How to Tell False Hope From Rational Optimism

Investors got some relief Wednesday as the S&P 500 rallied 3.9%, snapping a painful string of declines.^[i] Only time will tell whether the correction has turned or another leg down lurks, but if nothing else, the big day provides a good reminder: Stocks move fast, up as well as down, underscoring the importance of staying patient at times like this-particularly when the longer-term outlook for markets remains positive. We believe it does, but not for many of the reasons you might have seen in the financial media this week. Several outlets based their optimism on backward-looking or misinterpreted indicators, like employment or consumer confidence. We don't want to rain on anyone's parade, but in our view, these aren't reasons to be bullish, and overemphasizing them can lead you to a precarious place when this bull market's end does finally arrive. Again, we think the economic outlook remains strong, but it's important to discern between false hopes and rational optimism about actual, forward-looking fundamentals.

In the US, pundits seized on consumer confidence (up to a seven-month high in August), July's rising home sales, rising wages and low unemployment. UK pundits cited Q2's GDP reacceleration, rising bonuses outside the financial sector, a retail confidence survey and evidence of an August hiring uptick. All good news! But all are either backward-looking (coincident at best) or anecdotal. None predict the economy's future, in America, Britain or anywhere else.

Let's take them one by one, starting with employment-the ultimate late-lagging indicator. Conventional wisdom often says hiring boosts consumption, which boosts hiring, creating a virtuous cycle of growth. But the data disprove it. The last recession bottomed in June 2009. GDP resumed growing the next quarter. Yet payrolls continued falling through February 2010. Hiring also continued after the economy peaked in Q4 2007. Some claim an America near "full employment" must be in the driver's seat, but we were basically at full employment when the last two bear markets began. In the Tech bubble, stocks peaked in March 2000, when US unemployment was 4%. (It fell to 3.8% the next month, setting up a "slope of hope" for investors to buy into.) In October 2007, when the last bear market began, unemployment was at 4.7%, also lower than today's 5.3%. Growth drives hiring. Hiring doesn't drive growth.

Next up: housing. The housing market's background role in 2007/2008 leads many to view real estate as an economic driver, but it isn't so. Private residential investment is just 3.3% of US GDP. Buying a home does make folks more apt to buy furniture and appliances-theoretically boosting consumer spending-but spending on furniture and appliances is just 0.2% of GDP. Housing-related service expenses are bigger at 12.4% of GDP, but that includes utilities. Discretionary household services represent a small portion.

Consumer confidence surveys are also frequently misinterpreted. They capture how folks feel at the moment they're surveyed, not what they do. Those feelings can depend on their mood, the weather, the day's headlines, what they ate for breakfast-you name it. Folks' expectations for the future are often colored by the recent past. Sometimes people say one thing, then do another. Other times, they over- or under-state their activity. Or their feelings and outlook change! All are reasons why consumer confidence and retail sales often move in opposite directions in the same month.

Similar logic applies to the UK Confederation of Business Industry (CBI) survey of retailers, which includes items like planned hiring and investment. A nice thought, but plans change. Similar business surveys in Japan and Germany have spotty track records. One aspect of the UK survey, the preliminary retail sales estimate, is handy. But even this isn't a reliable measure of growth. It reports the net percentage of retailers reporting higher sales, similar to purchasing managers' indexes (PMI). Retail PMIs in the eurozone haven't been terribly reliable in recent months, frequently signaling contraction when actual sales grew. Like these PMIs, the CBI survey measures the breadth of growth, not the magnitude. In July, CBI reported a net 21% of British retailers grew, but that translated to just 0.1% total retail sales growth once the official statistics came in. So we're hesitant to call August's 24% CBI survey reading compelling evidence of a consumer upsurge. Plus, retail sales don't include spending on services, which is the lion's share of the economy. In short, the CBI survey is good news, but take it with a grain or three of salt.

Finally, rising employee compensation. Strong gains in UK non-financial-sector bonuses are a fun factoid, and great for those affected! But like employment, compensation tends to lag the broader economy. Companies usually boost wages, salaries and bonuses when growth is humming and the coffers are flush, and cut when hard times require them to get lean. The 2.7% rise in UK bonuses (for 2014/2015) reported Wednesday brought the total within 0.1% of its pre-recession high, but that doesn't account for inflation. Real-inflation-adjusted-UK GDP passed its pre-recession peak in 2013. Plus, bonuses are just a fraction of total compensation. We'd argue the ongoing rise in real wages is far more meaningful, and even that isn't exactly forward-looking. It's just nice.

So where is the useful good news? Wednesday's durable goods orders report for July had plenty to like. Aircraft (always volatile) contributed much of the 2% month-over-month rise, but it wasn't the sole driver. Excluding transportation, orders rose 0.6% m/m. Excluding also-volatile defense items, orders rose 1% m/m. Nondefense new orders for capital goods excluding aircraft-otherwise known as core capital goods orders-rose 2.2% m/m, accelerating from June's 1.4% rise. This indicator doesn't correlate perfectly with business investment (which also includes structures, software and research & development), but it does suggest firms aren't pulling back. Interestingly, even machinery orders-the category most impacted by oil-patch cost-cutting earlier this year-rose again, suggesting Energy firms might be somewhat less of a drag on US growth looking ahead.

The Conference Board's Leading Economic Index (LEI) also provides grounds for optimism, though it might be hard to see at first blush. Officially, US LEI fell -0.2% m/m in July, but that small drop carries a big asterisk. Only 2 of LEI's 10 components were negative-stock prices and building permits. The stock slide we don't put much ... err ... stock in, as LEI doesn't use the actual change in stock prices during the month. It uses the S&P 500's average daily closing price, which ticked down a tad in July-even though the index actually rose. So, that's a math quirk. As for building permits, the huge drop was tied heavily to big one-off factors like expiring tax breaks in New York and a change in Florida permitting policy. Both pulled demand forward from July to June, when permits spiked, teeing up July's drop. So we'd look past this outlier and focus on LEI's more consistent, forward-looking components, namely the yield curve spread and Leading Credit Index. Both contributed solidly. Moreover, one-off LEI drops are normal in expansions. The trend is what matters, and LEI has risen in 16 of the last 18 months.

A flurry of data will hit Thursday and Friday, and we'll be sure to give you the full rundown-either in this space or on our Headlines page. But we can tell you now, most of it won't have magical predictive powers. Revisions to US and UK Q2 GDP, the first look at UK Q2 business investment, US Q2 corporate profits and US July trade numbers will give us more insight into what the world economy did from April through July and shed additional light on trends, but they won't tell you where stocks or the economy go next.