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Consumer Crush
To Lead or Not to Lead?
Got a Market Headache?
The Weekly Rant-More BLS CPI Sleight of Hand
Idaho's Back Country

In September's ProfitScore IQ, I mentioned that we would begin publishing a smaller, fact-filled weekly newsletter called the ProfitScore Weekly Market Watch.  As promised, here is our first publication of that newsletter.  I hope you enjoy its content and that it helps you become a better investor.

In last IQ, we discussed household wealth and debt and how the growth rate of debt at all levels has rapidly outpaced both incomes and wages. As debt becomes a larger burden on our economy, it will increasingly strangle consumer spending and that is a problem when we consider that approximately two-thirds of our economy depends on it.

This week we take a final look at the health and financial staying power of the consumer.  Then we begin the search for some useful, leading market and economic indicators.

Consumer Crush 

This next chart shows just how seriously consumers have cut back their borrowing; cuts that have come for two reasons. First, when there is a real chance that you could lose your job, it is only natural (and financially wise) to curtail your debt load. To put this drop in perspective, the $108.7 billion drop was both the largest on record and the largest percentage drop since the time of the D-Day invasion in 1944 when allied forces were landing in Normandy in the largest military offensive in history.

Unfortunately in economic times like these, what is good for the economy (increasing spending) is simply bad for the consumer. Now squeezed between rising unemployment and tighter bank lending practices, consumers are hunkering down. Savings levels rose to a 14-year high of 6% in May, before dropping back to 4.2% in July, compared to just 1.3% at the beginning of 2008.

Figure 1 - Monthly chart of consumer credit closely tracking the business cycle over the last twenty years, showing the $109 billion drop so far in 2009.

To Lead or Not to Lead?

So will programs like the $3 billion cash-for-clunkers draw shoppers back into stores and get them spending again in an economy that has lost approximately 7 million jobs since the recession officially began in December 2007? As our charts of real time incomes (in 1970 dollars) showed last week, its not as if consumers have access to bigger pay checks to help them ‘grow' the economy.

If anything was clear from those charts, it's that the latest bubbles were not fueled by increasing incomes. Median incomes peaked in 1999 at $50,641 and were still below that level at $50,233 in 2007, according to the latest data available. There is little doubt that median incomes fell again in 2008 and will likely fall in 2009.  Spending to fuel these bubbles was made possible by a large jump in debt levels, thanks to central bank cheap-money policies.  

So how will we know when the worst is truly behind us? That's the trillion-dollar question.

One approach is try and stay one step ahead of the economic data. And, to accomplish this daunting task, it requires a combination of indicators, some well-known and some that are more obscure.

Got a Market Headache? Take a BDI and Call Me in the Morning...

One of the more widely used indicators is the Baltic Dry Index (BDI). The BDI represents the cost for shipping dry bulk goods like iron ore, coal, grain, etc., by sea around the world (not by tanker or in containers).  When international demand for goods is high, shipping rates go up, and when demand is low, they fall and so this is a good leading economic indicator.

What makes the BDI interesting is that there is virtually no speculation and very little opportunity for manipulation, since the price of shipping is not traded on an exchange. It is driven by real demand, so it is therefore not subject to trader fear and emotional greed swings. It also supports the theory that the bubbles in commodity and stock markets were not significantly driven by speculators as many politicians and regulators have charged.

This index climbed from around 4,000 in early 2007 to over 11,000 in May 2008, thanks to strong economic demand in a booming global economy. Last Monday (September 21^st), the index was sliding toward 2,300, down nearly 50% in just three months from its June 2009 high. It is interesting to note that the BDI bottomed on the same day that the 17 commodities of the CRB Index did - December 5.

Figure 2 - Chart of the Baltic Dry Index showing the significant double top in September 2007 and in May 2008 above 10,000, after which the index cratered to a low of 663 on December 5, 2008-lows in the index not seen since August 1986.  As this chart shows, the six-year average is just under 4,300. Its most recent peak briefly topped above it in early June, then reversed again. Data - Capital Link Shipping. 

So how good is the BDI as a leading market indicator? It took some digging to answer this question. First, we had to match data points for both the S&P500 Index (SPX) and the BDI. As we learned the hard way, both indices had quite a large number of gaps (even though both were supposed to be daily), which means we had to fill them in with the previous daily data, since charting programs don't work well with holes in the data. The Baltic Dry Index dates back to the beginning of 1985, so that is as far back as we could go.

Figure 3 - Daily chart of the S&P500 compared to the Baltic Dry Index showing the BDI peaking later, but bottoming earlier. Is this latest drop a warning of things to come?

