A Dash of Insight

Comparing Data Interpretation

Explaining and displaying data combines art and science.  The information itself is objective, as are calculations of trends and changes.  Despite this, there is an element of artistry.

A professor leading a class is motivated to help students find the truth.  One of our old professors described a certain statistical technique as grabbing the data around the neck, squeezing, and insisting, "Speak to me!"

If one starts with a conclusion, however, it is often possible to find support within almost any complicated economic report.  The analyst can look at changes from one period to another, or year-over-year.  One can look at seasonally adjusted or unadjusted data.  One can reject the overall number and look to "internals".  In such a case, the key question is whether the chosen indicator provides important information.

A Case Study: Today's GDP Report

With so many forecasting a recession, or insisting that the current period of slow growth will finally be judged as a recession, many are interested in the official report on GDP.  The estimate for growth in Q1, 2008, was revised upward to an annualized real rate of 0.9%.  While this is well below economic potential, it stayed in positive territory.

Since every economic report comes with plenty of commentary, let us consider the interpretation of the GDP data from three different sources -- all respected analysts who are among our featured sources.

We have provided extensive quotations, much more so than usual, but there is a reason.  Readers should take a few minutes to look carefully at each interpretation and see what conclusions they find.

Gary D. Smith

In his excellent "Bottom Line" summary Gary analyzes the Bloomberg report of the data and draws his own conclusions, including the following:

The economy grew more than previously estimated in the first quarter as Americans shunned imports and exports climbed to another record, Bloomberg reported. Jeffrey Frankel, an economist at Harvard Univ. who is a member of the panel that dates US economic cycles, said in a Bloomberg Radio interview, “I wouldn’t rule out going into recession” later in the year. This statement implies that he doesn’t currently view the slowdown as a recession, in my opinion.

and also this:

The gain in growth last quarter would have been even greater if not for a decline in estimates for inventories. Companies cut inventories at a $14.4 billion annual rate versus an initial estimate of a $1.8 billion gain. Inventories added only .2 percentage point to growth, less than the previously estimated contribution of .8 percentage point.

and finally this:

A measure of total sales, which excludes inventories, was revised to a gain of .7% at an annual pace rather than a .2% drop that was previously estimated. I expect 2Q GDP to easily exceed economists’ estimates of a .1% gain and growth to accelerate modestly into year-end on fiscal/monetary stimuli, lower commodity prices, decelerating inflation, an end to the American Axle strike, a firmer US dollar, inventory rebuilding, an end to the credit market turmoil, strong exports, diminishing housing fears and an improving job market.

Barry Ritholtz

Those reading the Barry Ritholtz blog (and that includes nearly everyone) might get a strikingly different picture.  Barry's key bullet points were as follows:

-Weakest two quarter growth since 2001 recession;
-Private inventory investment added 0.81% to GDP growth;
-Final Sales of domestic product: (GDP growth - private inventories) 0.7% (-0.2% previously)
-Personal consumption expenditure unchanged at +1%  (slowest since Q2 2001)
-Gross private domestic investment: -6.5% (previously -4.7%);
-Residential investment "improved" to -25.5% from -26.7% (most since 1981);
-Business fixed investment: -7.8% (improved from -9.7%);
-Exports weakened to +2.8% from +5.5%;
-Imports weakened to -2.6% from +2.5% ;
-Federal Government consumption expenditure and gross investment: +4.4% (+4.6% previously);
-State and Local Govt: 0.6% (+0.5% previously)

Barry also helpfully notes that if one subtracts trade and inventories, a key indicator according to Merrill Lynch's David Rosenberg, the actual quarter-over-quarter figure was a decline of 0.1%, indicating a "fragile economy."

Briefing.com

Briefing.com provides a timely and comprehensive analysis of every economic report.  Here is their bullet-point summary:

• The revised rate of 0.9% for Q1 GDP was due to an upward revision to net exports (0.6% additional contribution from 0.2%), and nonresidential structures (0.2% higher to 0.0%), and to inventories (0.6% lower to a 0.2% contribution).  All of these were about as expected as the March data on the trade balance, construction spending, and business inventories were out after the advance GDP report and all suggested changes of about this magnitude.
• The revision set GDP trends up for close to a 2% real gain in Q2.  Inventories will add about 0.5% to GDP if there is simply no more liquidation, and net exports and real PCE enter Q2 above the first quarter average.  Any modest improvement in these components in April-June will boost GDP solidly. 
• Real PCE (personal consumption expenditures) rose at a 1.0% annual rate.  This ultimate measure of consumer spending shows that lower home prices and higher gas prices have only dampened consumer spending, not produced declines.  Real PCE is tracking for another gain the second quarter.
• Exports continue to rise sharply and provide a boost to GDP.
• Housing (residential construction) remains a disaster and will continue sharply lower in Q2.  It is now down to just 3.8% of total GDP. 
• Business investment in equipment and software has been surprisingly resilient and will continue near flat in Q2.
• Nonresidential construction has started to weaken and will be a drag on Q2 GDP.
• Inventories provided a modest boost to Q1 GDP (due to a slower rate of liquidation) after taking a slice out of Q4.  Inventories will add further to GDP in Q2 as some accumulation might occur.

