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Business Conditions Index Update 12/1/17

“Stay away from negative people.  They have a problem for every solution.” - Albert Einstein

December 1, 2017 — As we approach the end 2017, business conditions remain neutral based upon the Aruoba-Diebold-Scotti Business Conditions Index. 

I have been asked how we use the Business Conditions Index.

We first want to see conditions to be about 0 for the index.  Extremes always get our attention.  If conditions become good for too long, it would be alerting us to a possibility the economy is benefiting from factors that usually prove to be unsustainable.

During times when the economy is expanding, like the present, lines consistently above 0 would be of some concern.  

Historically, during expansions we expect to see long periods when conditions are very good absent extended periods where below 0 conditions are routinely recorded.  Since 2008 conditions have clearly improved but have never consistently been above 0.  It is exactly what we prefer to see. 

When conditions are more consistently above 0 we believe it indicates the components of the index are mostly favorable.

Those conditions in the index include:

Weekly initial jobless claims
Monthly payroll employment
Industrial production      
Personal income less transfer payments
Manufacturing and trade sales
Quarterly real GDP

From the graph you can see that each time positive numbers are reported, there follows a move lower.  For us, we see it as indicating the economy is not too “hot”. 

We prefer warm and that is what the readings are telling us.

Eventually we will see consistently good conditions with readings between 1 and 2. When that happens our expectation would be the economy has reached a point when continued sustained growth is not likely.  It is when mostly positive conditions exist when the economy would tend to overheat with declines in stock prices more likely.

However, there is always a risk an intervening event (event risk) could cause the market to fall and the economy to stall.  Event risk is always present. Nevertheless, we believe underlying positive fundamentals in the United States and the world economy would quickly stabilize markets.  As we have said many times, our belief is we are in a long-term bull market.  During secular bull markets, bear markets should be relatively short followed by higher highs.

Historically extreme negative conditions do occur.  Extreme positive conditions have never been recorded.  Negative periods do not last very long but they destroy investor confidence.  The last time business conditions were extremely negative occurred in the Financial Crisis.  It is interesting to note it takes long periods of good business conditions to offset the loss of investor confidence that results from periods of extreme negative conditions like those occurring in the Financial Crisis. Fortunately, extreme negative conditions do not occur frequently.

It is our view extreme negative conditions like those we experienced in 2008 are not likely in the near term.

Our investment advice remains unchanged.  We favor stocks over fixed income. 

Each investor’s unique circumstances require an asset allocation based upon goals and tolerance for risk.  Whatever that may be, we continue to advise that portion in equities be fully invested and the portion allocated to fixed income to be high quality and short duration.  As always the long-term risk/ reward favors equities. 

However, fixed income offers little in regard to real returns and in many cases negative real returns. High quality short-term fixed income securities do offer portfolio diversification along with reduced portfolio volatility.  For those who have elected to achieve income goals by reducing quality and extending maturity, we believe the strategy will prove costly and frightening. 

The last previous secular bear market in fixed income ended about 1981.  Since then bond prices have risen and rates have declined as the bull market in fixed income has advanced. Reversing that trend is becoming increasingly likely.  The experience when rates rise may seem appealing and alluring but accompanying rising rates will cause declines in bond prices that could prove both frightening and demoralizing.  There is little reward and big risk in long term bonds of all quality.