LEI - Is There A Disconnect?
The data behind the Conference Board's Leading Economic Indicator (LEI) index has been drastically revised twice in as many months which has led questions about the relative strength of the economy during that period. The latest revised data shows a marked improvement over the data we were looking at a couple of months ago which continues to bolster my point about the problems with economic data and forecasting. However, even with the latest data revisions, the longer term trend of the data has remained relatively unchanged.
The chart below shows the annualized rate of change in the LEI index versus the S&P 500.
The annual rate of change tends to peak ahead of the market. Pre-1980 the peaks in the LEI index coincided more closely with peaks in the market versus more recent years. However, the negative trend of the LEI since the turn of the century has not only been a reliable indicator of the maturity of the economic cycle but a cross below the ZERO bound has been closely associated with a market peak. However, with the Fed artificially suppressing the yield spread and boosting asset prices (both of which are major components of the index) through repeated QE programs the artificial inflation of the index is likely masking the weakness in the economy.
Speaking of underlying weakness in the economy - the next chart is the annual change in the LEI versus the annualized growth rate of GDP.
The extremely high correlation between the two charts should provide for a pause. Juxtaposed to the chart of the S&P 500 the peaks and declines in the LEI are closely tied to the ebb and flow of the economy. Historically, when the annual rate of change in the LEI drops below zero the economy either has been, or was close to, a recession. At a current reading of 2.06% there is not a tremendous margin for error with regards to missteps with either fiscal or monetary policy. Furthermore, as discussed recently, with the global recession already providing a drag on the domestic economy - any drastic moves toward austerity could easily push the economy over the ledge.
While the trend of the LEI remains positive the rate of slower growth should be of some concern particularly in the light of the artificial inducements by the Fed which impact not only the stock market and yield spread components of the index but also sentiment. It is my best guess that the LEI index would look substantially different if the effect of the QE programs by the Federal Reserve were removed.
However, in the meantime, the markets remain on solid footing even as the economy continues to limp along. With earnings softening, multiples rising and overall risk appetite on the rise - it is likely only a function of time before something breaks. One of the biggest warning flags as of late is that even as the economic indicators point towards weakness there is a loud drumbeat that "no asset bubble" currently exists. This is a fairly bold claim considering that the majority of the rise in the asset markets over the last 4 years can be directly traced to the Fed's repeated interventions. Without such massive levels of financial support the S&P 500 would be trading at much lower levels currently rather than flirting with multi-year highs. However, for evidence that we may be further along in the creation of the next asset bubble - the chart below, from a recent speech by Fed Governor Jeremy Stein, shows the level of junk bond and leveraged loan securities in the market place. The issuance of these high risk securities set a new record in 2012.
Furthermore, while credit spreads have tightened in recent months due to the effects of the Fed's liquidity programs, the lower spreads continue to push investors to chase yield as they believe that the "Bernanke Put" will remain indefinitely. This lack of "risk awareness" or "fear" has pushed issuance of PIK bonds and Convenant-Lite loans to all-time records. As a gentle reminder - the last peak in these issues was just prior to the last crisis.
The point here is that much of the economic and financial data is being skewed by artificial forces (stimulus, government supports, warm weather) which is masking the real strength, or lack thereof, in the economy. While the LEI continues to grind higher the reality is that the data is being skewed by the Fed's interventions.
The current levels of bullishness about the markets, and the economy, puts investors at risk of a sharp, and unexpected, reversion if reality doesn't catch up with those expectations soon. What concerns me most is that the buildup in risk appetite is reminiscent of what we saw just prior to the last financial setback. Of course, the attitude at that time was that the major issues were "contained" and that the a "goldilocks economy" lay ahead.
Once again, Bernanke recently minimized the concerns that the central bank's monetary policy has spawned economically-risky asset bubbles. A closer look at the data doesn't really support that claim. However, this time could be different...right?