Their conclusion is as follows:  The recession has been postponed. (Read the entire article for a more complete analysis).

Our Conclusion

For today, the conclusion is up to the reader.  Three of our favorite sources seem to reach three different conclusions.  What is wrong?  Can we find an inaccurate statement?  Which approach does the best job of illuminating reality -- making the data really "speak?"

The key question is "How many readers can "cut through the spaghetti?" (as a key member of our team often puts it.)

Important News on the Housing Bill

When something important happens, with potential market effects, we interrupt our normally scheduled programming for an update.

We intend to publish the answers to the economics quiz and to announce the winners.  Meanwhile, potential entrants have another day to win this prestigious contest!

The Housing Compromise

At "A Dash" we have written a series of articles on  housing problems and possible solutions.  Since the government steps have been incremental in nature, the market has not really responded.  At some point, there will be a realization that something important has happened.

Last week we pointed out that investors should be watching Sen. Richard Shelby as the indicator of a real compromise.  A Senate Banking Committee compromise was reached today.  While there are more steps in the legislative process, we see this as the real hurdle.

The Significance

We note with interest the opinion of Nouriel Roubini, an outspoken bear on the housing situation.  In two articles, Roubini discusses the merits of the proposal and responds to critics of his viewpoint.  Here is a key portion of his argument, but readers should consult both articles.

Very few reflected on the substance of this proposal and its strong economic logic that would benefit borrowers, lenders and even the government as the fiscal cost of no action (a systemic banking crisis that would trigger a costly fiscal bailout of banks given deposit insurance) is much higher than the potential modest fiscal cost of this proposal.

Conclusion

This is good news for the housing market, the economy, and the stock market.  We shall delve more deeply into the proposal and the effects in future articles.  We shall also examine the reactions of economists and prominent bloggers.

UPDATE, 5/20/08, 1 PM CDT

The editors at TheStreet.com have kindly moved my article on the Frank/Dodd legislation to the non-subscription portion of the site.  Readers of "A Dash" can check out this article for insights from Doug Kass and Jim Cramer, the description of the remaining steps before it becomes law, and the reasons I believe President Bush will sign the legislation.  The process is going to take another six weeks or so, but it will get more attention before then.

Bailout for Homeowners and Lenders?

Developments in housing remain crucial for the economy and for stocks.  Nearly any account of the housing situation includes reports of the number of foreclosures, the inventory of empty homes, and the potential ARM re-sets that may stimulate even more foreclosure activity.

Any help for distressed homeowners would help to shift the supply curve for homes.  This would suggest more stable prices and a lower inventory overhang.  Some have speculated that demand has been suppressed by the expectation of further price decreases.  If this argument is true, then the foreclosure bill might affect demand as well as supply.

The House has already passed a version of the bill under the leadership of Barney Frank.  The Senate Banking Committee is now considering a similar bill.  The Chairman, Christopher Dodd remains optimistic that a compromise will be reached.

The Administration is using a veto threat to affect the legislation.  Their position is represented in the Senate by Richard Shelby (R- Alabama).  Shelby, a former Democrat who switched parties years ago, is calling for more aggressive regulation of the Government Sponsored Enterprises (GSE'S) in the home financing business.  He is also concerned about bailing out the undeserving with taxpayer dollars.

Those in favor of the proposal think that the cost of the bill, perhaps $2 B or so, is easily justified by the benefit for the housing market and the economy.

Putting aside our own opinions on the legislation, we believe that the market would react positively to something helping out homeowners.  For this reason, it is important to watch the key players, especially Shelby.

Meanwhile, housing remains firmly at the bottom of the sector ratings.

TCA-ETF Update

There has been a lot of movement among the top sectors in the last few weeks.  While energy and natural resources choices remain at or near the top, we now also see some technology.  All of the financial sectors have again fallen out of the "buy" range.

