A simple model

So the US economy is not, in fact, falling off a cliff...just yet.  Although durable goods orders are notoriously noisy, yesterday's solid print should assuage at least a few fears about the recent soft tone to some of the data.  That core CPI managed to beat expectations was icing on the cake, as the dollar and US yields both jumped smartly after the releases.   As Hannibal Smith used to say, "I love it when a plan comes together!"

Of course, it wasn't all pony rides and lemonade.  Weekly claims were quite a bit higher than expected, albeit in the context of seemingly interminable snowy, nasty weather for much of the country.  Still, the decline in claims seems to have stalled a bit recently; although it's probably too early to read too much into it, it nevertheless remains a development worth watching.

Every so often, Macro Man likes to take a step back and look at data in its unadulterated form- no rates of change, moving averages, or anything like that, just the level of the underlying data.  When looking at the level of durable goods orders, ex-transport, you can see the recent soft patch; put into context, it doesn't yet look particularly abnormal or worrisome.  Certainly the loss of momentum is nowhere as severe as it was in 2012.


Perceptive readers will note that durables are basically at the peak level of the last cycle, whereas the SPX is comfortably above it.  How, then, do these orders figures compare with other data?   Macro Man assembled a chart showing nominal retail sales, the ex transport orders noted above, and industrial production, scaling each series to 100 as of February 1992.  As you can see, the relative fortunes of the 3 data sets vary starkly.


As the title of the chart suggests, these three series capture the changes in the economy quite well.  Consumers have continued to spend (note that retail sales are substantially above the level of the pre-crisis peak), but not, it would appear, on goods made in the US.  This is hardly a stunning revelation, of course, but it's nice to see it demonstrated so sharply in a single chart.

This got Macro Man to thinking.   Retail sales, like the SPX, are very comfortably above pre-crisis highs, IP is marginally so, and orders are basically at the level.   What would happen if we regressed these 3 series against the SPX?  The results are set out in the chart below.

As you can see, the relationship is generally quite good, with an r-squared of .88.   Note that to some extent that should be expected, insofar as the entire time period was in-sample and your author regressed levels rather than changes.  Nevertheless, it's interesting to note that the divergence between the current level of the SPX and that suggested by sales, orders, and IP is larger than  it has ever been over the past couple of decades.

To a large degree, of course, that is a function of QE/easy monetary policy/low bond yields/low discount rates.   One would naturally expect, ex ante, that stocks should look a touch rich to exclusively growth-based indicators given that global policymakers have begged investors to move out the risk curve for more than half a decade.

Naturally, equities also benefit (and suffer) from leverage, both on a corporate and investor level.  Indeed, generally speaking the amplitude of changes in stock prices dwarfs that of changes in the underlying data, so it may well be the case that a simple linear regression is a decidedly imperfect tool.

To mitigate the impact of leverage, Macro Man ran the same regression, but on the natural log of the SPX to smooth the swings in stocks relative to the economy.  Upon obtaining model output, it was a trivial matter to reconvert the data back into SPX terms.  The results of this study are below.

This model suggests a closer fit between the current level of stocks and that implied by growth data (and a closer overall fit, with an r-squared of 0.93), though it still views equities as nearly 10% too high (when using current stock prices.)  However, "mispricings" of this magnitude are fairly ordinary; indeed, the same model suggests that stocks were undervalued by a greater amount in the run-up to the crisis.  That very fact should tell you everything you need to know about relying exclusively on growth-based indicators that take no account of financial conditions.

So what have we learned?  A very simple growth-based model suggests that US stocks should indeed be at all time highs, albeit at levels lower than those currently prevailing.  Introducing a liquidity term would indubitably close that perceived valuation gap; indeed, in Macro Man's own, more robust equity model, liquidity factors explain almost all of the ex ante expected return of the SPX.

As long as liquidity remains ample, growth doesn't necessarily need to roar to justify current if not higher prices.   If and when the tap gets closed off, on the other hand, simple indicators like these can provide a rough and ready guide to how deep the correction might be if we were to revert to using growth rather than easy financial conditions as the primary valuation metric.
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Anonymous
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February 27, 2015 at 7:13 AM ×

Very good job of explaining things by using statistics applied to economics and finance in a cohesive model. I'm stunned. Thanks.

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checkmate
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February 27, 2015 at 10:24 AM ×

That's why I come here to read.

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Cityhunter
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February 27, 2015 at 10:46 AM ×

Nice one MM, as always.

A picky comment would be that correlation is not causation - and rear view driving is dangerous in the market highway.

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Anonymous
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February 27, 2015 at 11:29 AM ×

Nice.

Of more interest though is the existence, or not, of a predictive relationship.

