March 13, 2009

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Signs of Recovery

An increasingly popular question these days is what might be some early signs of recovery? Although by no means a complete list, a partial answer might include the following.

Leading Economic Indicators

The index of leading economic indicators (LEI) is a good place to begin if you are looking for hope. The LEI has risen in each of the past two months, after having declined steadily from its peak in July 2007. The index is published monthly by the Conference Board and is comprised of ten components.

Leading Economic Indicators & Coincident Economic Indicators Indexes
January 2006 - January 2009

The contributors to the recent increases were the real M2 money supply (the largest index component), the interest rate spread between the 10-year Treasury note and fed funds, consumer expectations, manufacturers orders for non-defense capital goods and new orders for consumer goods and materials.

Detracting from the index were average weekly initial claims for unemployment insurance, building permits, average weekly manufacturing hours (the second largest index component), stock prices and the index of supplier deliveries.

The recent, rapid growth in the money supply may be misleading, however, since it has not yet translated into increased lending. In addition, the two new orders for manufactured goods components increased for the first time in January (the latest reading) after being revised downward in November and December. So, while the index is higher in each of the last two months, it is premature to say that it indicates a trend of real improvement.

Increasing Commodity Prices

Within asset categories, commodity prices are often monitored for evidence of improving demand. In particular, industrial metals such as copper and aluminum are watched for evidence of increasing demand for manufactured goods. Energy prices, particularly crude oil, are followed for the same reason, and are more broadly indicative of trends in overall economic activity.

Crude oil's recent low in futures trading occurred on December 19 at $33.87 a barrel. It is currently trading at $45.60, although certainly much of the increase is attributable to OPEC supply cuts.

Gold is often viewed as a proxy for risk aversion. After rising by 42 percent between last November and February it has recently retreated by some 10 percent.

A broad index of commodity prices, such as the Reuters Jefferies CRB Index, includes energy commodities, industrial metals, precious metals and agricultural commodities, broadly defined. This index has not yet begun to rise in a meaningful way - although it has stopped falling. Its subcomponents of copper, precious metals and grains have firmed. Energy prices are mixed to slightly higher. As with the LEI, the positive development is that the index has stopped falling, but it cannot be said to have emerged into a new uptrend.

Reuters Jefferies CRB Index
September 11, 2008 - March 10, 2009

Even the cost of shipping commodities around the globe, as captured by the Baltic Dry Index, is widely followed as an early sign of increasing demand. After collapsing by 94 percent from nearly 12,000 in May 2007 to less than 1,000 in December 2008, this index has recently risen some 230 percent off its low to almost 2,300, but remains at a depressed level.

Baltic Dry Index
September 11, 2006 - March 10, 2009

Investor Sentiment

Increasing risk appetites are indicative of improving investor sentiment. It is partly for this reason that stock prices are a component of leading indicators, in addition to the positive wealth effect associated with rising values. The behavior of specific sectors with greater economic sensitivity can offer evidence of rising risk appetites.

Historically, healthcare, consumer staples and utilities have been viewed as defensive groups, more likely to retain their value when conditions are weak.

Conversely, consumer discretionary stocks have been considered early movers in a cyclical upturn. In the present environment, that assumption is being questioned as much of the strain in this downturn has been centered in this sector of the economy.

Technology stocks also tend to have early cyclical sensitivity, and the sector has been the best performing year-to-date, although that is a relative statement. Perhaps "the best of a bad lot" might be more accurate. Nevertheless, its relative outperformance is a positive development.

One of the major headwinds confronting stock prices currently is the deterioration in earnings estimates. Not too long ago, the consensus expectation for 2009 aggregate S&P 500 earnings was over $100. Today, that consensus is closer to $60 and there are a number of individual estimates in the $40-50 range. Most recently, however, we have seen some improvement in earnings revision sentiment, defined as the ratio of upward company earnings revisions to downward revisions. This is a potentially important inflection point for equity market sentiment.

Other positive indicators include the current extreme in investor bearishness (historically a strong contrarian sign) as well as the record amount of cash sitting in money market funds as a percentage of total equity market capitalization. Market technicians point out, however, that in the absence of positive momentum, sentiment alone is inconclusive.

Within the fixed-income universe, contracting yield spreads between bonds of different risk characteristics is also a sign of improving sentiment and falling risk aversion. Unfortunately, after showing some improvement early in the year, spreads have once again widened, although not quite to their earlier highs. For example, the option-adjusted yield differential between the 10-year Treasury note and the Merrill Lynch High-Yield master II index of high yield corporate bonds set a record high of 2239 basis points on December 15. By February 9, that spread had contracted to 1648 basis points. Since then, it has once again widened out to 1925 on renewed concerns about the relative health of the banking sector.

The same pattern can be seen in the spread to investment grade corporate bonds, which has also recently widened. On a positive note, liquidity in the short-term fixed-income universe has improved markedly, and the market for new investment grade corporate bonds has recently been robust.

Conclusion:

Both monetary and fiscal policy has been supportive of an economic, and market, recovery. Headwinds remain, however. Housing demand remains stagnant as prices continue to fall and mortgages are harder to get, although not impossible. Confidence in the banking system remains deficient, as does lending activity. But, a number of early indicators are showing signs of stability, if not improvement.