The percentage of ETF's earning a "buy" signal is down to 53%, well off the recent highs.  The overall strength ratings are also not as high as in recent weeks.

Listed below is the weekly update.

Musings

Occasionally we find ourselves with a number of topics which are all important, but do not provide the basis for a full column.  These "musings" are still highly recommended for your consideration.

• James Hamilton at Econbrowser takes a look at the unusual movements in InTrade's prediction market contract for a recession in 2008.  He correctly notes the thin trading, and the recent and temporary price decline.  This is exactly our viewpoint.  These markets may show quick moves when someone sweeps through all of the extant bids or offers, but then other players join.  It is price discovery, and the process is not unlike what we see in the housing market.  The political and economic markets have nothing like the liquidity in the sports markets on their sister site, TradeSports.com.  Prof. Hamilton wisely notes the difference between the NBER definition of a recession and that used to settle the InTrade contract.
• There is another good take on prediction markets by Eddy Elfenbein, who correctly notes that they set odds.  The actual outcome does not mean that the odds were incorrect.
• Scott Rothbort, one of our most valued sources, has established a new web site, TheFinanceProfessor.com.  Scott is a money manager, an adjunct professor at Seton Hall, and a valued colleague on RealMoney.  Most importantly, he shares with us the desire to educate investors, helping them to achieve their goals.  His new site has many educational features and is geared to draw content from readers.  Please check it out and visit regularly as we plan to do.  His blog has also been moved, so we have updated our featured listing.
• Thanks to Bill Rempel for reminding us about his earlier work on comparing home price methodologies.  Thanks also to David Merkel, Tim Plaehn, and VennData for their typically constructive comments in response to the question we raised.  We encourage readers to check out the useful and educational discussion on this topic, and follow the links, starting here.
• Turley Muller at Financial Alchemist has a nice series on Apple Computer, Inc. (AAPL), which we own in both institutional and individual accounts.  After hours traders sent the stock as low as 155 and as high as 170 while we were watching.  We shall see tomorrow.  We sold some very juiced May 170 calls against our positions, expecting to profit from the post-earnings reduction in volatility.
• Abnormal Returns has an excellent article on diversification and the benefit of considering additional asset classes.  We have done this in our TCA-ETF portfolio, but we are always looking for new candidates.  The article is a great source both for ideas and general approach.
• Dr. Brett Steenbarger has a free Webinar session on "Reading the Psychology of the Market."  It is after the market close on Thursday.  We know from our personal experience that any chance to learn from Brett is time well spent.

These are all good sources on important issues, of benefit to investors and traders alike.

A Simple and Honest Proposition

Here is a simple and honest proposition:  Data interpretation should lead to conclusions, not the reverse.

If an analyst believes that an indicator is important, and trumpets news about that indicator, it is intellectually dishonest to abandon the measure when it moves the other way.

If one endorses the Baltic Dry Freight index, Dr. Copper, or the inverted yield curve, then one should be willing to change forecasts when those indicators reverse.

Fair enough?

Some of these have recently rebounded, with little attention.  We shall follow up in more detail.

The Application to Housing

Nearly everyone, even those who are not equity investors, is interested in the housing market.  Calculated Risk (a site we feature, along with everyone else!) covers this like a blanket.  There are several key articles today.  Our advice is to read them all.

• A story describing the absolute worst case of subprime lending and packaging.
• Downgrades of a couple thousand securities, formerly in Aaa.  More writedowns?
• The most recent Shiller estimate.  CR objectively notes the discrepancy with OFHEO data (a difference we need to understand) and the use of nominal data.
• Foreclosures soaring in California.
• An analysis of existing home sales.
• An analysis of inventory, at a very high historical level.

It is a great job of telling us all what is at stake and where things stand.

Seasonal Adjustments

We are a bit confused by the analysis from The Big Picture, another featured site.  Barry Ritholtz correctly observes that there are important seasonal factors in home sales.  This is, of course, the reason that everyone else uses the seasonally adjusted data to compare one month to another.  Barry maintains [RealMoney article not yet available, but promised] that we should use unadjusted year-over-year data for comparisons.  We do not understand the advantage of this approach.

Everyone agrees that things are much worse than a year ago.  The seasonally adjusted pace of sales was up 2.9% last month and down 2% this month.  The year-over-year was down 19.9% this month, actually a bit better than last month.  Does that tell us something?  Is it an improvement?