Would you run the stats to see if last month's or last quarter's unadjusted econometric information predicts the move in the S&P Futures (not physical index) the following month or quarter. Perhaps further present the idea with an absolute and volatility adjusted comparison with a simple BUY AND HOLD for the relevant period.

The results will be enlightening to us readers, I'm sure. By example, the point is that whilst - say - EUR USD and GBP USD are 'correlated' 0.85+ that is measuring coincident moves. Unfortunately the move yesterday in EUR USD says nothing, statistically, about the upcoming move TODAY in GBP USD.

Anyway, if you choose to do the above I will be fascinated to see the result.


Your work continues to be top 5 on the web.


Best.

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Anonymous
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February 27, 2015 at 11:49 AM ×

Curious who's the other top 4

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Anonymous
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February 27, 2015 at 12:14 PM ×

The 'Other 4' would include:

* rareviewmacro.com

* a piece entitled 'Daily Persiflage' which is not available to general distribution

* two quant sites that I do not believe would be of interest to regular readers of this site. (Coding short cuts, how to guides for various exchange connections.

* and, of course - dealbreaker.com Ha!

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Macro Man
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February 27, 2015 at 12:45 PM ×

Anon @ 11.29: The model is obviously a very simple one, with no lagging, smoothing, or other techniques. I ran Granger causality, and lo and behold the data suggests that stocks drive data, with a F-test of 31 and a p value of 5x10^-8. This can be attributed to the fact that data is released with a lag (Jan data is only available in late Feb), as well as the crisis (the collapse of equities anticipated the depth of the recession, though in that case it was an example of both being impacted by similar factors rather than one of directional causality.)

At best, you can probably view analysis like this akin to PPPs for FX- utterly useless for market timing, but useful for having an idea of how things can go once the rubber band snaps.

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Anonymous
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February 27, 2015 at 1:25 PM ×

Fed's Bullard: The normalization process is not tightening. It's still going to be a very accommodative policy even if we move off of zero.

Wonder what the Fed is really worried about.

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wcw
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February 27, 2015 at 3:35 PM ×

Sunspots! Ya gotta love sunspots:
http://schwert.ssb.rochester.edu/jme78.pdf

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Anonymous
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February 27, 2015 at 3:52 PM ×

@Anon 1:25
You can see evidence of the Fed, BoJ etc directly buying equities this afternoon. They know that if they stop this whole house of cards comes crashing down.

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wcw
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February 27, 2015 at 5:22 PM ×

For fun, I regressed log differences of the Russell 3000 (more available on FRED2) against the same three vars. The result:
https://www.dropbox.com/s/hn2k5yc2c5jayc6/R3Kp.png

R-squared is 0.1 now, of course.

Toy models are fun.

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Leftback
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February 27, 2015 at 5:53 PM ×

Don't laugh at sunspots. That's a window on the output of the most important nuclear fusion reactor in the solar system. Sunspots are a less widely appreciated driver of global climate. Slower sunspot activity, especially during the peak of the cycle is associated with cooling go the global climate. Recent sunspot trends are consistent with multiple previous episodes of "Little Ice Ages", and a review of climate records back to the Middle Ages suggests that we are well overdue for the kind of Little Ice Age that caused the Thames to freeze over in Dickensian times. Perhaps the Sun is bailing us out from our CO2 emission binge?

Now, MM, that reminds me, it's been such a hard winter again in Connecticut, Mianus has frozen over..

(been waiting months to use that line)

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Leftback
admin
February 27, 2015 at 6:08 PM ×

Nice model, btw, I always did appreciate a nice model. But... if you look at recent US macro v Europe macro surprise index and earnings forecasts, especially the first derivative of the afore-mentioned, one wonders many things:

1) What the hell is USD doing up here, and
2) Why are punters still pouring lemming-like into leveraged shite like the biotechnology stocks?
3) Who does the Fed think it is kidding about a target Fed Funds rate of 3.5%?

This morning we saw Q4 revised lower and Chicago PMI into recessionary territory. The US macro misses just keep on coming, even as EZ data improves steadily and stealthily.

As far as the US market is concerned, I am expecting one last pump to Nasdaq 5k to suck in the last group of mental midgets, and then would suggest we just watch AAPL. It's such a huge component of QQQ that once it starts to under-perform it's all over.

Chart-watchers anonymous points out: NBG, GREK and GDX all pulled back this week from recent highs to find support on top of the 50day averages. That's bullish in anyone's language. Perhaps the worst is behind us for these much maligned assets.

