Warren's "Desert Island" Indicator
So What Is It Telling Us?
The Weekly Rant - The Rocket-Riding Stimulus Junkies
Moose for Dinner

Last week, we discussed the Baltic Dry Index as a leading economic and market indicator. We showed how it had performed during the recent highs and lows of the market. This week we continue our discussion on leading indicators as we examine the indicator that Warren Buffett would rely on if he were on a desert island and could only use one to make his investment decisions.

Warren's "Desert Island" Indicator

The data that powers Warren Buffett's desert island indicator, or more appropriately, set of indicators, are produced by the Association of American Railroads (AAR). They publish data every Thursday morning (East coast time). These indicators are useful because they show real demand for the raw materials and finished products for a broad spectrum of commodities and merchandise shipped by rail, which is still the most cost-effective way of shipping around the U.S.

In their latest monthly report for August, the AAR reported that total U.S. freight rail traffic was down 16.4% (to 1.116 million freight carloads) from August 2008.  In addition to that, intermodal (truck freight trailers on rail cars) was down 16.7% and Canadian rail traffic was down 20.5% (reflecting a drop in commodity demand). Cyclical traffic (autos, steel, lumber, chemicals, etc.) was down even more on a year-over-year basis at 44.6% in Q3-2009.

We examined various data sets provided by the AAR and on a quarterly basis, all figures are down from the same quarter the year before. This next chart of intermodal traffic shows an interesting relationship to the stock market. As we see from the green "V" pattern (Figure 1) in Q1-2002, intermodal traffic hardly suffered during the recession of 2001-2002 and began to recover more than a year before the stock market recovered in March 2003. If there was a recession in transport, you would have never known it from intermodal traffic.

Figure 1 - Quarterly intermodal rail traffic report comparing the impact of the recessions in 2001-2002 and now. TOFC stands for (truck) Trailers On Rail Cars. Data - railfax.transmatch.com

Intermodal traffic also peaked out in Q4-2006 (magenta inverted "V"), well in advance of the stock market peak in Q3-2007. But then something interesting happened. Instead of recovering in advance of the stock market rally, traffic fell in Q4-2008! Traffic dropped 37% between Q3-08 and Q3-09.

According to Drew Robertson of Atlantic Systems, the drop in intermodal traffic demonstrates the decline in U.S. manufacturing (and increase in reliance on foreign imports that don't ship intermodally) combined with the effects of the recession. Atlantic Systems produces proprietary transport and stock indicators for investors. Robertson believes that as the recovery takes root, intermodal traffic will rebuild as U.S. manufacturing picks up again.  But that probably won't happen until at least next year. 

Figure 2 - Transmatch chart showing year-over-year weekly changes in total rail and intermodal traffic. Both charts show a bottom around the end of June, but total traffic looks to have bottomed first. A positive sign? Source - railfax.transmatch.com

Figure 3 - Another perspective on rail traffic showing a rolling four-week average of both total and intermodal rail traffic showing a bottom in Q1-2009.  Source - railfax.transmatch.com

So what is Warren's desert-island indicator saying?

There is little doubt that this time is most certainly different than past recessions when it comes to rail traffic, and especially intermodal truck/trailer rail traffic. Down by more than one-third in the past year, traffic will have to increase by nearly 60% just to get back to where it was last year. Given the trend of increases in imports, that won't happen anytime soon. But is a recovery in U.S. manufacturing back to prior recession levels necessary before the economy can recover this time around?  Probably not, however an increasing dependence on imports is certainly not positive for long-term national prosperity. 

This does not mean that the current rally can't continue for a few more months. More importantly. from a shorter term investment perspective, the latest weekly data suggests we have seen a bottom of sorts in rail demand and that is positive for both markets and the economy as long as it persists...which brings us to our next topic.

The Weekly Rant - Rocket-Riding Stimulus Junkies

"Our nation is suffering from ‘stimulus addiction,' and the path of least resistance is to continue feeding the habit." - Dr. Chris Martenson in a September 28, 2009 report

Last week, a friend of mine told me that a Canadian bank was offering five-year variable-rate mortgages at 2.25%. I checked and sure enough, rates for our pampered neighbors to the north are at their lowest in more than 30 years, according to the ad. A five-year fixed rate was advertised at 3.89%. Is it any wonder that the Canadian real estate market is again rising faster than a Roman candle on Canada Day? And a number of sectors of the U.S. market are enjoying a similar resurgence if the latest real estate statistics are any indication. 

ProfitScore readers are by now familiar with the forces that drove real estate prices to unheard of heights (even after adjusting for inflation). And as discussed in our last monthly report, this growth was certainly not due to any measurable rise in real wages or household incomes. It was made possible thanks to a seemingly endless supply of cheap money. No one seems too concerned about the rather unpleasant side-effect of rapidly rising debt levels (see Figure 8 in last month's report). 

It could be argued that the availability of cheap money created demand that spread like wildfire and eventually enveloped the nation. But was this demand real or artificially created?

In a "normal" market, no matter what the product, demand is driven by the ability of potential customers to buy it. That means that they must have a job and the disposable income necessary to pay for the product.

But as we all know, unemployment is still rising and the average work-week was just one-tenth of an hour above its all-time low at 33.1 hours in August (see Figure 1). Real unemployment measured by the more realistic all-inclusive BLS U6 unemployment rate hit a six-decade high of 16.8% in August.