If that is the real test, the year-over-year is going to start looking better in September or October, just because last year was so bad.  Will Barry call a turn in housing if year-over-year flattens out?  That would seem to follow from his analysis, even if the month-to-month seasonal data shows a decline.

We still do not see the advantage of this approach over looking at the seasonally adjusted data.  When one spots a big seasonal effect, as Barry demonstrates, doing the adjustment seems routine.  (We note that he criticizes the WSJ article from last month as not recognizing seasonality, even though it employed the seasonally adjusted data, a 2.9% increase.  Had they used the raw data, the increase would have been 12.3%.  (Check out the data for yourself here).

Questions for further Review

What does it mean for a home to be in "inventory?"

We have not yet seen a good answer to this question.  Let us offer a simple comparison that everyone will understand.  We hold various stock positions.  Each day there is a point where we would buy more and a point where we would sell.  We enter stock offers "away from the market."  Are these offers part of inventory?

Furthermore, if the stock price were to move higher, more stock would be offered.  If it were to move lower, more bids would appear.  The market clearing mechanism involves price discovery, where the market-clearing price is found.  This affects both price and volume.

Applying this to Housing

In our neighborhood, there are people, empty-nesters since this is a kid-friendly town, who are willing to sell at a price that is not realistic.  These homes are part of "inventory" but the offers are not really serious and the sellers are not motivated.

Meanwhile, CNBC reported today that there was a survey as part of the report [UPDATE: here].  18% of homes offered were in foreclosure.  We may assume that these are motivated sellers, as are those who have a job transfer or other personal needs.

Our point is that the concept of "inventory" in existing home sales is a bit elusive.  If prices were to move higher, the "inventory" might increase dramatically.  Things would be worse than we think.  Meanwhile, the existing "inventory" may not really measure the motivated sellers.

Conclusion

We do not have a firm conclusion -- only questions.

We would like to see more analysis where economists looked at shifting demand and supply curves and talked about market-clearing prices.  Instead, nearly all market commentators (mostly non-economists) view both supply and demand as black and white.  This does not recognize that a buyer whose credit score does not qualify at one price may be good enough at another.  This affects the demand curve.

Another question relates to the effect of government programs.  We know that the liberalization of the conforming loan limit on jumbo's has shifted the demand curve.  How much?

We also know that efforts to help those threatened by foreclosure will shift the demand curve.  How much?

No one is analyzing the problem in this way.  At some point -- who knows when? - there will be some bottoming action.  What indicator should we follow to observe this effect?

What is the difference between OFHEO prices and Shiller?  Why?

It will be interesting to see if those who have been the most aggressive in pointing out problems use their methods and indicators that signal the onset of the solutions.

"Sticky Sentiment": Part Two

Market sentiment is an important variable both for traders and investors.  Simply put, if nearly everyone is bullish, who is left to buy?  If there is a high level of bearish sentiment, asset allocations can shift to stocks both rapidly and dramatically.

Readers of "A Dash" know that we use different measures of sentiment for different time frames.  We see sentiment as "sticky" or slow to change since those who have formed opinions are reluctant to accept the significance of new information.  We described the entire process using the real-time trading of a sports event, attempting to help readers to escape the normal trading biases.

Application to Stocks

Gary D. Smith, who has an excellent multi-year record of finding profits, is quite willing to adjust his daily positions to reflect events.  He graciously shares many of these viewpoints, and a lot of important market data, for anyone wise enough to follow his work.  We repeat our strong recommendation to do so.

Gary reports on the most recent data from the American Association of Individual Investors as follows:

The AAII percentage of bulls fell to 30.4% this week from 45.8% the prior week. This reading is still at a depressed level. The AAII percentage of bears rose to 48.7% this week from 37.3% the prior week. This reading is still at an elevated level.

There is plenty of additional detail, including the 10-week averages that show the "sticky" behavior of this sentiment.  The entire article is worth reading.

Gary adds additional information about other indicators.  Here is the more comprehensive story:

Individual and professional investor pessimism towards US stocks remains deep-seated and historical in nature. It is also noteworthy that short interest continues to soar to new record highs, corporate insiders continue to display downright giddy behavior, domestic mutual funds continue to see significant outflows, hedge funds remain net short, the equity put/call 20-day moving average recently hit an extreme, a massive mountain of money market cash on the sidelines continues to grow and according to Google Trends the use of the word “depression” in the news media has recently spiked over the last year. [check the useful links in the original article.] This is just some of the evidence of the current “US negativity bubble."

