In my last lesson, I showed you the powerful predictive value of the yield curve—the bond market’s crystal ball on the economy and the stock market.  We learned that the yield curve foretold the events of 2000 when in January of that year the yield curve inverted in anticipation of events that would likely occur as a result of interest rate increases by the Federal Reserve.  The yield curve’s main message was: Don’t fight the Fed!

Yet many investors did.  The Nasdaq continued to defy the Fed’s rate hikes even as the pace of the Fed’s interest rate increases was set to accelerate.  But the stock market’s fate was sealed and it wasn’t long before it finally succumbed to the Fed.  For those who heeded the message of the yield curve, they were able to protect their portfolios against irreparable harm.  For those who didn’t, they’re still standing like a deer in headlights.

The message of the yield curve is far different today and is pointing to brighter times ahead.  In December of 2000, the yield curve became positively sloped again as the spread between 2-year Treasury notes and 30-year bonds turned positive (30-year bonds yielded more than 2-year notes) for the first time since January 2000.  The curve has continued to steepen and is now at its steepest point since November 1998, in the throes of and toward the end of the Asian Financial Crisis.

As with the inversion in January of 2000, the recent steepening of the yield curve is the result of the Fed’s handiwork and its anticipated effects.  Historically, a steep yield curve has generally foretold a strengthening of economic activity, rising corporate profits and rising stock prices.  At present, there’s every reason to believe history will repeat itself.

Stock investors sure hope so.  Since 1970, the S&P 500 has performed very well in the aftermath of the onset of rate cut cycles, gaining 9% after 3 months, 19% after 6 months and 24% after 12 months.

Indicators You Should Be Watching

Aside from the yield curve, there are many other indicators that you should be watching and which are also pointing to an eventual recovery in the economy, corporate profits, and stock prices.

Here’s one which some of you may have abandoned long ago: the money supply.  In 2000, it slowed sharply, suggesting liquidity was eroding and that the economy might be soon slow.  It did. 

The gauge that I use is M3, which is released every Thursday at 4:30 pm EST by the Federal Reserve.  M3 is a broad measure of money supply growth containing M1 (checking deposits and currency in circulation), M2 (M1+small time deposits, small money market funds), and large time deposits (greater than $100k) and large money market funds (greater than $100k).

When the economy is growing strongly, M3 typically grows in the high single digits, say around 7-9%.  In 2000, there were some months when it grew at near zero percent.  Lately, however, it has begun to explode.  From late December to mid-February of this year, it surged a whopping $226 Bln, or at a 19% annual rate.  Growth of this magnitude is normally followed by strong economic growth and higher stock prices.  The lag time should be no more than a few months to a year at most.

So as they say, follow the money!

Oh Give Me a Home…

I’ll bet very few of you use mortgage applications as a top indicator.  Released weekly, I have found mortgage applications to be one of the best indicators on the economy, and hence the markets.  Why?  Because the housing sector is one of the most important sectors of the economy.  It can be argued that roughly 25% of the U.S. economy has its roots in the housing sector.  This makes sense when you consider the fact that a home purchase is the biggest purchase that most individuals will ever make.  A home purchase can lead to the purchase of a variety of products including carpeting, appliances, and so forth.  Housing turning is critical to many consumer cyclical companies such as Sears, Lowes, and Home Depot.  It is also important to banks, of course.

Activity in the housing sector also yields clues as to the degree of responsiveness to a given interest rate environment.  So if the Fed is cutting interest rates, what you look for is a response—higher mortgage applications.  If there is indeed a response in the interest rate sensitive sectors such as housing, autos, and capital spending, then you know the Fed’s interest rate cuts are working and that the economy will strengthen.  If not, then there’s a problem and suggests that there are deeper problems in the economy that interest rate cuts won’t easily resolve.  This is often called a “liquidity trap” wherein the Fed is said to be “pushing on a string.” 

But that is not the case at present.  Mortgage applications have surged in response to falling interest rates.  Particularly encouraging has been the surge in mortgage refinancing activity.  In early 2001, it has increased fourfold over the 1-year average.

Mortgage refinancing can give a solid boost to the economy.  In a study conducted by the Federal Reserve, they found that during the last refinancing boom in 1998 and 1999, households that refinanced their mortgages saved an average of $147 per month on their mortgage payments—a good deal of money to the average American.  Nearly all of that money was likely used for other expenditures given the low U.S. savings rate.  In addition to the monthly savings, many households took cash-out mortgages totaling roughly $55 Bln in all. Of that $55 Bln, about one-third was spent on home improvements, and about one-quarter was spent on other expenditures.  The rest went toward debt repayments and so forth.

So as you can see, mortgage refinancing can give a solid boost to the economy.  With this activity exploding, help to the economy is on its way.

You can track mortgage applications by using data released weekly from the Mortgage Bankers Association every Wednesday at 7:00 am EST.  Their indexes are widely followed and very reliable in terms of their correlation to the housing sector.

Take Stock

Almost universally overlooked, but critical in the current environment, business inventories are a very good indicator of what’s next in the manufacturing sector.  When inventories rise, as they did in 2000, cutbacks in production inevitably follow.  Conversely, low inventory levels typically mean that production increases are on the way.

In 2000, I picked up on important developments on the inventory front that I mentioned in my columns way back when.  I noticed that in May, retail inventories rose their most in five years after retail sales had fallen for the first time in 20 months in April.  At that time, with consumer spending weakening and likely to stay weak due to the falling stock market, I sensed that the manufacturing would eventually falter.  Retailers, plagued by unwanted inventories, would have to cut back on new orders to manufacturers and this would result in decreased industrial production.

