ELF
Capital Management, LLC
(Endowment
Like Fund Management)
May
6, 2011
This is the ELF Capital Management,
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Understanding the Economy: Lagging Indicators
What drives your
economic thinking? What information contributes
to your business decisions? Or, your investment
decisions? I pose these questions because a great many
people allow themselves to be influenced by looking through the rear view
mirror and let the past guide too much of their future. In fact, always looking backwards may only serve
to increase your chances of becoming the victim of an accident.
Take for example, how
the average investor makes decisions when selecting mutual funds for their
company retirement plan account. According
to the annual investor behavior studies conducted by Dalbar Inc., an
organization that performs research in this area, the average investor most
often selects funds that were the prior year’s winners. And, more often than not, in the following
year, these past winners earn below average returns. Even after several years of poor results, the
average investor keeps chasing past performance. This strategy keeps them in the same battle,
fighting the same counterproductive war over and over.
Now I’m not saying
that backward-looking information isn’t useful.
The Dalbar example was just an illustration. At the same time, these average investors may
just be giving too little thought when making changes to their retirement plan
selections. Rather than taking more time
to learn how to make better decisions, or seeking professional help, they may
just be giving short-shrift to the selection process and hoping for the best.
Yet, I wouldn’t be
surprised if this introduction led you to think: Why waste my time learning
about lagging indicators? And, you may
be right! However, depending upon the
type and use, lagging indicators can provide a signal that a real trend has or hasn’t
yet started. And, this could be very
important if those current and forward looking indicators are simply misleading. If leading indicators weren’t so notorious
for giving false signals, you wouldn’t need to look at coincident and lagging
indicators too!
This article is the
last in a three-part series that discusses some of the more widely followed
economic indicators. And, my goal was to
bring context to their usefulness through summarizing them as: leading
indicators, coincident indicators and lagging indicators. My prior articles discussed “leading” and
“coincident indicators” and this one will review “lagging indicators”.
Each month, various
governmental agencies and research associations compile and release a wide
variety of information about the economy.
Much of this data is “after the fact” information or relates to measures
of confidence. In addition, quite often the
data is derived from statistical sampling methods which carry a margin of error
– usually, the smaller the sample, the greater the potential for sampling
error. Yet despite their potential for
error, these “economic indicators” can help guide our ability to make more
confident financial decisions. That is,
if you take the time to understand them.
As the categories indicate,
leading indicators help to predict
what the economy will do in the future; coincident
indicators help us understand the current state of the economy; and lagging indicators help to confirm or deny
the validity of the other two.
The Lagging Indicator Index Components
For the sake of
efficiency and debate, I will describe these indicators in groupings used by
The Conference Board. The Conference
Board is a global, independent research association who compiles data and
publishes the indices of leading, coincident and lagging indicators each month.
The Conference
Board’s lagging indicator model is composed of seven economic measures currently
thought to be indicative of confirming the validity of economic trends. The lagging index can also serve to signal
the sustainability and momentum of an existing economic trend. Each component indicator is described as
follows:
Average duration of
unemployment: usually expressed in “number of weeks”, this
is a measure of how long the average individual is unemployed. While the sharpest increases seem to occur
after a recession has started, decreases in unemployment generally occur only
after a recovery or expansion phase gains strength.
Inventory to sales
ratio: inventory and sales data from manufacturing,
wholesaling and retail businesses are used in this measure. And, as used in the LEI, the numbers are
adjusted for seasonal business cycles and for inflation.
Actually, this ratio
can be very telling. When an economy
begins to slow down, what do you think happens to sales figures? You’d expect sales to slow also, wouldn’t
you? And, if sales are slowing before
manufacturers and purchasing managers find out, inventories should begin to
build up. As a result, it’s not unreasonable
to see this ratio peak by the time we’ve reached the middle of a
recession. Alternatively, you should be
able to observe a big decline in this ratio at the beginning of an
expansion. Why? Because inventories may not be replenished
fast enough to meet the newly increased demand.
Change in
manufacturer’s labor costs per unit of output: this is another business
related measure that focuses on the manufacturing sector. This ratio is considered to be erratic on a
month-to-month basis, so The Conference Board “smoothes” over the data before
including it in the index. To smooth
things over, they apply seasonal adjustments and recalculate the numbers over
“rolling” six-month periods.
In a recession, labor
costs per unit should increase as production is scaled back faster than workers
are being laid off. That’s the example
given in The Conference Board’s literature.
Yet, unit labor costs could also rise as a result of a number of factors
– including wage inflation.
Average prime rate
charged by banks: prime is one of several short term interest rates
used by banks to price business loans.
As implied, this is an average rate posted by a majority of the largest
U.S chartered and insured commercial banks.
While prime rate statistics are compiled daily, the measurement used in
the LEI index is a monthly number compiled by the Federal Reserve Board of
Governors.
This, perhaps, might
be one of the most lagging numbers in the LEI index for one reason. The U.S. Prime Rate has been traditionally
tied to the Fed Funds Target Rate set by the Federal Reserve’s Open Market
Committee. It is potentially the most
lagging indicator as the Fed doesn’t usually change the target rate unless it
wants to take significant steps to either slow down or stimulate growth in the
economy. This factor aside, the Prime
Rate has commonly been 3 percentage points higher than the Fed Funds Target
Rate
Commercial and
industrial loans outstanding: this measure reflects the trend of business
only lending activity in the economy. The majority of these loans are usually
short-term in nature and tied to some form of collateral. This series measures business loans held by
banks plus the amount of commercial paper issued by non-financial companies as
published by the Federal Reserve Board of Governors.