A Typical Opposing View

Writing in his weekly column for Barron's Alan Abelson states a typical opposing viewpoint:

No arguing that the various and sundry surveys of how investors feel about the market show they've been uniformly and emphatically negative. But our own sense is that the bearishness is a mile wide and an inch deep. That to judge by how they act rather than what they say, the investing multitudes have been champing at the bit to take the plunge...

Rejecting the traditional indicators, Abelson cites anecdotal evidence from the attendance at presentations by a bearish economist.  A novel approach indeed!

Others making similar long reaches for an argument ask, "How can the market have bearish sentiment, when it is reaching new highs?"  Market averages can and do fight sentiment -- all the way up (or down).  This was the point of our out-of-the box illustration from sports.

Our Take

Investors should let evidence lead them to a conclusion, changing opinions when indicated.  When one instead begins with the conclusion, it is always possible to find some new indicator that seems to confirm one's viewpoint.

Understanding the difference is crucial to investment and trading success.  We agree both with Gary's evidence and his conclusion, "I still expect US stocks to rise sharply from current levels later this year..."

Housing Problem: What Inning is It?

Are we the only ones getting tired of the "What inning?" question?  When we think baseball, it is better to enjoy the early success of Chicago's two teams, especially the suddenly slick-fielding White Sox.

For several months financial television asked everyone about recession chances.  Prior training or experience not required -- all opinions welcome.

The question du jour is now, "Which inning of the mortgage crisis are we in?"

John Hussman's Answer

The widely-read and respected John Hussman complains as follows:

One of the fascinating aspects of Wall Street is the ability of analysts to provide opinions without the faintest backing from evidence. Among the latest topics of opinion is how far the mortgage crisis has to go. Evidently, the idea is that the recession that these analysts didn't forecast is already over, so it is time to “look across the valley” on the belief that most of the writedowns are behind us.

Hussman's own approach is to take a schedule of resets and integrate the curve to show a cumulative effect.  From this, he concludes that we are still in the early innings, with each inning lasting three months.  The worst is yet to come, etc.  Check out the entire article.

Two Errors

The Hussman analysis makes two serious errors.  First, he uses data from nearly a year ago.  This is assuming that ARM resets are a stationary target.  In fact, many mortgage holders have already refinanced.

This was reflected in a recent AP-AOL survey, the subject of an article we wrote for Real Money (subscription required).  Two survey results were especially relevant to this question:

1. Only 11% of those with mortgages have adjustable rates; 18 months ago, the figure was 22%. This suggests that there has already been a lot of refinancing.
2. Among homeowners with adjustable-rate mortgages, those who are worried about making their payments after an increase is 36%, exactly what it was in the prior survey.

We are hesitant to mix two different methods of measurement and two different time periods, but surely there has been some change since the stale chart cited in the Hussman article.  If he is going to use some fancy analysis to impress and frighten the average reader, at least he could update the data.

The second Hussman error is quite common.  He is focused on the problem while completely ignoring any solutions.  The loosening of restrictions on Fannie and Freddie (including the conforming loan cap and the overall portfolio cap) will help to encourage refinancing that was difficult a few months ago.

Jordan Kahn at In the Money, one of our featured sites, writes as follows:

I think the news from Freddie Mac (FRE) today was pretty significant, although it received little attention.

In the press release, Freddie said it will buy jumbo mortgages in high-cost regions from Wells Fargo (WFC), JPMorgan Chase (JPM), Citigroup (C) and Washington Mutual (WM). The government-sponsored enterprise expects to finance between $10 billion and $15 billion in new jumbo mortgages in 2008.

He points out that the old caps were ridiculous in some areas, a theme we have also argued.  Jordan calls it "big news" which will help us get closer to a bottom in housing.

[Jordan sat in the hot seat today, covering for Doug Kass on his daily investing blog, The Edge.  Doug is doing a lecture at the Harvard Business School!  We hope that the Wharton man gets the appropriate respect from the Harvard crew.  Meanwhile, Jordan did his usual great job as a substitute.]

Conclusion

Ironically, John Hussman did exactly what he accused others of doing.  The evidence he adduces for his answer to the "innings question" is no more plausible than anyone else's.

Our own answer?  We do not know.  Neither does anyone else.  It is going to depend upon the ability of people to refinance, where fixed rates go, how quickly Fannie and Freddie and the FHA provide help, and whether a foreclosure assistance bill passes Congress and gets signed by the President.

We do not know the answers to those questions, but at least we know what to look for.

