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ECONOMIC RESEARCH
July 2001
Synopsis:
Our
approach to the economy is unusual in not attempting to interpret Fed
policy in order to determine
changes in earnings or GDP growth. Instead, we created a set of Boom
Indicators based upon
the path of key financial series through all 5 previous New Eras. These
key fundamentals have anticipated developments the Fed is responding to on
an ad hoc basis.
This doesn't include the standard economic series and our approach to
stock and bond policy is directly based upon the Indicators and, at
expected trend changes, seasoned technical research. In anticipating major
changes in investment performance, this has been remarkably reliable.
Although "the economy" is only ancillary to our more direct
approach to investment decisions, our work on the business cycle was
appropriate in identifying the top near the start of 2000.
TRACK RECORD
January 1, 2000: Turn Of The Decade Study
From the 1870s to the 1980s, there have been 12 decade-ends and a
business contraction of varying severity closely followed 11 of them.
Essential to this, of course, has been a strong expansion going into the
window of the turn of the decade.
February 7, 2000:
As
the yield curve turned towards inversion, the Street rationalized it as
due to policy and therefore benign. We looked at it as the traditional
warning and noted that since the 1850s "whenever
the curve inverted, a recession has inevitably followed".
This was the feature of a February 7 th
special report entitled An
Important Transition (Yield
Curve and Credit Spreads). This concluded with "The
ratio of risk to reward no longer merits a full commitment to equities.
Fixed income managers should minimize exposure in lower grade securities."
May 5, 2000:
"In
all five [New Eras], the recession started virtually as the bull market
ended. The wealth effect turned quickly to the dearth effect."
February 23, 2001:
This
edition of Pivotal
Events included the
following review:
The Economy:
We
are usually reluctant to discuss the typical series that are so tediously
covered by Wall Street economists. This includes housing starts,
unemployment, GDP, etc. Our view is that if it doesn't have a board lot,
high, low, and last trade, it's unreal. In normal times, the stock market
leads the business cycle by some 10-12 months so even during conventional
conditions it was difficult to make money in the stock market by studying
the "economy". Typically, rising economic numbers kept investors
too long into a bear market and then, with some irony, poor numbers kept
them out in the early stages of the next bull market. In such conditions,
to be brutal, economic studies are misleading.
These are not normal times
and, at the end of every financial mania, business activity has declined
almost immediately with the failure in the stock market. In most cases,
the contraction began rather dramatically. (This was one of our hypotheses
made as our research was completed in 1980.) In this case, near the end of
a new financial era the conventional set of leading indicators should be
changed. The stock market component should be removed from
"leading" and placed within the "coincidental" set of
indicators.
In moving away from non-trivial academics, the business slump is rapid
and seems in line with previous post New Era contractions. As noted on
December 15, under these conditions Greenspan will be permitted to lower
administered rates frequently until the contraction ends. Also mentioned
was that it is dangerous to be confused about cause and effect. As a rule,
short rates for senior obligations in the reserve currency rise during the
boom and then decline during the contraction.
Boom Indicators:
The
behaviour of the key financial series has been similar on the way up each
financial mania and then similar in the transition to each contraction.
The main ones make up our Boom Indicators, which reached their maximum
reading (+12) at the beginning of 2000. These reversed to a warning some 6
weeks before speculation blew out in March. These continued their negative
trend such that our May 5, 2000 Pivotal Events introduced our Recession
Primer. By June 9, the Indicators had turned negative at –1 and we began
the Recession Watch. On June 23, 2000, this observed that if the
Indicators remained at that barely negative level for a few months a
recession would be inevitable. Since then, the reading declined to –9 in
January 2001, from which, with gold's breakdown, it has improved to –8.
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