My Favorite Leading Indicator

My favorite leading indicator is Young Research’s Moving the Goods Index. Moving the Goods is a market-capitalization-weighted index of non-airline transportation companies. Transportation companies are some of the first businesses to realize a change in economic activity. You have to move the goods before you produce or sell the goods. Young Research’s index is a real-time leading indicator of economic activity. GDP data show the economic downturn started in the third quarter of 2008. I recognize that the National Bureau of Economic Research, the official arbiter of U.S. recessions, dates the start of the recession to the end of 2007, but the GDP data didn’t peak until June of 2008. The NBER has it wrong. Moving the Goods peaked in early June of 2008, ahead of the peak in GDP, and then bottomed in early March of 2009, ahead of the June trough in GDP.

Chart of GDP Growth

My Moving the Goods chart shows that the index was again forecasting economic growth for the first quarter of 2010, and GDP data released today confirm that the economy grew at a 3.2% rate in the first quarter. For the current quarter, Moving the Goods is off to a strong start, indicating that the economy is still growing. I remain skeptical of the sustainability of the economic recovery. I monitor Moving the Goods daily for early warning signs of a slowing economy.

Chart of Young Research's Moving the Goods index.

If I could only use one economic indicator to help guide my investment strategy, Young Research’s Moving the Goods Index would be it. I include charts and analysis on Moving the Goods monthly in Intelligence Report.

Are Small Stocks Safer Than Large Stocks?

A recent study in Financial Analysts Journal (FAJ) found that a portfolio of small-capitalization stocks is no more risky than a portfolio of large-capitalization stocks. And if the number of stocks in a small-cap portfolio exceeds 25 or so, that portfolio may be less risky than a large-cap portfolio. The authors compare volatility in two time periods, 1963 to 1984 and 1985 to 2008. In the earlier period, a portfolio of small-cap stocks was found to be significantly more volatile than the market, even for a portfolio of 50 equally weighted names, but in the more recent period, once a small-cap portfolio included 25 equally weighted names it was about as volatile as a large-cap portfolio. According to the authors, the reason for the decline in volatility of a portfolio of small-cap stocks relative to large-cap stocks can be explained by an increase in institutional ownership of large-cap stocks relative to small-cap stocks.

The takeaways for you are twofold. First, while small-cap stocks individually are often more volatile than individual large-cap stocks, that does not hold for a portfolio of small stocks (including 25-plus stocks). I would not advise conservative income focused investors to focus exclusively on small cap stocks, but adding a moderate number of small cap stocks to a portfolio can reduce risk. Second, many advisors rely on the diversification benefits of an asset, which are derived from historical correlations to justify investment in that asset. Remain skeptical of this approach. As the FAJ study shows, increasing investor participation in an asset can alter that asset’s return profile and erode its diversification benefits.

If Greece Fails, is Portugal Next?

Greek government bond yields have surged to over 16% in recent days. If Germany doesn’t step into to save the Greeks, a default is not out of the question. But the larger problems for Europe are the risk of contagion. Bond yields on other overly indebted euro-area countries are now surging. Portugal is the market’s next target. Yields on short government debt have surged 230 basis points in a matter of weeks.

Beat the S&P 500 by 2 to 1

My chart shows the long-term performance of $1 invested in the consumer non-durables sector in June of 1926 to $1 invested in the S&P 500 at the same time. The consumer non-durables industry includes companies that make and sell everyday items. Demand for non-durables, or what are more commonly referred to as consumer staples, is not heavily influenced by the business cycle. You don’t stop eating or brushing your teeth just because the economy is in recession. The consistency and stability of consumer staples companies definitely appeals to investors in or nearing retirement, but all investors should consider these stocks. Consumer staples have outperformed the S&P 500 by a margin of more than two to one over the last 8 ½ decades. Investors writing off this sector of the market are potentially forgoing one of the most profitable opportunities in the stock market. In my monthly strategy reports, Intelligence Report and Young Research’s Global Investment Strategy, I advise investors on which stocks to favor within the consumer staples sector. If you are not already a subscriber, please join me.

