Revising 2011 US GDP Growth Yet Again
(May 29, 2011)
Dear Subscribers and Readers,
Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;
12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;
13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.
In our January 9, 2011 commentary (“Our Dark Sides”), we estimated real GDP growth in 2011 to be 3.0% to 4.0%—and argued that one of the largest downside risks to this benign economic scenario is another spike in commodity prices, especially in oil prices. At the time, the 12-month strip for WTI light crude was about $92 a barrel and we noted that supply constraints were reappearing. Since our January 9, 2011 commentary, crude oil prices have steadily increased—with the WTI crude oil peaking at nearly $113 a barrel during early April. Because of the rise in crude oil and gasoline prices, we revised our 2011 real GDP growth estimate to a range of 2.8% to 3.8% in our April 17, 2011 commentary (“US GDP Growth Revision”). Based on new information, we are again lowering our 2011 real GDP growth estimate—to a range of 2.6% to 3.6%.
Since mid-April, however, oil prices have remained stubbornly high despite the 25% rise in CME margin requirements a couple of weeks ago. Moreover—as we discussed in last weekend's commentary—crude oil supplies are expected to remain constrained for the next 18 months, pending the further development of US oil shale and Brazilian deep-sea offshore production in 2013 and beyond. In addition, the ECRI's Weekly Leading Index has weakened substantially, while the Ceridian-UCLA Pulse of Commerce Index dropped 0.5% in April, after rising 2.7% in March. I first discussed this index in our March 28, 2010 commentary (“Building a Better Mousetrap”). To recap, predicting U.S. economic growth (not to mention economic growth of other countries) has is a tricky endeavor, as timely and accurate leading indicator is usually difficult to obtain, and are typically subject to significant revisions. As a response to the lack of real-time and accurate data, the UCLA Anderson Forecast, in a partnership with Ceridian, has created an alternative index that has been more accurate as a leading indicator of the U.S. economy. Among other services, Ceridian provides credit and debit cards, including fuel cards and employer pay cards, and processes card transactions for various industries in the U.S., including the transportation industry (see the following link for the company's background). The underlying data of the Ceridian-UCLA Pulse of Commerce Index is derived from credit card swipes for the purchase of diesel fuel at over 7,000 truck stops all over the country. Per the Forecast, “The interstates that crisscross America are the arteries along which flow the products that are the lifeblood of the economy. If the goods do not move, the economy turns comatose. Rather than measuring the pulse at a couple of locations, like the wrist and the neck, Ceridian has, in effect, installed sensors at truck stops all over the United States that measure the flow through this arterial system…
“The Pulse of Commerce Index is based on real transactions, observed instantaneously, with rich geographic detail. By tracking the volume and location of fuel being purchased, the Pulse of Commerce Index closely monitors the over-the-road movement of produce, raw materials, goods-in-process and finished goods to U.S. factories, retailers and consumers. Working with economists at the UCLA Anderson School of Management and Charles River Associates, Ceridian releases the index monthly for the national overall and for the nine Census regions, but the geographic detail of the data offer vast opportunities for studying details of local economies.”
The PCI has its limitations. For example, if some retailers shift their transportation contracts from trucks to railways due to increased freeway congestion, then diesel purchases will decline, and will have an unjustified negative impact on the PCI. Similarly, an increase in the fuel efficiency of the general vehicle fleet will also have a detrimental impact on the accuracy of the PCI. That said, the PCI has three major attractive features: 1) the data collected is in real-time – in theory, the PCI can be updated on a daily basis, 2) the data is accurate in that it measures actual transactions, as opposed to survey data as collected by the BLS or other government organizations, and 3) the data is very granular. For example, the Federal Reserve's Census region data is quite spotty and thus, the PCI can add significant value in terms of being a leading indicator of economic growth in the nine individual Census regions. In fact, the various regional Federal Reserve banks have engaged in discussions with Professor Ed Leamer in utilizing the PCI as part of their Beige Book reports (which are published 8 times a year).