TCA-ETF Update

As we regularly do on Thursday, we are showing an update on our TCA-ETF sector model rankings.  The overall result for the third cycle, begun on January 25th, is about even, roughly the same as the S&P 500 and a bit ahead of the NASDAQ.  There are two interesting things to observe.

First, the strongest sectors remain the "weak dollar" plays.  Second, the overwhelming majority of sectors are in the "buy" range.

Interested readers can get a report via email on participating in our weekly trading program for individual investors.

Doug Kass on Housing Predictions: An Update

At "A Dash" we have frequently cited the work of Doug Kass, a colleague at TheStreet.com.  Even before we contributed to RealMoney, we were paying customers to get Doug's work.   We found it to be a source of trading profits, as long as you understood the perspective.

We were therefore a bit surprised when Doug, writing on RealMoney Silver (where we can make no reply), took issue with our conclusions in an article about a survey.  Discussing reasoning and conclusions is fine, of course, but his comment was completely lacking in substance -- nothing about the article in question!

Instead, Doug engaged in an ad hominem attack.  Here is a key quote:

You (and many others) have been dead wrong on the magnitude of the drop in housing while the housing Cassandras have been dead right. (Just go back to your site and reference your reaction to my housing "hyperbole" several years ago.)

Those are the facts. They are not debatable.

We are delighted to see this statement of the issue.  Since we have no ability to reply where Doug wrote, we will have to write here.  As we have often done in the past, we invite Doug Kass to write something in response.  We promise to publish it without any edits.

Let us examine the quantification question.  But first, a bit of background on the housing issue.

Our Position on Housing

In the days before we were writing on this blog, we sent a quarterly newsletter to our investors.  Here is a quotation from the issue of June, 2005:

Housing

Is there a bubble? We see some disturbing facts, all signs of market tops.
People who were formerly day-traders in stocks or had good jobs in software development are now going into real estate.

If you tried to look at housing like a stock, using a PE ratio (rent/price), the number is about 35, 75% above the historic norm and double that of the major stock market averages.

Average folks with absolutely no real estate experience are buying properties with interest-only mortgages expecting to make their profits on appreciation.

We can smell some toast burning here.

We advised our clients against over-investment in real estate and those who followed our program for individual investors did quite nicely in stocks.  Doug Kass was not the only one seeing a problem in housing; he was just too early -- way too early -- in predicting the impacts.  (Check out Doug's timing here).

The "Batman" Chart

Since the issue is quantification, not direction, a great example to consider is Doug's prediction about personal consumption from a year ago.  He had this impressive chart with a distinctive pattern that we called "Batman" around our office.  The time period and the scales had been adjusted to give a false illusion of a strong correlation.  Here is the original chart.

Doug highlighted this chart in his column multiple times and took it on CNBC calling it a .9 correlation.  Charts of this sort are very dangerous for investors.  They do not understand statistics and causal modeling.  They are especially susceptible to visual evidence.

We reconstructed the data and did the calculations.  In one of the best articles we have ever written, we showed the problem in this analysis from a causal modeling perspective.  We expect this article to have a prominent place in our forthcoming book in the "Misleading Charts" chapter.

The obvious implication was that PCE would rapidly decline to below the 2% growth rate.  We analyzed the intermediate results in this article where we showed that the prediction had failed.  We think that Doug was a victim on this entire story.  Someone sent him this chart -- someone with dubious quantitative skill -- and convinced him to go with it.  He should have renounced it at some point.

Current Chart Update

The most recent evidence, one year after the original article, is even more dramatic.  As one might expect, the lending restrictions of banks have increased dramatically.  The changes are actually off of the scale.  The Fed altered the question to split out lending on qualifying mortgages versus subprime and Alt-A.  Bending over backwards, we have used the prime mortgage series in the chart.

Conclusion

As one can readily see from the chart, the precipitous change in lending standards (Doug used an inverted scale so that tighter standards would match lower PCE) did not result in a similar decline in Personal Consumption.  The direction was correct.  As we stated in the original article this is called a "spurious relationship" by those who do causal modeling.  A weakening economy causes all sorts of effects that do not have a causal relationship.

Doug Kass never cited this chart again, nor did any of the other blogs who picked it up.  The conclusion from this chart is inescapable:

Kass grossly overestimated the impact on Personal Consumption in March, 2007.  As he says, "Those are the facts.  They are not debatable."

 

How to Win a Recession-Predicting Contest

For the last few months, and much longer for some, there has been a barrage of commentary about whether or not "we are already in a recession."  The financial media have continuously polled the public to see what they think, and asked everyone who appeared on financial television.  It did not matter whether the respondent had any forecasting credentials.  Apparently we all want to know what anyone thinks about this important question.