The #1 Investment Book

You may be surprised to hear that Moneyball by Michael Lewis is my #1 investment book, given that it’s about baseball, not Wall Street or the stock market.

Moneyball is a story about how one of the poorest teams in baseball, the Oakland A’s, and their GM, Billy Beane, built a roster chock full of talent and won 103 games. Beane did it by discovering hidden value through faith in his convictions and obscure stats, like a hitter’s pitches per plate appearance—helpful in tiring out a pitcher and getting on base. He drafted baseball players who were overlooked by other GMs blinded by their herd-like analysis.

You’ll learn from the book that as an investor, hard work and tireless research can help you discover value where others don’t see it. Plus, it’s a better read than your typical investment book.

Michael Lewis also wrote The Blind Side, now a motion picture, which is another story about value. Again, it has nothing to do with stocks or bonds. It’s about football and the rise in value of the second most important player on the field, the left tackle, who protects the highest-paid player, the quarterback, and his blind side. You’ll love the story about Michael Oher, who embodies what it takes to be a good left tackle.

The stories Michael Lewis tells through his books are the closest most readers will ever come to Wall Street, and thankfully so. In the cult classic Liar’s Poker, Lewis, fresh out of Princeton, is employed in the highly sought-after Solomon Brothers training program. When the mortgage-backed security bond is created, he’s there. Led by John Gutfreund, the bond traders rig the odds in their favor like a casino. At a moral crossroads, Lewis leaves the well-paying job and literally writes the book that defines an era of greed.

Ironically, his new book, The Big Short, comes full circle. It is about the demise of the subprime mortgage-backed security bond market Solomon helped to create years ago. The characters alone make it worth reading. What you’ll learn, in addition to the workings of synthetic collateralized debt obligations (CDOs) and credit default swaps (CDSs), is that the market implosion was simply a matter of time.

Of course, now Goldman Sachs is facing civil fraud allegations from the government. Three years too late, I might add.

As Lewis explains in his book, Goldman Sachs was a big player in the CDO market and was eventually a big loser, too, since CDOs lose when subprime mortgages default. According to Lewis, Goldman held $16 billion in CDOs when subprime loans began defaulting and eventually incurred billions in losses, some of which it reduced with shady maneuvering. Hedge fund king John Paulson, among others, profited with CDS positions, which, on the other side of the bet, benefit from a default.

To blame just Goldman Sachs and Wall Street would be wrong. Government led by Republicans and Democrats pushing home ownership for all, easy-money mortgage lenders selling no-documentation loans, and speculative unemployed borrowers all share responsibility for the mess. Unfortunately, risks to investors will remain if toothless reform—and it is toothless—still supports a safety net for Wall Street and business as usual for the bloated Fannie Mae and Freddie Mac.

Until we see real reform, you’ll be wise to follow the lessons learned in Michael Lewis’s books and focus on value.

E.J. Smith is Managing Director of Richard C. Young & Co., Ltd. an investment advisory firm managing portfolios for investors with over $1,000,000 in investable assets.

A Wake Up to Governments & The First G7 Nations Raise Rates

IMF Warns of ‘New Phase’ in Crisis – By Tom Barkley and Bob Davis, The Wall Street Journal
“Higher debt levels have the potential for spillovers across financial systems, and to impact financial stability,” the IMF said, noting that debt levels among advanced countries have already risen to levels not seen since the end of World War II…. “Careful management of sovereign risks is essential: governments need to design credible medium-term fiscal consolidation plans in order to curb rising debt burdens and avoid taking the credit crisis into a new phase,” the IMF said in its report. Greece’s struggles should serve as a “wake-up” call to governments, Mr. Viñals said…. The IMF report said money is flooding into Asia and other emerging markets amid low interest rates in the U.S. and Europe. Some markets are showing evidence of overheating, it said. These include residential real estate in Australia, China, Hong Kong and France, and sovereign debt in Japan.