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washedup
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February 27, 2015 at 6:12 PM ×

Very true - plus, I was standing outside my house laughing at sunspots just the other day and got very strange looks from the neighbors.
I highly doubt the timeline of creeping impacts of the new ice age is within the investment horizon of anyone on this board. I would just like to know if global reflation 2.0 sponsored by ECB and Kurodasan is on, or not.

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Leftback
admin
February 27, 2015 at 6:49 PM ×

washed - it would appear that a few characters out there believe in global reflation 2.0:

1) "Brent"
2) "Goldfinger"
3) "Tip"
4) "Dr Copper"

Although the following are slow to get the message:

1) "Mr Bond"
2) "Texas Tea"
3) "Old King Coal"
4) "Professor Schatz"

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CJ
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February 27, 2015 at 7:35 PM ×

Leftback,

If you look at my preferred measure of domestic demand--real final sales to domestic purchasers--that was actually revised up 0.4% to 3.2% for Q4. I think this data, combined with the somewhat stronger CPI is giving people confidence that the Fed will have room to hike in late 2015.

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washedup
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February 27, 2015 at 8:00 PM ×

Left - all good indicators to watch - it all really boils down to whether the rate of change of GDP growth for europe and Asia can be higher than that for the US (thereby reversing the dollar rally).

Put differently - of course Europe can grow a little as the US grows at 2-2.5% - OR the US can slow a bunch and all hope would be lost globally - but I am very skeptical that the EM led (with Europe a side beneficiary) global reflation with weak dollar and capital outflows from the US is coming back as a secular theme (cyclical countertrend rallies such as the one we are in notwithstanding) - bear in mind that for all the talk of rig count reductions and mine closures, I do not remember a single commodity bust that resolved itself because of supply reductions - it was always demand that caught up and surprised eventually, and in a time frame always measured in years, not months.

I also think the guys who think DXY can reach dizzying pre Plaza accord heights when Volcker the inflation conqueror and Reagan the supply sider were in charge, or even the less rarefied Pets.com heights from the late 90's are on mind expanding drugs - but if the dollar won't be allowed to be the safety valve, something else would have to give - maybe thats why gold refuses to break down below 1200-1250 despite dollar strength - maybe Mr Market is being a believer in king dollar, but with a healthy dose of skepticism and a large side bet placed on the only non paper currency out there, you know just in case nothing works and CBs truly lose the plot.

The biggest problem with being fond of gold, of course, is the company you keep while doing so - good night and don't let the bed bugs bite.

MM - glad you include granger causality in your tool kit - has helped me separate the wheat from the chaff a few times - isn't it fun what it told you? Namely that the economy will do fine as long as equities do fine - quite an unappreciated nuance - like bernanke said, some things work better in practice than in theory!

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Anonymous
admin
February 27, 2015 at 11:01 PM ×

Indian business and competiton..lol.

"To promote 'Make in India' campaign, the government needs to shield domestic companies from foreign competition and eliminate those exemptions that work as 'negative protection', suggested the Economic Survey".

http://www.tribuneindia.com/news/nation/end-negative-protection-to-boost-campaign/47977.html

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Anonymous
admin
February 27, 2015 at 11:40 PM ×

The best concise view of current Financial Markets:

http://www.zerohedge.com/news/2015-02-15/only-question-about-so-called-recovery

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Anonymous
admin
February 28, 2015 at 12:23 AM ×

Who loves Putin..err..Putin tolerates opposition:

http://edition.cnn.com/2015/02/27/europe/russian-politician-killed/index.html

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Polemic
admin
February 28, 2015 at 12:29 AM ×

no supply of debt left for the investor to buy?

Well excuse my french but isn t that the whole fequing point? make it so impossible to buy debt that people stop buying debt and buy something else instead? like 'things that people make' perhaps?
At some point someone will realise that there are other things to buy than -ve yield debt and as soon as they buy those things the price of those things will go up and that voila is called inflation. at which point people wont want to buy debt as there is now something else going up in value and woh don t want to miss that and you dont buy bonds in inflation do you? oh look us moving out of bonds to spend money on things is making inflation go up even more quick quick buy stuff sell bonds.. woops this is moving fast. are the cbs going to act? no sry i m a cb and i m waiting to see pruces move last month and then next month to make sure.. fk me prices are higher wooh bonds are tanking. shit yield diffs are making eqs not that great better sell them and buy stuff too. quick make more stuff. people ate buying it.. hire people. sry im not trained in it yet.. ok hire the people that can make stuff.. they want more money? just fking pay them jeez we missing making stuff fast enough to sell.. Hang on i m a cb. i d better raise rates a bit .. but oh. thats odd eqs down bonds down inflation up gee my refunding is expensive .. and the corp roll. overs expensive too oh.. i m paying people more to make stuff and funding at higher better sell more stuff. god weve got a stuff bubble. oh yeah thats called real high inflation. fk me but yesterday we had deflation thats confusing bugger we re fkd the other way now.

or something like that... goodnight

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Not a goldbug
admin
February 28, 2015 at 1:16 AM ×

@POl(12:29)

Buy gold and sweet dreams:-)

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checkmate
admin
February 28, 2015 at 8:56 AM ×

Pol,
That was a wonderful goodnight.

