Tuesday, January 10, 2012

2012: Housing, Oil, and the race between Deleveraging and Deflaton

- by New Deal democrat

Part I: The K.I.S.S. method forecast

This is one of those times when I am working on so much different material that nothing gets finished on time, like my year-end review of housing sales and prices, and reflections on the Oil choke collar. The good news is, I have been spending so much time decoding ECRI's black box (with a great deal of success, I might add. It just isn't finished yet) that I can give you a much more detailed forecast for 2012.

Let me begin this year the same way I began last year: why I use the K.I.S.S. method of forecasting. Even though the LEI is the statistic most denigrated by Wall Street forecasters, it has the inconvenient habit of being right more often than the highly-paid punditocracy, especially at turning points.

Since I'm not a highly paid Wall Street pundit, I simply rely upon the LEI for the short term, and the yield curve for the longer term with the caveat of watching out for deflation. The simple fact is, with one exception, if real M1, and real M2 (less 2.5%), are positive, and the yield curve 12 months ago was positive, the economy has always been in expansion. When real money supply is negative, and the yield curve was inverted 12 months ago, the economy has always been in contraction. The exception is that the yield curve does not help to project the economy 12-16 months later if the economy at that later date is in deflation - as it was in 1930-32 and late 2008 through early 2009 - which will feature a negative real money supply.

The simplest forecast, therefore, is that since the LEI were positive all during 2011, and since both M1 and M2 are positive -- in fact, courtesy of the tsunami of cash that washed ashore in August and September due to the Euro crisis, both have been almost off-the-charts YoY positive for the last few months -- and since the yield curve did not invert at any point in the last year, so long as we don't fall into deflation we should have growth all through 2012.

This year, though, simply citing leading indicators is uniquely complicated because of what Doug Short calls The Great Leading Indicator Smackdown. The Conference Board's LEI shows clear sailing ahead. ECRI called for a recession to begin by the end of 2011, and has insisted that at very least one will begin by the end of this half. Here's Doug Short's close-up of the divergence between the two indexes:

The divergence is due in part to differing approaches, and in part to what are elements of the indexes. ECRI makes use of long, short, and weekly leading indicator indexes, while the Conference Board relies upon one mixed medium-term index. While we don't know exactly what is in ECRI's black boxes, we do know what indexes they inherited from their founder, Prof. Geoffrey Moore. Specifically, we know his proposed long leading index consisted of real M2 money supply, the Dow Jones Bond Average, housing permits, and a measure of corporate profits. His proposed WLI included weekly readings of M2, the DJBA, the S&P500, Dun and Bradstreet's business birth/death count, and (probably) the Mortgage Bankers Association's Purchase Mortage Index, and credit spreads. The Conference Board, by contrast, does not make use of the DJBA or corporate profits, but does include the yield curve.

That difference is crucial. In fact at some point between December 2009 and June 2011 one or more of ECRI's 4 legacy long leading indicators were always negative: real M2 (minus 2.5%) was negative the longest, but housing permits also declined by 150,000 between April 2010 and February 2011, corporate profits dipped at the end of 2010, and the DJBA turned down between August 2010 and February 2011. Here's the graph, showing each of the LLI normed to 100 at their maximum reading before turning down in 2010 (note: substituting the nearly identical BAA bonds trend for the DJBA):

That is about equivalent to their collective negative turn in advance of the 2001 just-barely-a-recession, although the relative components were different. The yield curve, by contrast, did invert in 1999 but did not come close in 2011. Nor did real M1, which has also always turned negative before at the inception of a recession. Here's the equivalent graph with each LLI normed to 100 at their pre-2001 recession peak:

Since the long leading indicators are designed to give at least 12 months warning of a recession, that puts us in the greatest window of weakness right about now.

In this respect, the LEI aren't that different: their weakest readings were in April and September, and if you discount the M2 and yield curve readings, were negative in April and again from June through September (h/t EconomPicData):

meaning that they also forecast maximum weakness right about now.

Just as interestingly, though, all of ECRI's long leading indicators have turned up since last spring, with real M2 and the DJBA making new all time highs. Here's the same graph we looked at above -- you can see that all 4 LLI's have rebounded and two have made new highs:

This, plus the positive yield curve, tells me that for the second half of 2012, the indicators are really in agreement -- there will be growth.

So what do the shorter leading indicators say about the first half of 2012? I'll spare you a very noisy graph, but here's the scorecard:

- The positives are that the stock market has been rallying for the last 5 months, durable goods orders are still climbing, and consumer expectations have regained virtually all their losses from the July debt debacle. Initial jobless claims have come down to 3 1/2 year lows.

- The negatives are that the ISM manufacturing indexes have been just barely positive for most of the last 6 months, the vendor delivery subindex has declined substantially, and credit spreads are at their widest since 2009. Also, the gasoline price spike from a year ago has reached the point, based on past history, of maximum impact, and will remain there through April. Commodity prices are falling, and the last two months the CPI has actually registered deflation, raising a caution flag about relying upon the yield curve. Finally, as I will detail more in part 2, you can't go on forever with real wages in decline, as they have been for all of 2011.

One other item: typically recessions do not begin until at least 8 of the 10 LEI's are lower than they were 6 months ago: through November 6 are negative, 4 are positive. That's close, but not quite enough.

Ultimately the question as to whether the trend is slightly positive or slightly negative in the first part of 2012 becomes whether housing will show enough actual strength, and whether the Oil choke collar will weaken sufficiently, to support US growth if manufacturing and exports falter. For reasons I will explore more in part 2, my best judgment is that we will avoid recession, but that at least one quarter of negative GDP, with the likelihood greater in this quarter than the second quarter, can't be ruled out.