Don’t Fret About the GDP

Posted by on May 5, 2014

Week over week, the markets closed higher. The highlight of the past week was the Dow Jones Industrials setting another new all-time high.

For those of you following the Dow Theory, this is very good news as it confirms the new high set by the Transportation Index the week before. Put another way, since its creation in 1884 by Charles Dow (he being the Dow in Dow Jones), it’s been a bullish indicator for the markets.

About the GDP figures

The first of three revisions to the first quarter GDP was issued this week showing real (after inflation) growth of 0.1%. There were all kinds of commentary around this, to include variations of the “we’re on the brink of doom” from the usual suspects. The fact that it shouldn’t be a source of concern was validated by the total lack of negative reaction in the markets. Matter of fact, the announcement took place on the same day the Dow set its record.

The Fed, in the opening sentence of its policy statement last week said, “Growth in economic activity has picked up recently, after having slowed sharply during the winter, in part because of adverse weather conditions.” Seems to me this suggests they aren’t all concerned about the figure either. The real GDP result was a combination of surprisingly strong consumer spending and weakness almost everywhere else.

Although nominal GDP (real GDP growth plus inflation) grew at only a 1.4% annual rate in Q1, it’s still up 3.7% from a year ago. This suggests that the Fed could raise rates without harming the economy.

The bottom line here is that the weak GDP growth in Q1 should have been expected, but also should be ignored. The weather was the culprit. I think it sets us up for a nice rebound in Q2.

Looking ahead

For an investor, identifying trends is an important task. You don’t want to base your long-term investment decisions on what’s already happened. More to the point is the fact that the GDP figure is what’s termed a “lagging indicator.” It’s a historical reference point. It comes under the heading of nice to know. From an investor’s standpoint, leading indicators are much more important.

One of the more important of these is the one created by The Conference Board; the Index of Leading Economic Indicators or LEI. By combining monthly a number of individual leading indicators, it’s intended to give us a look into the economy about 3 to 6 months ahead. It has been and remains positive.

Others LEIs include the stock market, manufacturing activity, consumer spending, retail sales, employment trends and building permits – among others. Tracking how these are doing can help be your canary in the coal mine. Let’s look at a couple for what they may be indicating now.

The ISM index, a measure of manufacturing sentiment around the country, continued to move higher in April. (1) The index now shows manufacturing activity expanding at the fastest pace since the end of 2013, with seventeen of the eighteen manufacturing industries surveyed reporting growth in April. While not quite back to the levels we saw in mid-to-late 2013, the index has stood in expansion territory for eleven consecutive months. The better news is that, according to creator of this index, the Institute for Supply Management, the current index level is consistent with real GDP growth of 3.9% annually.

Regarding consumer spending, the Commerce Department reported last week that household purchases, which, according to some, account for as much as 70 percent of the economy, climbed the most since August 2009. This was after a gain in February that was larger than previously estimated.

Regarding real estate, let me ask my friend, Dr. Brian Wesbury, Chief Economist at FirstTrust, to do his usual fine job of explanation.

In the past three years, construction of multi-family units is up 82%, while single-family construction is up 48%. (Think so-called ‘smart growth.’) So, if Americans are buying or renting a larger share of multi-family units, it’s natural for new home sales to be on the soft side. What would concern us is if builders were churning out lots of single-family homes that weren’t getting sold. But inventories of unsold new homes are low when compared to history. The ratio of new home sales to single-family housing starts has been 70% in the past 12 months – versus a 30-year average of 68%. (Teardowns, and building, on land already owned by the future occupant are not counted in sales.)

In other words, current soft new home sales reflect the general shift toward the multi-family sector, among buyers and renters alike. This doesn’t matter much for the size of the economy. Nationwide, multi-family units, are similar in value to 1-family homes, so the “mix” of construction doesn’t have a noticeable effect (on GDP). In other words, fears about housing leading to a recession are overblown.

Strategy

First, pay no attention to the “sell in May” crowd. They got whacked badly the past couple years and, even if this May turns out ugly, the point is that you’re not investing for a month – yours is for multiples of years. A month is background noise, at best.

As to whether stocks still represent good value, let me ask another highly-regarded pro for his thoughts. Strategist and economist Dr. Ed Yardeni pointed out this past week that stocks have approximately 50% higher yields than corporate bonds.

To determine that, the current price of the S&P500 is divided by its earnings. This provides the earnings yield. On this basis, stock profits are yielding about +6.6% vs +4.2% for corporate bonds and vs +2.6% for a 10 year Treasury. In other words, for every $100 invested in stocks, companies are earning $6.60 in profits on average, which are then either paid out to investors as higher dividends or to their companies for future growth. Conclusion – stocks still look somewhat cheap today.

The bottom line for all this note’s data is that the weakness in GDP is a backward looking indicator. The forward-looking indicators present a truer signal of what’s happening in the economy.

Add to this continued good values in stocks and it makes the wait for further moves higher seem a lot more worth the wait.

If you’d like to talk more about how to position yourself for your future or to review your current strategy, please call or email me.

Cheers!

Mike

509-747-3323

(1)  MarketWatch, 1 May 2014

16,512 1881 4123 $1,298 $19.43 $99.81 2.59% $7.90 – $7.97 May

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