It didn’t take long for these effects to be felt.  By September, the manufacturing sector began a contraction that has lasted to the present.  The ripple effects have been broad with numerous companies, including technology companies, issuing earnings warnings and announcing poor results.

Fed Chairman Alan Greenspan has noted that the biggest economic problem in the U.S. today is that businesses have excessive inventories.  He has noted that the inventory correction that has ensued has been particularly severe because the use of new technology has made it easier to detect unwanted inventory buildups:

“New technologies for supply-chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage--virtually in real time--and can cut production promptly in response to the developing signs of unintended inventory building.”

While Greenspan feels the prompt production response also means that the inventory correction may end more quickly than usual, he is mainly worried about the psychological toll it is taking:

“This very rapidity with which the current adjustment is proceeding raises another concern, of a different nature. While technology has quickened production adjustments, human nature remains unaltered. We respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down…”  These comments make it crystal clear that Greenspan is not worried about the inventory adjustment per se but the impact that it will have on consumer confidence.  That is why, Greenspan explained, the Fed moved so aggressively with their rate cuts in January.

Recent data on inventories suggest the inventory correction is advancing.  In December, inventories posted their smallest gain since January 1999 and business sales actually exceeded the inventory gain.  This means that demand exceeded supply for a change.  And in January, with retail sales having increased at a solid 0.7% and with businesses having substantially slashed their production schedules, inventories likely continued to rise more slowly than sales. 

At some point in the not-too-distant future, if demand continues to exceed production, production will rise and this will strengthen the economy.  It’s almost inevitable that production will rise because companies risk losing market share otherwise.

Because companies do not raise production immediately following pickups in demand, inventory data can give a solid lead on important turning points in the economy.  A car manufacturer, for example, will generally not increase production of new vehicles simply because they have a month or two of strong sales.

So I strongly suggest that you pay close attention to inventory data.  Follow the government’s inventory data monthly at http://www.census.gov/mtis/www/mtis.html and also look closely at Corporate America’s comments on their inventory situation.

As it stands, it looks as if the inventory burden is lifting.  This is good news.  Stay tuned.

Junky Moods      

A great place to look for signs that that markets are seizing up as a result of decreased risk aversion and for evidence that companies might be having difficulty obtaining the financing they need for expansion is the junk bond market.  When problems arise, the yield spread between high yield bonds and U.S. Treasuries widens.  Conversely, the spread narrows when investors are comfortable with the economic outlook.  In the summer of 2000, widening spreads between high yield bonds and Treasuries began to widen, pointing to growing concerns about the economic outlook.

A key gauge of this is Standard & Poor’s speculative grade credit index.  They report on the spread daily.  You can obtain the data from many news services including Market News.  I report on this data daily on my web site, http://www.bondtalk.com.  You can also get this data on Bloomberg by typing spcispec index (go).

By no coincidence, the S&P spec index peaked the day prior to the Fed’s surprise rate cut on January 2^nd at 1,074 basis points, or 10.75 percentage points over Treasuries.  Since then, the spread has narrowed a whopping 180 basis points.  This narrowing shows that investors have become less risk averse—a must in any economy—and reflects optimism about the future direction of the economy.  After all, why would investors buy junk bonds if they felt the economic outlook was poor?  The fact is they would shun junk bonds under these circumstances out of risk they might lose their capital.

The narrowing of spreads has enabled companies that were unable to issue bonds just a few months ago to enter the junk bond market and issue new debt to obtain capital for expansion.

Here again, therefore, is a sign that the economy will eventually strengthen.

Wrapped in Chains

One of my favorite indicators is the data on weekly store sales released by the nation’s biggest chain stores.  Since consumer spending is two-thirds of the U.S. economy, every bit of information on consumer spending patterns is critical information.  The chain store sales therefore give a good sense of what the consumer is up to.

I obtain information from retailers every Monday.  Wal-Mart’s weekly sales, for example, are made available (so shareholders, so they say but anyone can call) on Monday mornings by telephone at 5012738446 (it is a touchtone recording; type 4, then 1 once the recording begins).  Other chains are also available by phone including JC Penney and Dayton Hudson.  If you are unable to get the information this way then await data from Bank of Tokyo Mitsubishi and or LJR Redbook on Tuesday mornings.  Both companies do a survey of about 70 chains and therefore give a solid indication on the behavior of consumer spending.  Look especially at they way they characterize sales qualitatively.

The retail stocks often respond to this data on a weekly basis but the general market pays little attention.  That gives you an edge.  You can also have an edge on trading the retail stocks since it is mostly smart money that is trading on the data and the laggards follow weeks to months later.

More Indicators

There are many other indicators that will help give you an advance read on where the economy and the market might be headed next, but the above are some of the best indicators to watch in the current environment.  Some of the other indicators pointing to better times, which are no less important include: record bond issuance in January (companies that borrow money today will be spending money tomorrow), double-digit gains in commercial and industrial loans (released every Friday by the Federal Reserve and available on their web site at http://www.federalreserve.gov), the recent strengthening of the dollar, and the relative out-performance of cyclical stocks relative to defensive stocks.

Add it all up and throw in a tax cut and you have a truly credible case for more bullish times ahead. 

A prelude to a bull indeed. 

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