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Headlines versus Underlying Data, part II: Rare Rational Realists?

Monday, December 05, 2005 | 07:35 AM

I am somewhat fascinated by the current debate between those who consider themselves "Realists" (including me) and the people who call us "Pessimists." It all stems from looking at the economic data and drawing the approriate conclusions.

Optimists versus Pessimists? Realists versus Fantasists? Jeerleaders versus Cheerleaders?

As I have stated in the past, a good strategist/trader/analyst/investor should be neither a Bull or a Bear. That means interpreting the data before you, without a bias. When I do that, the data clearly reveals signs of weakness below the surface. I don't expect the economy to be perfect -- but for me to believe that we are in a robust expansionary phase, I would expect to see more indicia of sustainable growth -- broad signs across many sectors.

Instead, I find that most data showing sectors of supposed strength do not stand up to close scrutiny.

To grossly oversimplify: A healthy economy comes out of recession as Government (deficit) spending leads the way (Keynes and all that). Then, pent up consumer demand takes over, as individuals begin spending in earnest. Finally, to ramp up to meet all this new demand, businesses begin (CapEx) spending and hiring. This begets a virtuous cycle that runs on until it eventually shows signs of inflation, which begets rate hikes, which (of course) go too far and cause the next recession. Then it all starts over again.

Withthat scenario in mind,lets pull a few graphs from the pages of the Cleveland Fed's Economic Trends: This time, we'll review the Sectors Contributing to GDP (percent changes) and the always scintillating Labor Participation Rates (employment to population ratio).

Have a look at this chart -- and before I write anything "negative" about -- see what you think about it. What sectors are contributing to growth?

% change real GDP

Data are seasonally adjusted and annualized

Source: Economic Trends November 2005 (Federal Reserve Bank of Cleveland)

Ok, have you reached any conclusions yet?

Here's mine:

First, we see that personal consumption has increased. You may be wondering what consumption has to do with producing goods or services, but we will save that discussion for another time.

Second, despite my co-guest from Thompson Financial claiming their proprietary model showed enormous gains in Corporate CapEx Spending (on Kudlow & Co. last week), we clearly see that Business Fixed Investment decreased last quarter. (Funny how those proprietary models do that).

Third, we see that government spending has gone up (and up and up). 4 years into the recovery, government spending is still accellerating. Hmmmmmm.

After a torrid run, Residential investment cooled in Q3. The drop in Q3 exports was likely hurricane related, as the Mississippi was mostly closed for a while there; it does not signify much either way. I'm not sure what to make of the big move in inventory draw down. Perhaps this is somehow reflecting the build up of GM/Ford cars and their subsequent big selling during the employee-priced giveaway.

Conclusion: I see GDP strength coming largely from consumer spending, as well as from Government spending. Surprisingly, at this phase of the recovery, it is not a function of increasing corporate CapEx. Private inventory investment was also negative.

Here's another example where I find the non-pessimist argument wanting: Some very Bullish commentators have used the low 5.0% unemployment rate as proof of the economy's strength.

When I look at the unemployment rate, I see something very different:

Labor Participation Rate
click for larger graphic

Source: Economic Trends November 2005 (Federal Reserve Bank of Cleveland)

This chart, from the Federal Reserve Bank of Cleveland most recent "Economic Trends," shows that over the past 5 years, the Employment-to-Population ratio has dropped precipitously, falling from about 64.7% (2000) to 62.2% (mid-2003). Two and half percent may not sound like alot, but when applied to *143 million Americans, its quite huge -- over three and half million (-3.6M) people who dropped out of the Labor force.

The good news is that over the past 2 years, this has crept back up to 62.9% (+0.9M). The bad news is that nearly 3/4 of those "dropped out" of the labor force (2.6m) have yet to return.

This is quite apparent to anyone who bothers to look at the data. Because of this, whenever someone trots out "5% Unemployment rate" as proof of the strength in the economy, I just shake my head. The data is what it is, and to spin it otherwise is proof hackdom or incompetence. (Sorry for the unvarnished truth, but that's how I see it).

How'd you do? Looking at these two charts of data from the Cleveland Fed, what conclusion's did you draw?

Are you a Pouting Pundit of Pessimism? Or, are you a Rare Rational Realist?

Your portfolio awaits your answer. So do your returns . . .

_________________

* BLS reports a baseline number of 142.6 million employed and a civilian labor force of 150.2 million.

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Comments

Great article, though I wonder if it's a case of the headline writers consciously providing headlines that the editors want to project or if it's a case of the writers unconsiously adapting the data with the schema of the world?

Dave

Posted by: Dave Evans | Dec 5, 2005 8:55:09 AM

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