicating a recession call. No two recessions are the same. Trigger

levels can be too strict (missing some recessions) or too lose (giving too many false positives). We

therefore created a range. The lower ("strict") boundary is the level necessary to avoid false positives;

the upper ("lenient") boundary is the level necessary to catch all recessions. A high-quality indicator will

have a narrow range, and recessions will be called with high confidence. An indicator at the upper

boundary will be awarded a 50% probability, increasing towards 100% at the lower boundary.

The overall "Lighthouse Recession Probability Indicator" (LRPI) is a weighted mean of individual

indicators. High confidence and timeliness of signal have been awarded higher weights (maximum: 3)

then those with low confidence or tardiness (minimum: 1). We have added "non-farm payrolls" to our

list of recession indicators. On the following page you see the LRPI since 1971, predicting every recession

(assumed once 40%-50% probability is exceeded).


5/23



LRPI: Recession probability (long-term)

The Federal Reserve Bank of St. Louis publishes a recession probability indicator by Chauvet / Piger

(black line). It is based on four inputs (non-farm payrolls, industrial production, real personal income and

real manufacturing and trade sales). However, the most recent data point for Chauvet/Piger is usually

three months old, while LRPI is constantly updated (1 months old data).

You can see that LRPI (both the weighted and non-weighted version) begin to show first warnings signs

much earlier than Chauvet/Piger.

In a recent response to a blog post, Chauvet clarified their indicator calls for a recession only "afterexceeding 80% for a couple of months". Additionally, their indicator is "smoothed" as the raw data can

reach 70% (2003/4) without being followed by a recession.

Incidentally, the weighted LRPI (bold red line) does not deviate significantly from the non-weighted

(dotted red line), speaking for the quality of inputs.

On the next page we zoom in on the most recent recession.


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LRPI: Recession probability (short-term)

The recession probability by Chauvet/Piger for August has been revised downwards quite a bit from 20%

to 4%. Last data point is September (3%).

The latest data point by LPRI (November) is 17% (non-weighted) and 11% (weighted). Due to revision of

economic data the probabilities for September have been revised slightly downwards to 15% (from 22%)

for the non-weighted and to 11% (from 13%) for the weighted LPRI.

For December, the only data available so far are the University of Michigan Consumer Sentiment (74.5,

down from 82.7 in November) and the Conference Board Consumer Confidence Index (65.1 down from71.5).


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Interpretation of latest LRPI

LRPI is a superior recession indicator, giving warning signs at early stages.

The current level does not suggest the US economy to be at risk of a recession. However, a slight upward

trend in recent months calls for increased vigilance, especially should past data be revised downwards. It

wouldn't take much to push several indicators through the upper boundary (50% probability), sending

LRPI higher.

Annex: LRPI Components

Despite the large effort that went into building LRPI we are completely transparent regarding inputs and

calculation. Please find charts for all contributors to the LRPI on the following pages.


8/23



Fed Funds Rate

The US central bank ("Fed") increased interest rates ahead of each of the last 9 recessions. The black line

shows the absolute level of the Fed Funds rate; the blue line the increase from the prior post-recession

low. An increase between 2 and 4.5 percentage points from the previous low preceded every recession

since 1954.

Recessions are shaded in gray. Yellow dots indicate the beginning of a recession; green dots the end.

The absolute level (black line) is usually on the right-hand scale, while percentage changes (blue line) are

on the left-hand scale. Negative absolute numbers should be ignored as they are merely needed for

better formatting.


9/23



Crude Oil

An increase in the price of crude oil of 75% to 100% preceded five out of the last six recessions.

Close call in March 2011 and February 2012. Currently not a red flag.


10/23



Building permits

Want to build a house? Need a permit! Any decline in permits of 25%+ from prior peak and you can bet

on a recession. Missed the one in 2001 though. 2011 was a close call. Absolute level still below 1990/91

recession lows (despite US population growth from 250m then to 315m in 2012).

Due to housing overhang unlikely to give boost to economy. Due to low level unlikely to do much

damage to GDP either (should permits decline again).


11/23



Non-Farm Payrolls (new)

The number of people on "payroll", or employed, is a good proxy for the health of the economy. You can

see the long "valleys" of lost payrolls after recent recessions compared to earlier ones. A decline of more

than 1% from previous peak payroll level indicates a recession. There have been no misses and no false

positives; even the "tricky" back-to-back recessions in 1980 and 1982 have been called correctly by this

indicator.

However, not all jobs are equal; only 47% of all working-age Americans have full-time jobs. Since 2007, 6

million full-time jobs have been lost, but 2.5 million part-time jobs gained. Part-time jobs often come

without "benefits" such as health insurance. From peak employment (Q1 2008) to Q1 2010 1.2 million"higher-" wage jobs (median hourly wage $21-54) have been lost; in the subsequent 2 years only 0.8

million have been recreated. While almost 4 million mid-wage jobs ($14-21) have been lost, only 0.9m

have reappeared. Among lower wage jobs ($7-$14), 1.3 million have been lost, but 2 million gained.

The current payroll growth approximately 133,000 a month indicates zero probability of recession.