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Anonymous
admin
March 1, 2015 at 12:50 AM ×

Goldbugs on notice:

"The minister proposes to introduce a gold monetisation scheme, which will replace both the present gold deposit and gold metal loan schemes.

"The new scheme will allow the depositors of gold to earn interest in their metal accounts and the jewellers to obtain loans in their metal account. Banks/other dealers would also be able to monetise this gold," Jaitley said in his maiden full-year Budget speech.

India is one of the largest consumers of gold in the world and imports as much as 800-1000 tonnes of gold each year.

Though stocks of gold in India are estimated to be over 20,000 tonnes, this gold is largely neither traded nor monetised, the Finance Minister said".

http://www.tribuneindia.com/news/nation/steps-proposed-to-monetise-gold-contain-imports/48002.html

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March 1, 2015 at 5:49 PM ×

In Europe there's only big asset remained cheap: real estate in Germany.

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Polemic
admin
March 2, 2015 at 8:17 AM ×

Bondstrategist. Totally agree

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Anonymous
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March 2, 2015 at 5:23 PM ×

@TheBondStrategist

You don't need cheap assets, macro analysis or even any financial knowledge. Just front-run QE (like everyone else):

http://www.zerohedge.com/news/2015-03-02/what-entire-world-frontrunning-ecb-looks

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Danny Trees
admin
March 2, 2015 at 6:53 PM ×

I run a similar model using nominal GDP and margins. One thing I've struggled with , as you touch on is low rates. Other issues are a changing economy. To take it to an extreme, what happens if baba us equity became just enormous. It does very little business in the us, but is listed here. Nothing it does pops up in domestic retail sales, IP or durable goods. And yet stocks would go up. I know that's one stock, but the point on foreign profits and changing composition - tech companies for example at higher weights. Is the SPX high to model because of low rates, or other things?

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March 2, 2015 at 9:54 PM ×

@anon: yes can't disagree but it's not for me now... There are people bolder than me around... and they make feel me a really stupid

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Leftback
admin
March 2, 2015 at 11:08 PM ×

Naz 5k. We all called that one.

Pol, that was really excellent, old chap.

This is indeed the whole point. Everyone is already long EU core bonds, so there is no longer any point in buying them, whether or not there are any more of them to buy. So eventually punters will buy something else. Anything.... and since everyone also already owns Apple and dodgy Biotech, may as well buy European stocks or commodities. Nothing else left.

I bet you had a few, sat down to write a comment, scratched your head a bit, had a couple more and then - genius...! That's the way it works here when LB does the "Macro Toons" song lyrics, innit?

Another ECB "tempest in a teapot" mini-crisis this week. Another world-saving fudge later in the week to enable Greece to get its T-bill sale off.

MM will still be grinning like a Cheshire Cat at Ireland's win in Dublin, and MM crushing LB in the recent FX arm wrestling contest between USD and EUR. "What goes around, comes around, dude", or something to that effect.

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Leftback
admin
March 2, 2015 at 11:53 PM ×

The best Ambrose in ages. We are not always AEP fans here in the peanut gallery but this is good.

Ambrose on Greece Game of Chicken

Decent piece of writing, with historical context and some political depth. This one is better than 100 of those shallow and condescending Peston "describe what happened last week to the man on the Clapham omnibus" jobs. Bravo, Ambrose.

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Nico G
admin
March 3, 2015 at 6:28 AM ×

real estate in Germany - for all of you folks who always wish to spend holidays in Kiel or Jena, or punt Dortmund glorious commercial estate

what ever happened to the 'wait and see' you know, when everything seems a bit stretched you fund managers out there is it ok to do nothing, the concept of precaution could still justify management fees.. for a while

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March 3, 2015 at 8:05 AM ×

@nicog: honestly I expect something more from you...nobody would buy a house in Germany to go only on holiday..as in a lot of other places. ..because according your reasoning we have to buy only houses in front of the sea in sardinia!!!

Sometimes you have to buy something...you can't be short forever..tell me is there something that you would buy? Don't tell me a put please!

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Nico G
admin
March 3, 2015 at 8:52 AM ×

sure i am buying a massive oceanfront villa in Hawaii

i had to stop my short ages ago, Amen

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