Spying the green shoots

The US economy is in tough shape currently, and is probably experiencing the worst recession since World War II, or very close to it. There are four metrics considered to be the gold standard regarding the health of the economy--industrial production, real income, employment, and real retail sales. All except real income are at their worst levels compared with the six previous recessions. When all is said and done, I expect that the US economy will decline around 3% from its high in the third quarter of 2007 until the economy bottoms sometime in the second or third quarter of 2009. This would also be in line with the recessions of the mid-1970s and early 1980s, but far better than the 20%-plus decline reported during the Great Depression. Unfortunately, US unemployment, a lagging indicator, is likely to peak later this year or even early 2010 at something like 9%-10%.

Some early positive signs, but still fragile
We are seeing some signs that parts of the US economy may be turning. However, we must strengthen our financial system and avoid a catastrophic auto industry shutdown for things to continue to improve. My analysis focuses on the positives--the so-called green shoots--because the negatives are well known and we are 17 months into this recession, the longest recession since the Great Depression. However, we would be careless not to acknowledge that the current situation is bad, especially regarding employment and the banking system. We are on a knife's edge too, with just one stupid policy decision or negative event potentially undoing our progress.

ISM New Orders Index bottomed in December
One of our favourite indicators that has turned positive is the Institute for Supply Management monthly survey of new orders. This indicator has one of the longest lead times of the economic indicators we consider, with an average lead time of more than four months. The ISM New Order Index bottomed in December at 23, followed by two readings in the low 30s in January and February, and then moved all the way to 41 in March and 47 in April. The trend has clearly been positive for several months. I caution that this series can be volatile from month to month, but it feels like the economy has made the turn. Besides a great track record, I like this indicator as a leading one because it measures orders to be fulfilled in the future. And once that order is received, it might take a while to actually fill it. Therefore, it is prone to move before production and employment.

Initial unemployment claims have stabilised with some improvement
Although I am not a fan of employment numbers in general as a leading indicator, it appears that initial unemployment claims may have peaked. After doubling during the last two years, the four-week average of claims has dropped from 658,000 five weeks ago to 623,500 the week of May 2. Given that layoffs are halted first in a recovery (influencing initial claims), initial claims is a much better indicator than employment growth (that happens once managements feel comfortable that the turn is for real). The unemployment rate tends to peak even later because discouraged workers (who aren't included in the unemployment rate) pile back into the workforce.

Commodity prices stabilising
Stable to improving commodity prices are another indicator that the economy might be turning. Not every commodity is showing increases, but oil at around $50 a barrel--up from a low in the mid-30s--is indicative of an improved demand environment. Given that oil is used by consumers and in industrial applications, it has broader implications than many other commodities. Copper, widely used in construction and manufacturing, has moved up more than 50% off its bottom. Commodities can make interesting indicators because prices are widely available daily and not subject to the revisions often facing more conventional indicators.

Housing showing some improvements at last
Housing was the key area to drive the US economy into a recession, so we are watching housing metrics very closely, looking for any signs of improvement. Although the housing data remain mixed, we are relatively confident that things are on the mend. Housing statistics are volatile and hard to read. There are large seasonal factors, and they can be affected by weather. That said, inventory levels of unsold single-family homes as reported by the National Association of Realtors peaked last summer at 4.5 million units and subsequently declined in fits and starts to 3.7 million. This compares with a more typical inventory level of 2 million units. The Wall Street Journal recently reported inventories in key markets were down substantially from peak levels, with many markets reporting decreases of 20%-40%. We are also beginning to hear stories, especially from California, of bidding wars breaking out. A combination of record affordability (median house payments to median income) and an $8,000 first-time homebuyer tax credit are beginning to work their magic.

Our housing team, led by Eric Landry, is also optimistic that we may be nearing an end to the large price decreases in some markets. The team's analysis of data from Housingtracker.net suggests median listing prices (not actual selling prices) have begun to increase in many key markets. Early work suggests that these listing prices can lead the closely watched Case-Shiller pricing numbers by at least a couple of months. Also, the Federal Finance Housing Authority House Price Index showed small sequential increases in both January and February as did the National Association of Realtors Median Sale Price Index.

Financial markets turning
The financial markets are also beginning to show signs of life. In the first quarter of 2009, corporations raised more than $840 billion in the global bond market. That is more than double the issuance in the first quarter of 2008. Although much of this is investment-grade and government-guaranteed, it is still good to see corporations raising money outside the banking system. A number of the new issues were used to retire bank debt.

Lenders are also willing to take on more risk because rates have fallen from their October highs. The rate that banks lend between themselves fell from more than 4% to less than 1%, below where it was before the Lehman Brothers collapse last autumn. Although the Fed has nudged the overall rate structure down, we like that rates, including those of mortgages, car loans, and corporate bonds, have fallen a great deal.

Consumer confidence is bottoming
Usually we don't put much stock in consumer-confidence figures because they are coincident indicators, not leading. However, aside from banking-system issues, the lack of consumer confidence has been the major driver of this recession. For a time in late 2008 it was in a lot of people's interest to talk down the economy. For example, Barack Obama highlighted the economy's plight to further his election campaign. The auto industry had to talk up its troubles in an attempt to get bailout money. Furthermore, the US Treasury Department painted a bleak picture of the economy to get TARP (Troubled Asset Relief Programme) through Congress. These factors certainly influenced consumers to save more.

Earlier we noted that this is one of the worst recessions based on three of four key metrics. The lone near-average marker was real income. Either because consumers were scared by the factors noted above or because of lack of financing, they didn't spend nearly as much as their income levels might have suggested. US consumer spending was off 3.8% in the third quarter and 4.3% in the fourth quarter of 2008 (on a seasonally adjusted annual rate). However, consumer expenditures jumped 2.2% in the recently released first-quarter report. The strong increase was not enough to offset dismal investment spending numbers, and as a result first-quarter gross domestic product numbers for the US showed a 6.1% decline. The good news is in seven of the last nine recessions, consumer spending led investment spending by one quarter.

The spending data is consistent with the University of Michigan Consumer Sentiment Index, which also shows signs of bottoming. This index plumbed a low of 55.3 in November 2008 and then bounced around a bit. But it was up in March, at 57.3, compared with February. The report for April was even better at 65. In my view, consumer confidence (and the broader economy) is on the mend after the trauma of late 2008.

A version of this article appears in the May issue of Morningstar StockInvestor in the United States.