The chart revealed an interesting relationship. First, the correlation between the two before 2000 was low, but increased from 2005 into 2009. But as we see from Figure 3, although both peaked around the same time (October 2007), the SPX dropped after putting in a lower high and the BDI rallied again to a higher high in June 2008. However, it then dropped off before hitting bottom in early December, a full four months before the SPX (and a number of other global stock market indices) bottomed.

More importantly, is the recent drop from its 2009 high in June a warning of market trouble ahead? This argument becomes more compelling when we look at China's Shanghai Composite Index that has been in a bear trend since peaking in August and can therefore not be ignored.

Because of its importance in measuring global trade demand, the BDI has the potential to provide advance warning of both increasing and decreasing demand. But, as any good trader knows, one indicator does not a trading (or investment) system make.

Next week we'll take a closer look at the indicator that Warren Buffett would choose if he was stranded on a desert island and could only use one to make his investment decisions.

The Weekly Rant-
More BLS CPI Sleight of Hand

Longer-term PS IQ subscribers are familiar with our views on government-generated statistics. At best, they leave much in the way of impartiality to be desired. At worst, they are little more than propaganda tools to make incumbent governments look better at dealing with economic challenges than they really are and have become crucial aids in keeping governments in power come election time.

In the September 16^th Consumer Price Index (CPI) August news release from the Bureau of Labor Statistics contained the following terse statement:

"In contrast to these increases [in food and other prices], the index for new vehicles fell 1.3 percent in August, partly due to ‘cash for clunkers' incentives." (For the complete report, please see Related Stories below.)

Excuse me? Since the description was very brief, it left a lot of room for interpretation. But, if I understood correctly, it meant that the $3 billion in taxpayer assistance was treated as non-existent. Did the BLS just do what I think it did - reduce the cost of all the cars purchased under the program (which by the way works out to 666,666.66 cars sold if you divide $3 billion by $4,500)?

If so, it sets yet another interesting "moral hazard" precedent. Not only does it make inflation look tamer than it really is because car prices weren't in fact reduced by $4,500, they used your money to help buy them and then treated the cash as non-existent. Since inflation is subtracted from GDP growth to get real economic growth, this sleight of hand also has the effect of making GDP look better than it really is. But that pales in comparison to the $787 billion TARP program and all the trillions in business, bank, mortgage and other bailouts that have been handed out so far. 

So how will the statisticians treat all the stimulus cash? Will it also be treated as non-existent? The answer to that question is that the government will treat it pretty much any way it pleases, thanks to hedonics, which gives these minions the ability to treat any statistic any way they please and to make the government look more effective than it really is.

And these methods don't have to be consistent, which means we will likely see a mess in the way this cash turns up on government balance sheets and in the "official" government statistics.

Related Stories

Baltic Dry Index Dives as Chinese Coal, Iron Ore Demand Slumps
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aFnXgNO6O._U

Record Plunge in U.S. Consumer Credit Signals Weakened Spending
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avvF5aNtrCfc

U.S. Economy May See Its Slowest Recovery Since 1945
http://www.bloomberg.com/apps/news?pid=20601068&sid=aBj5AeyQqun8

Is the Government Using Cash for Clunkers to Supress Inflation?
http://www.businessinsider.com/is-the-government-using-cash-for-clunkers-to-suppress-inflation-2009-8

Link to BLS Cash-for-Clunkers September 16 news release
http://www.bls.gov/news.release/pdf/cpi.pdf

Idaho's Back Country

I was notified this summer that my archery hunting buddy Doug Bolen and I were drawn for one of Idaho's special Moose Permits.  I say "special" because you have less than a 1% chance of getting drawn and if you are drawn you won't get to put in for this hunt again for the rest of your life.  If you grew up enjoying hunting like I did, getting picked for this hunt is the equivalent of winning the lottery. 

Doug is one of the most capable guys I know in the woods and the best part is that his camping gear is second-to- none.  Camping in Doug's sheep herder's tent is like living in a small, cozy cabin with about every accommodation you could ask for besides indoor plumbing.  Being comfortable is a good thing because running around in Idaho's rugged back country is not for the weak of heart. 

In a typical day, we will walk 10 to 15 miles, starting our day around 4:30 AM and getting back to camp an hour or so after dark.  I wore a device that tracked my calories burned in a day a few years ago hunting elk and I burned around 5,500 calories a day.  That is about the same as Navy Seals burn in training camp. 

Doug and I have trained hard for this trip, so hopefully our preparation and hard work will reward us by filling our freezer for the year.   


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.


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