Canada Bank Shift Signals Strong Recovery – Phred Dvorak, The Wall Street Journal
Canada’s central bank said it now sees the economy growing 3.7% this year, more strongly than expected a few months ago. The need for ultralow interest rates to stimulate growth is “now passing,” it said in its Tuesday policy statement. “It is appropriate to begin to lessen the degree of monetary stimulus,” it said…. Economists say Canada’s announcement likely means it will be the first among the Group of Seven leading nations to raise rates, and sharpens the contrast with the U.S., where economy watchers have been divided over the strength of recovery.

Emerging Market Stocks Up Over 110%

Emerging market stocks are up over 110% since hitting lows in March of last year. Net flows into foreign stock funds, much of it into emerging market funds, have been positive for 11 months in a row while U.S. stock funds have seen outflows in six of the last seven months. Those investors liquidating U.S. stocks and piling into emerging market stocks could be disappointed over coming quarters. Our relative strength chart shows that emerging market stocks have a very toppy look vs. U.S. stocks. Individual country and issue selection in emerging markets is now more important than ever.

Stay Defensive

Confidence in the economic recovery is improving, and retail investors are moving back into equities. Here are four reasons to remain defensive in the face of this renewed optimism:

  1. Stocks are now discounting a sustained and robust economic recovery. A second contraction in economic output is no longer priced into the market. If the economy contracts or comes up short of expectations, stocks could be in for a significant correction.
  2. Taxes on income, capital, and possibly even consumption are going up. Higher taxes resulting from Obama’s health-care boondoggle are only the tip of the iceberg. The Bush tax cuts on dividends, capital gains, and income expire at the end of this year. And the administration is already floating the idea of a consumption tax to help pay for the massive expansion in government that is now under way. Higher taxes detract from GDP—significantly so. Economic research by Christina Romer, the chairman of the President’s Council of Economic Advisors, shows that higher taxes have a negative 3X multiplier effect on private spending. That means that each $1 increase in taxes reduces private spending by $3. The implications for the economy and financial markets are bearish.
  3. The recovery has been bought with easy money and unprecedented fiscal stimulus. Despite what Chairman Bernanke may believe, easy money does not create a sustainable economic recovery. All the new projects and investments that look profitable when interest rates are set artificially low become unprofitable when rates are normalized. The easy-money recovery is sowing the seeds of the next economic bust.
  4. Interest rates have no place to go but up. Short-term interest rates are essentially zero and negative in real terms, and long-term rates are far too low given the amount of government debt that will be issued over coming years. Rising interest rates have never been bullish for stocks.

In my monthly strategy reports, Intelligence Report and Young Research’s Global Investment Strategy, and at my family-run investment company, I continue to advise a defensive investment posture.

Comparing Bull Markets

Based on the historical performance of four bull markets that were preceded by devastating bear markets, the current bull market is approaching exhaustion.

The Future of Oil Demand

According to the International Energy Agency, Organisation for Economic Co-operation and Development (OECD) countries’–i.e., rich countries’–oil demand peaked in 2005 near 50 million barrels per day. OECD oil demand is down 10% from the 2005 high, yet total oil demand is up over the same time period. The reason of course is that oil demand in non-OECD countries has risen 50% over the last decade–a 4% compound annual growth rate.

Global economic growth is the primary driver of oil demand. My Oil Demand Growth vs. Economic Growth chart shows that economic growth and oil demand growth are closely correlated with global economic growth accounting for over 40% of the variation in oil demand growth. Since oil consumption has peaked in rich economies, oil demand growth moving forward will become more heavily influenced by economic growth in non-OECD countries. If you invest in oil or oil companies, evaluating the economic prospects of non-OECD countries is vital to your investment success. In Young Research’s Global Investment Strategy we cover the global economic and monetary landscape. To sign up for a trial subscription click here.

Jeremy Jones, CFA, is the Editor of Young Research’s Global Investment Strategy and the Chief Investment Officer at Richard C. Young & Co., Ltd., Investment Advisors.