The Conference
Board’s rationale for this index is that
the measure tends to peak after an expansion peaks because declining profits
usually increase the demand for loans and it typically bottoms more than a year
after a recession ends.
Consumer credit
outstanding to personal income: this ratio measures the relationship between
consumer debt and income. Consumer
installment credit is a statistic compiled by the Federal Reserve Board of
Governors that measures the difference of new consumer credit less the
repayment of principal on existing debt; and, the personal income data is the same
employment related measure that I discussed in my article about Coincident
Indicators – it is compiled by the Bureau of Economic Analysis.
The Conference Board
contends that because consumers tend to hold off personal borrowing until
months after a recession ends, this ratio typically bottoms after personal
income has risen for a year or longer.
Change in Consumer
Price Index (CPI) for Services: this is the change in the service component
of the CPI that is compiled by the Bureau of Labor Statistics. The Conference Board asserts that it is
probable that because of recognition lags and other market rigidities, service
sector inflation tends to increase in the initial months of a recession and
decrease in the initial months of an expansion.
Which Indicators are Considered Important?
As mentioned at the
onset of this article, lagging indicators are useful in confirming long-term
trends – but not for predicting them.
They help investors, managers and consumers understand that the economy
has already begun to follow a particular pattern or trend.
In my two prior
articles, I reviewed that leading indicators are useful to help predict turning
points in the economy and coincident indicators help us compare where we are
versus where we’ve been. Adding on, lagging
indicators provide you the ability to understand the strength and reliability
of the other two which should reduce uncertainty.
In constructing the lagging
indicator index, the Conference Board assigns weightings and averages to the
individual components listed above in order to smooth out any volatility in the
readings. The weightings given to the
individual components are summarized as:
- Three of the seven components
account for almost 70% of the index.
The Average Prime Rate (28.2%) is considered the most influential,
with the Consumer Credit to Income ratio (21.2%) and Services CPI (19.5%)
rounding out the top tier.
- The remaining measures comprise
the balance: Inventory to Sales
12.1%; C&I Loans 9.7%; Labor Cost per Output Unit 5.9%; and Average
Duration of Unemployment 3.6%.
It is interesting to
see that short-term lending activity and inflationary forces are considered the
most influential lagging components and unemployment has less of a footprint on
it. After comparing the component types,
can you really agree with the general assumption that employment data is one of
the most lagging of economic indicators?
I know I can’t…
ELF’s Outlook and Performance
It’s been a
brisk several months since issuing our last letter as business activity has
kept me from finding time. The markets
have been brisk too. Since the beginning
of the year, investors have been returning to
As a group,
emerging market stocks have spent most of this year in negative territory while
the US Dow Jones Industrial Average has remained positive and is currently
besting most of the major market averages by roughly 2%. The Dow ended April up 10.65%. But this year’s rise has not been steady. In mid March, all of the major averages gave
back all of the year’s gains before reaching new highs by month’s end. And, since the beginning of 2011, the Russell
2000 gets the award for the most volatile performance of the bunch.
Running
into May, we’re seeing momentum shift into “low gear” as the old adage “sell in
May and go away” may bear some credence.
Many are anxious of the uncertain effect as we near the end of the Fed’s
money printing exercise in June. By some
accounts, it was believed that the Fed had already completed 95% of their
announced $600 billion of bond purchases by mid-April. So, we’re not so sure that the end of QE2 is
the reason. Perhaps reaching $4 per
gallon at the gas pumps and high food costs has created fears that consumers
will cut back on their spending.
Nevertheless, the past week’s market action implies that there is a
major sector shift afoot as precious metals and other commodity related stocks
have just had a significant correction and it is too early to say if it is
over. West Texas Intermediate Crude
ended the week dropping more than 10% to settle under $100 per barrel. Hopefully, that translates into lower gas
prices as we enter the summer driving season – but don’t bet on it.
As for our
activity, we began taking profits in mid-April and have raised our cash
positions to slightly better than 40%. I
don’t see us holding such high cash levels throughout the summer but with the
market’s current downward sentiment, it sure feels good to be ready to go
bargain hunting if the momentum stays to the downside.
Our portfolio clients
ended the month of April up 2.08%. Here are some comparative numbers for
you to review:
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for
both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
ELF’s
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.
Broad market
index information provided is solely for the purpose of comparison. This index data was obtained from third party
sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should
not be construed as an investment in an index or in a program that seeks to
replicate any index. In most cases,
investors choose a market “index” having comparable characteristics to their
portfolio as a benchmark. An ETF is a
security that tracks an index benchmark or components thereof. As ELF actively manages a strategic
allocation of primarily ETFs, selecting a comparable benchmark poses
significant challenges. Over time, the
broad market indices provided above may exhibit more, similar or less variability
of returns and risk than ELF’s strategic allocation. As well, the broad market index information
provided above reflects gross returns and have not been reduced by any
estimated fees or expenses that a person might incur in trying to replicate an
index.