And as we also learned last month in Figure 2, real wages are still lower than they were in 1982.

So, if real wages are lower than they were 27 years ago, unemployment is at a multi-decade high (and rising) and the number of hours worked per week is near an all-time low, just how are people buying homes?

In his latest weekly newsletter, Chris Martenson makes an interesting case for the argument that in an effort to re-inflate the housing bubble, the federal government and Federal Reserve now have become the housing market. Is this possible and if so, how?

Thanks to Federal Reserve "generosity," interest rates are at or near a half-century low, but that alone was not enough to re-ignite this housing market without a bigger push. The next step was trillions in stimulus that included programs to take over and refloat[O1]  the failed GSE mortgage giants Fannie Mae and Freddie Mac with billions in new cash; agencies that failed because they had too many non-performing loans. So what does the government do? Instead of decreasing the size of the amount of loans it issued as would be the responsible thing to do, they increased the maximum loan limit! The plan also included forcing banks to "renegotiate" billions in risky mortgages, instead placing this risk squarely on the shoulders of the taxpayer.

The latest federal housing stimulus program is a credit of up to $8,000 (or 10% of the value of the home whichever is less). This allows new home buyers to purchase their first home (in three years) and get a tax refund. A total of 1.8 million buyers are expected to take advantage of the program. There is now a bill (introduced by Senator and former realtor Isakson) before the Senate that would raise this credit to $15,000.

Martenson calculates that through August 2009, a total of $686 billion in new mortgages were issued.  Compare that to mortgage-backed securities (MBS) purchased by the Federal Reserve over the same period totaling $624 billion, plus another $98 billion of agency debt for a total of $722 billion injected into the housing market through Fannie Mae, Freddie Mac and the Federal Home Loan Bank (FHLB). 

"In other words, the Federal Reserve alone bought $722 billion of mortgages and agency debt when only $686 billion in new mortgages were issued.  So, through August, the Fed bought more than 100% of the entire supply of mortgages in 2009," according to Martenson (emphasis are mine not his).

Here is the obvious conclusion. National demand has created a political machine that is doing the voters' bidding. That overriding demand is to cure economic and housing ills, no matter what the cost and no matter who has to pay for it. Put in simple terms, we have become a nation of debt junkies who demand our fix no matter what the cost and the majority of our politicians are only too happy to comply.

But, as any junkie who has recovered and lived through it will tell you, the bigger and more deep-rooted the habit, the more painful and costly it is to cure. I wonder how long it will take our nation of debt junkies to figure out that we can't live beyond our means. That will be a tab left to our children and children's children to pay. 

Some legacy! 

Related Stories and Links

Warren Buffett's "Desert Island" Economic Indicator
http://manualofideas.com/blog/2009/09/warren_buffetts_desert_island.html

American Association of Railroads Monthly Report
http://www.aar.org/NewsAndEvents/~/media/AAR/RailTimeIndicators/Rail%20Time%20Indicators%20September%202009.ashx

Atlantic Systems Weekly Railfax Report
http://railfax.transmatch.com/

Chris Martenson's Website
http://www.chrismartenson.com/

First-Time Homebuyer Tax Credit Claims Soaring
http://finance.yahoo.com/news/Firsttime-homebuyer-tax-cnnm-973908072.html?x=0&.v=5

Banks Are Forcing Homeowners to Keep Paying After Short Sales
http://www.businessweek.com/the_thread/hotproperty/archives/2009/09/banks_are_forci.html?ref=patrick.net

U.S. Mortgage Delinquencies Set Record
http://www.reuters.com/article/gc03/idUSTRE58K29E20090922

Almost One-Third of Home Loans Under Water
http://www.marketwatch.com/story/almost-one-third-of-home-loans-are-under-water-2009-08-13
           
"Banking system like South Sea bubble," says senior Bank of England official
http://www.guardian.co.uk/business/2009/jul/01/bank-england-south-sea-bubble

FDIC Weighs Extraordinary Steps to Shore Up Fund
http://finance.yahoo.com/news/FDIC-weighs-extraordinary-apf-3266069115.html?x=0

FHLB Website
http://www.fhlb.com/

Moose for Dinner

It doesn't get any better than spending time with good friends and family in Idaho's backcountry.  Doug's camping accommodations continually get better year after year, and this year was no exception.  His new pellet stove burned warm the entire night, knocking the edge off of the cold mountain air.  It was a refreshing change to not have to build a fire on a cold, dark morning to warm the tent.    

As usual, we got a big snow storm.  This storm came on Wednesday and dumped 8 inches in the valley and 12 inches in the higher elevations.  I call these big storm days "pancake days" because we normally get a late start and get to enjoy a big country breakfast before braving the cold.    

I was fortunate to fill my moose tag on the 2^nd day of our hunt before the snow came, so we were blessed to have filled our freezers with Idaho's finest.  Hunting moose in Idaho's backcountry will be one of my all-time fondest memories.  As I have aged, it is more about the experience and the special times with friends and family and less about the hunt. 

My father is due to visit in a couple of weeks for our annual bird hunt with my new dog, Jack.  My wife is a spectacular southern cook, so I can't wait to eat our traditional quail dinner with all the fixings, topped off with homemade pumpkin pie.  Talk to you next week.


Working to grow your wealth,


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


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