Maria Bartiromo, whose interviews other journalists might well study, draws a careful line.  She does not advance her own ideas and then ask the expert to agree.  Instead, she draws out information.  She does show enthusiasm and encourage her interview subjects.  It is amazing how often she asks exactly the question we are thinking of.  Bartiromo warns that the media fixation on recession could become a self-fulfilling prophecy.  On the Today Show, she made this thoughtful comment:

“[T]he truth is, [“Today” co-anchor] Meredith [Vieira], it doesn't matter if we’re in a recession,” Bartiromo said. “We can talk ourselves into a recession, and that seems to be what we’re doing right now and that certainly begets more weakness.”

Meanwhile, a majority of economists now agrees that "we are in a recession."

It Really Does not Matter

There is no light switch that makes things terrible if the economy is in a recession and acceptable if it is not.  Economic data show that we are experiencing a period of economic weakness.  This means lost jobs and lost profits.  It is a permanent loss and painful to many.  This is true whether or not the economic weakness attains status as an "official" recession.  It is a range of results, not a black or white question.

The Contest

There is persistent interest about the recession question.  It is a proven winner for pundit and media articles.  It is as if there was a contest going on.  Let us make it official.  How should we determine the winner?

There are some logical steps involved in winning a contest.  First, you need a definition of a recession.

Warren Buffett, esteemed by all and especially by us, says that this is a recession by any common sense definition.  Maybe so, but common sense is difficult to codify.

Some embrace the rule of thumb:  two quarters of negative GDP growth.  This is the definition at InTrade, where those living outside of the US can trade the prediction markets legally.  Since InTrade has to pay off to winners and losers, they need a specific rule with a timely resolution.  The punters have the odds at 70% or so.   Bespoke Investment Group and Greenback Consulting report these results.  We should note that the public has been wrong on this forecast and those selling short the 2007 InTrade recession contract collected.

The official definition comes from the National Bureau of Economic Research (NBER), the accepted recession-dating authority for decades.  Here are the NBER criteria, also known as the official rules for this contest by which contestants will be judged:

The committee places particular emphasis on two monthly measures of activity across the entire economy: (1) personal income less transfer payments, in real terms and (2) employment. In addition, we refer to two indicators with coverage primarily of manufacturing and goods: (3) industrial production and (4) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes. We also look at monthly estimates of real GDP such as those prepared by Macroeconomic Advisers (see http://www.macroadvisers.com). Although these indicators are the most important measures considered by the NBER in developing its business cycle chronology, there is no fixed rule about which other measures contribute information to the process.

The NBER also notes the following:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

Implications for a Winning Entry

Many contest entrants have not studied the rules:

• The effects must be broad based, not emphasizing a specific sector;
• The definition is monthly, not quarterly;
• The official start of the recession will go back to the last peak of economic activity; and
• The result is not known for months -- maybe many months -- after the recession has occurred.

The last point is especially noteworthy.  The study of economics involves the use of accurate data.  The official data get revised as more information becomes available.  This means that no one really knows the key factors for many months.  It is not that economists are stupid  or incompetent.  They are attempting to develop data that are useful in econometric models.  Recession dating is inevitably retrospective.

The dating procedure has important implications for those entering the contest.

1. Those who started forecasting the recession too far in advance should be disqualified.  There has to be some statute of limitations.
2. If the current period gets defined as a recession, those "calling it" at the time of the last peak will be the winners.  The official date will go back to that time -- perhaps October or November.
3. There could be a recession, as defined by the NBER, even if there is no single quarter of negative GDP growth.  Careful readers will observe that all criteria could be met without an actual decline in GDP.

Handicapping the Field

The Perma-Bears. Readers can submit their nominations, but quite a number of forecasters have been on the recession theme for more than a year.  They are disqualified, unless they specified a starting point.

October-November predictors.  These entrants might win, if the NBER conditions are met.  These are the pundits who have said for months that "we are already in a recession."  A better formulation of their comments might be that these conditions, if sustained for a long enough period, will eventually be judged as a recession by the NBER.

The Deniers.  There are several respected pundits who do not believe that current experience will constitute a recession.  These include Rich Karlgaard, Vince Farrell, Gary D. Smith, Dick Green, Mark Perry, and David Malpass.  These observers, all of whom we respect, note that current data are not actually at the levels of past recessions.  We note that the NBER might deem this a recession if the pullback from the peak is great enough, broad enough, and long enough.

