Turned The Corner
Posted: February 2009
On the one year anniversary of Unicorn jumping out in front of virtually every economist, soothsayer and shaman in the industry by predicting the onset of a bear market and eminent destruction of financial sense in the Western (and Eastern, as it turned out) world, we are prepared to climb onto a proverbial limb and say with little trepidation that the free fall is over and recovery has begun.
Calmly anticipating derisive hoots, tossed shoes (and when did that become a vogue way of protesting, anyway?) and various bric-a-bats, we offer modest evidence using our models and key indicators to suggest the naysaying cacophony is again behind the curve. Our particular predictors, preferred and proven to our satisfaction, are the Personal Consumption Index, the index for manufacturing production, and (oddly) the consumer confidence index. Adding to our confidence is the performance of NASDAQ and an underlying solidifying of the jobs market.
Now you are invited to throw tomatoes (relatively cheap on the futures market), frozen orange juice concentrate (also cheap) or barrels of oil (incredibly cheap for the moment) and decide we’re insane. Given a moment to develop our position, however, we may convince a few well timed investors to get out of cash (a position Unicorn has held steady since August) and get back into the severely undervalued midcap and value stocks central to our philosophy.
First, the PCE. We become aware of this cute fellow with interesting predictive authority by way of Joseph H. Heller and his 2005 book Ahead of the Curve: A Commonsense Guide to Forecasting Business Cycles (Harvard Business School Press). Unicorn’s quants (our numbers guys) have quibbled for three years about some methodology and math behavior exhibited by Mr. Heller and our quacks have picked at his philosophic underpinnings but neither group have found even one example where his theory or structure have been disproven. The PCE is a leading measure and has proved out as a relatively stable measure for finding bottoms (and tops) of macroeconomic cycles.
January showed a 1% increase in PCE, year over year, for the first time since last February and resulting retail sales in elementary sectors, including home electronic mid-ticket items (flat screen TV’s, for example), mid-level home improvement purchases, and (huh?) automotive were the leaders in that movement. Moreover, consumer movement to generic or store brand products at the expense of name brands looks to have flatlined, suggesting spending is not as aggressively seeking lower price levels.
Alone these elements only suggest direction, despite Mr. Hellers’ confidence. Since beginning study of the PCE as a predictor, however, Unicorn has found the other two features which, when combined, have a reasonably high correlation to business cycle turnarounds and form the basis of our sense the worst is behind us. The index for manufacturing in January showed the third month of slowing declines – another way of saying that the negative direction is slowing. As a predictive element, this is a necessary forerunner to an increase and has consistently in historically begun the turnaround somewhere in months five through 7 after the slowing decline is noted.
Finally, the consumer confidence index (we use the University of Michigan survey as a matter of form and convenience) is demonstrated a similar slowing in decline in the fourth quarter and has actually ticked up a short bit in January. Applying these arrows to current consumer psychology lends us to believe most consumers are less fearful of spending, manufacturers are more confident in producing and the resulting economic activity will become noticeable early in the second quarter and be obvious even to economists, the financial press and possibly even to bankers by the third.
Strengthening our resolve is more subjective feelings and observations about large scale economic events. First is the sheer volume of job losses announced between October and December last year – a volume reduced to mere tinkling noise since. We believe additional announcements of job cuts will be mild and sporadic for the balance of this quarter and largely disappear by April. The unemployment rate as reported will climb for a while yet, as much because the Federal stimulus package (or, as we call it, the “Too Late for Any Good Package”) has unintended incentives for people to claim benefits by filing, people who would not appear in those unemployment statistics today.
Real unemployment, our phrase for actual working people who lose jobs, is just about at the maximum it will see, even while some regions (Detroit, New York) suffer even more losses. Other dislocations in particular sectors will also get a lot of press, generating a lot of noise, will be centered on smaller manufacturers on the economic fringe with less impact than what we saw in late 2008. Moreover, scuttlebutt among Unicorn sources in cubicles and plants around the country is running solidly toward maintaining employment levels rather than cutting and a few intrepid executives have begun preliminary talks about renewing hiring. Remember, this piece is subjective and Unicorns quants are somewhat concerned that we even offer it as rationale. They’re probably right.
The measure our quants like (it has numbers, so naturally they like it), is how NASDAQ is behaving. Safely insulated from financial stocks, silly manufacturers of durable goods or transportation based companies, NASDAQ hasn’t been showing either the declines or volatility of the other exchanges in recent weeks. Indeed, the NASDAQ anchor tech stocks downstream from the big names are showing surprising durability in earnings, margins, sales and cost control, all suggestive of steady business continuation rather than deterioration. Investment in technology has always been a productivity driver for American and Western companies in general giving consequent underlying strength to emerging market economies in the process.
Together, puzzle pieces make a whole picture and Unicorn sees a picture for a faster recovery than others. There are several caveats (of course) that need to be considered but given our core assumptions and beliefs, our direction in March is to begin buying equities in solid, dependable mid to large cap companies, focusing on dividend yields, substantial recurring-demand products, and proven management expertise as our screens. Avoiding companies with heavy debt loads is still a primary concern because rolling over debt in coming months will continue to be a significant problem and heavy leverage is likely to sink more than a few reputable companies into bankruptcy or forced sale to private equity pirates, hedge fund hounds and similar parasitical lifeforms.
For the caveats, we have to note several concerns. First and foremost, our favorite bugaboo, escalating credit card defaults, appears to be under control. Default rates have leveled off while primary issuers of cards have made significant increases in reserves to address that problem. Americans, in particular, are well past reasonable amounts of credit card debt but as a contagion, the disease may be effectively quaranteened. A rapid increase in defaults with subsequent negative impact on card issuers and retail sectors would destabilize our model and impact our confidence quickly.
Similarly, failure by governments globally to support their automotive industries will, without question, send all the developed economies into a massive, irreversible tail spin. Unicorn does not believe even the most confused government body (the American Congress) to ever exist will permit that to happen. Not supporting the US auto industry would cause massive job losses, a trillion dollar transfer of health and pension liabilities from the private sector to the public trough and fully sink the rising confidence of US and international consumers with predictable consequences for producing Asian nations.
While less severe, comparable inaction in Europe or Japan has similar results and smaller, yet still major ripples, of consequences throughout the global economy. If US inaction is generally unbelievable, inaction in the European socialist economies is absolutely inconceivable. Should the unbelievable and inconceivable happen, our best sense is for every one of us to load up on bottled water, canned veggies and ammunition because there is no saying where the resulting revolution will end.
Finally, and perhaps scariest of all, is the rising idiocy of protectionism being heard in multiple world capitals. Unicorn believes (belief: an act of faith) that leaders in most nations today understand protectionism is a guaranteed road to international economic ruin and will not undertake more than token efforts toward trade barriers, tariffs and similar madness. Certainly, all the national stimulus packages have some stilted language giving radical right politicians, misguided populists and related ilk cover in their home constituencies, but none appear to have any real fanged monsters capable of ravaging international commerce in style reminiscent of Smoot-Hawley.
We hope.
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