As shown in the following graph, the PCI would have been instrumental in calling the last recession, as the index started turning down in late 2007. The launch of the Ceridian-UCLA Pulse of Commerce Index is one of the most exciting launches (in the world of U.S. leading economic indicators) since the launch of the ECRI Weekly Leading Index. We will continue to track this index going forward. The following chart contains the most updated reading. As suggested by the new PCI data, Ceridian and the UCLA Anderson Forecast assert “the 0.5 percent drop in the index in April reinforces our long held cautious, below consensus outlook for growth in GDP and employment.” This is consistent with the action of the following graph—note while the Ceridian-UCLA PCI has consistently risen since late 2009, it has pretty much stalled over the last 12 months.
Furthermore, the rise in crude oil and food prices have spurred the world's central banks—such as those of China, Brazil, and India—to raise their policy rates by more than expected since early April. That is, we're not only seeing a slowdown in US economic growth, but around the world as well. The rise in commodity prices—while not likely to flow into higher wages given the US “output gap”—means that the Federal Reserve will likely stop its “quantitative easing” policy once QE2 expires at the end of June. The synchronized slowdown in economic growth is exemplified by the following chart (courtesy of Goldman Sachs) showing the dip in global manufacturing activity in April:
Indeed, many recent economic data points (with the exception of the relatively strong equity markets) have signaled an even more serious slowdown than implied by our new 2011 real GDP forecast of 2.6% to 3.6%. However, we caution our subscribers against extrapolating the current slowdown, as 1) global policymakers still care about economic growth, and 2) the structural bull market in global equities remains intact. While there is still no sign of a significant pick-up in May, we should note that global central bankers could easily reverse their tightening policies if the economic slowdown becomes more serious.
As mentioned, the primary uptrend in US equities remains intact. However, both our liquidity and breadth indicators are deteriorating—a signal that the bull market is maturing. Volatility in both the US stock market and individual securities will likely be higher going forward. However, given the momentum behind global equity prices, the market rally should continue in the short-run, although we are still looking for a larger-than-expected correction this summer. Again, should the Dow Industrials continue to rally (preferably to over 13,250) on dismal upside breadth and/or volume, we will likely go 50% short in our DJIA Timing System.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:
For the week ending May 27, 2011, the Dow Industrials declined 70.46 points, while the Dow Transports declined 42.64 points. Both Dow indices remain close to their three-year highs, and show no signs of any weakening just yet. In fact, the momentum behind this rally should propel the market further, especially given decent market valuations and oversold sentiment levels. However, given the weakness in our technical indicators, we expect a market correction this summer. We remain neutral in our DJIA Timing System, and may shift to a 50% short position should the Dow Industrials rally further on weak upside breadth/volume.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The four-week moving average of these sentiment indicators declined from a reading of 19.0% to 14.5% for the week ending May 27, 2011. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1999 to the present:
After peaking at 30.8% (its highest reading since late February 2007) in late January, the four-week MA declined to 14.5% last week. Note that this sentiment indicator is no longer overbought—and given the positive momentum behind the market, likely has more upside in the short-run. However, the lack of a recent correction suggests the market is highly vulnerable to a larger-than-expected correction sometime this summer. We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the Dow Industrials rally to over 13,250.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
The 20 DMA declined from 107.4 to 103.6 last week—its most oversold level since early September of last year. Similarly, the 50 DMA is also approaching oversold levels. Given the oversold readings in our sentiment indicators and the resiliency of the stock market, there is likely more upside in the market in the foreseeable future, especially since valuation levels remain decent. However, should the Dow Industrials rally to above 13,250, we will likely go 50% short in our DJIA Timing System.
Conclusion: We are again lowering our 2011 US real GDP growth estimate from a range of 2.8%-3.8% to 2.6%-3.6%. Note recent data is suggesting an even lower estimate, but given the resiliency of the global equity markets, and the fact that global policymakers are still concerned about growth, we doubt US real GDP growth will likely be lower than 2.5% this year. In the meantime, the short-term momentum of the stock market remains to the upside. We remain neutral in our DJIA Timing System and will likely go 50% short if the market rally further on weak upside breadth/volume. Subscribers please stay tuned.
Henry To, CFA, CAIA