12/23



Consumer Sentiment: University of Michigan survey

One false positive (2005), one miss (1981). 1980-1981 were back-to-back recessions, so let's not be too

harsh about that. Decline of 25%+ from peak indicates recession. 2011 was a close call.

The initial December reading has been distinctly weaker than October and November, but not enough to

trigger any warning sirens.


13/23



Total Credit Outstanding

Most recessions have been accompanied by a reduction in the growth of debt. But, for the first time in

60 years, debt has actually shrunk in 2009. A meager 2% reduction caused a massive recession. The

classic question of chicken and egg comes to mind: did the recession cause debt to shrink or did

shrinking debt induce a recession?

I have included the 1987 stock market crash (red triangle). A dramatic revelation dawns: the economy is

so dependent on credit (debt) it cannot grow without additional debt.

Unfortunately, data becomes available only once every quarter, with the latest data often many monthsold. To ensure timeliness for our LRPI we had to exclude this measure, however present it here for

informational purposes.

In Q3, TCMDO was growing at a $2.3 trillion rate over the last 8 quarters (unchanged from Q2). TCMDO-

to-GDP has declined slightly to 350% (Q2: 353%).


14/23



Electricity Usage

If you run a business you need electricity. Sure, weather has an impact (electricity use in the US peaks in

summer due to air conditioning), but this thing seems to work. If electricity usage drops by 1% or more,

it's a recession. Limited historic data, but no misses and no false positives. Close call towards the end of

2011.

Currently no red flag.


15/23



Consumer Confidence: Conference Board survey

The CB's Consumer Confidence is similar to the UoM Sentiment. Two false positives (1992, 2003), but it

did catch all recessions including the ones in 1981/2 and 2001 (difficult for a lot of other indicators).

2011 was a "close call".

Similar to the UoM Consumer Confidence this indicator showed a slight deterioration in December.

Currently no red flag.


16/23



Retail sales

US retail sales (excluding food services) have declined for three consecutive months (April, May, June

2012), visible as a small drop in the black line above. As Gary Shilling ("Insight") points out, these

circumstances usually meant the economy was already in recession or entered one within three months.

However, both August and September were strong. On top of that, July ($0.4bn) and August ($1.6bn)

have been revised upwards. You would expect the opposite (downward revisions) to happen during a

recession. September(-$0.4bn) and October (-$0.7bn), on the other hand, saw downwards revisions.

This indicator currently gives 0% probability of recession.


17/23



Manufacturing: Hours Worked

Before firing employees companies prefer to reduce their working hours. A drop in average weekly

working hours in the manufacturing sector of 2% or more indicates a recession. Except for 1996.

According to this indicator, the US economy is still sailing smoothly. However, it wouldn't take much to

tip it into the red zone should the recent trend continue.


18/23



Manufacturing: Orders

The Institute for Supply Management (ISM) regularly asks company executives about orders, sales,

inventories etc. A level of 50 indicates "unchanged" (economy stagnates). One false positive (1989).

The current decline from prior peak is not yet large enough to raise recession alarm. However, the

current level (50.3) indicates stagnation.


19/23



Miles Traveled

The US population increases approximately 1% per annum, so traffic increases constantly. If total miles

driven grow less than 0.1% versus its own trend, you are likely to be in a recession (the unemployed

drive less).

The 2001 recession was missed. This indicator says we had a recession in 2011 (which is theoretically

possible - we might not know it yet). The prolonged decline in miles traveled since 2007 is puzzling; the

decline being deeper than the back-to-back recession 1980/81. Online shopping might have contributed

to this trend.

Unfortunately, the data is made available only with a time lag of three months. This, combined with

lower confidence, made us exclude this indicator from the LRPI.


20/23



Orders: Capital Goods

Defense and aircraft orders are lumpy and distort trends, so we exclude them here.

"Medium" confidence in this indicator due to limited historic data.

The "red zone" has been set at -4% to -2%. October data has been revised upwards by 1.5%, and

November data has been the strongest since June.

The 3-month moving average currently (November data) stands at -4%, giving a 100% probability of

recession.


21/23



Electric and Gas Output

Electricity production should be linked to economic growth. This indicator, unfortunately, had many

false positives (1983, 1992, 1997, 2006), so confidence is "medium". Setting the trigger lower than -0.5%

would eliminate false positives, but make you also miss some recessions.

Recent data has seen quite some revisions of up to 2.5% magnitude. Regardless, electricity production

suggests we are in a recession.


22/23



Manufacturing: Supplier Deliveries

ISM manufacturing supplier deliveries: The current reading suggests a mild contraction. Multiple false

positives (1985, 1989, 1995, 1998, 2005) muddy the water. Therefore, this indicator has been slapped

with "low" confidence and a corresponding weighting.

Recent surveys hovered around the 50-point mark. The indicator is very close to indicating a 50%

likelihood of recession, but not yet.


23/23



Gasoline

Cars need gas, and gas needs to be delivered to gas stations. Inventory effects are unlikely because of

high turnover. "Low" confidence because of false positive (1996) and limited historic data. The recent

decline is puzzling, and points to a recession. This indicator is related to "miles driven", confirming

trends on one hand, but being redundant on the other. It has therefore been excluded from LRPI.

Any questions or feedback highly welcome.

[email protected]

lighthouse macro report - 2012 - december

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