The Probability Analysts.  Some of our most thoughtful and respected sources consider the data and make forecasts in a careful fashion.  These forecasts weigh probabilities, mostly the question of whether the NBER criteria will be met.  They ask the question of whether the current economic weakness will eventually prove to be long enough and broad enough to meet the definition.  This group includes two of our favorite sources, including the ECRI (recently calling the recession) and Econbrowser (with an ongoing evaluation).

The Winner?

Winning the recession forecasting contest is a bit like wining one's NCAA March Madness pool.  The most thoughtful handicapping may lose to those taking an eccentric but winning position.

We expect the ultimate winner to be a pundit from two polar opposite groups:  one calling the start in October or November or one predicting that no recession will occur.

Our reason?  If this time period is ultimately deemed to be a recession, the dating will go back to the last peak.  Those are the rules.

Corrections?  We invite anyone whom we have missed to check in with an entry.  Readers, too.  Also, please let us know if we mis-represented anyone's position.

Winners will be announced in a year or so, when the NBER analyzes all of the revised data!

Sentiment and Reality

At "A Dash" we do not indulge in the very short-term market calls.  It is a popular thing to do, and someone has always made a spectacular prediction.

Our problem with these methods is that they are not testable.  Someone is always right, but how should one evaluate the overall record?

Friday's Trading

On Friday we saw a steep decline in the market averages that was the virtual flip-side of the pre-weekend trading seven days ago.  What was the difference?  The hot-money traders learn quickly.  A single data point is enough!

Charlie Gasparino's prediction last week of a "bailout" for the bond insurers did not pan out.  End of story.

Actually, the Gasparino coverage was quite strong.  He revealed some of the actual discussions, showing that there was a dialog among the insurance commissioners, the potential investors, and the ratings agencies.

To anyone with some understanding of how agreements are formed, this should be good news.  The rating agencies are not rolling over and accepting anything.  The investors are listening and crafting a package.  There will be time allowed to do it right.

Meanwhile, investors are acting like spoiled children.  We want a solution, and we want it now!  There is little understanding that problems which develop over years might take a few weeks to solve.

The Bearish Victory

The disparity between expectations and data continues.  Those with a bearish bent argue that there is already a recession, it will be terrible, it is not priced into the market, earnings estimates must move much lower, and there will be a general calamity on the scale of the 70's stagflation or even the Great Depression. Wow!

When stocks move lower, it seems to prove the point.  This is most interesting and worth some thought.

Anyone who claims to provide a market edge, almost by definition, must find occasions when the market is wrong and the analyst has a superior viewpoint.  The most bearish economic pundits now get to claim victory -- even if the economy never enters a recession!

It is not necessary to be right on the facts to be right on the market.  As the market moves lower, there is a building sentiment that it "must test the January lows."  This advice is usually offered in a deep and stern voice.  If enough people believe it, it happens.  It is seen as proof of the economic forecasts.

We are now a few points away from those lows in the S&P 500 and even closer in the Nasdaq.

Data, Anyone?

Meanwhile, there is a different picture available to those willing to look at data.

• Today's ISM number was widely publicized as showing contraction in manufacturing.  The actual data are consistent with GDP growth of 2.0 - 2.5%.  This is much better than most think.
• All of the consumer data shows record spending.  David Malpass writes "Many U.S. indicators are at new all-time records, including the February 29th data on consumption in real terms ($8.351 trillion annual rate in January) and both income and consumption in nominal terms ($11.93T and $10.02T respectively).
• Earnings results outside of financials have been excellent.  Financial earnings have been hit by write-downs enforced by marking to market in extreme conditions.  The jury is out about next year, but many see the artificial markdowns as contributing a bounce. 

Markets can, should, and will look ahead...

Media types and bloggers have a fixation with scare tactics like "stagflation."  The cooler heads, like Bob McTeer, try to make careful and reasonable comparisons.  Take a look at his latest thoughts.

Meanwhile, the markets have underestimated the impact of Fed rate cuts and the stimulus package.  These will start to show up very soon -- perhaps in a month or so.

A Final Observation

There are other policy actions in the works.  It is popular to point at the list of potential housing foreclosures.  In fact, it is open season for those working to avoid disaster.

So many are so busy at the job of criticizing government officials.  In this environment it is easy for the investor to forget a key point.

Those who chose to work in government did so because they wanted power rather than salary.  When we tally up the results, whom do you think will be proven correct:  The critics, or those who actually have the power?

Our bet is with the Fed and the Treasury.