The Margin

It’s amazing how a 4% pullback over a couple of weeks in US equities can send headlines and Twitter chatter from complacency to shock and awe.

 The S&P 500 (SPY) hit an all-time high on January 15 and has since corrected 3.6% as of Friday’s close.  US small caps (IWM) hit an all-time high on January 22 and has since pulled back 4.4%.

 The headlines out there are gruesome, and as usual, misleading.  But I’m not complaining.  The predictability of the mass media and bloggers makes my job of sifting through the garbage to focus your attention on what really matters, just that much easier..and enjoyable.

 What matters most in financial markets occurs at the margin. It’s not the holy grail of trading but it's damn close.

 What exactly do I mean by “the margin?”  In the purest since of the word, it means the rate of change of a series of data.  While the mainstream media tends to focus on the headline number of a particular economic report, I’m more interested in where that headline number fits within the history of that number.

 For example, take last week’s US durable goods number, which provides data on new orders received from more than 4,000 manufacturers of durable goods, and are generally defined as higher-priced capital goods orders with a useful life of three years or more, such as cars, semiconductor equipment and turbines. The media focused on the fact that the number had fallen 4% from November and seemed to indicate that businesses weren’t quite as optimistic about economic growth as they had been a month earlier.

 However, what they missed was “the margin.”  First, November’s durable goods number was revised downward from the original 3.5% to 2.6%.  This means that while Novembers orders grew 2.6% from October, they did so at a rate 26% less than originally reported.  That’s the margin.

 Secon, December’s number was down 4.3% from November, as reported.  However, what wasn’t discussed was that the number also decelerated on a year over year and on a two-year basis.  So, an indicator that's one of the more reliable economic reports out there is slowing on a 1-month, 1-year and 2-year basis.

 And how did the markets react?  The S&P 500 (SPY) was up 0.6% and US small caps (IWM) were up over 1% on the day.  Do you think investors were looking at the headline number or the margin?

“The margin” in its purest form is the rate of change.  However, I apply a broader definition.

 The margin is also anything new that happens.  And very often it's anything new that happens that no one seems to notice yet.  For example, last week’s preliminary Q4 GDP, and specifically the personal consumption numbers.

 To start, the US economy grew at a slower rate in the Q4 than Q3.  At the margin, bad.  However, the economy grew at a faster rate in the Q4 of 2013 than it did in the Q4 of 2012.  At the margin, good.

 The economy grew for the full year of 2013 at a slower rate than the it grew for the full year of 2012.  At the margin, bad.

 Here is where things get interesting.

 Personal consumption, as a component of GDP, was over 50% of Q4 GDP, growing over 90% quarter over quarter.  That’s a huge acceleration, at the margin.  This increase garnered a lot of air-time and blog posts, but isn’t the entire story.

 What did we learn from the GDP report that is new?  US consumer disposable income fell month over month and also declined year over year at the fastest rate since 1974.

 That’s new.  Disposable income was also negative for the first time in four years.  That’s new.  Consumer spending increased for the third straight month and had the highest year over year growth rate, 3.6%, in the last 12 months.  That’s new.

 Wait.  How can spending and consumption increase so dramatically while disposable income is falling?  Savings.  The savings rate is falling in order to make up the difference between what US consumers earn and what they spend.  The last time I checked, savings is a finite number.  How long can the consumer continue to prop up the US economy out of their savings accounts?

 Would you like to know something else that is new that no one is discussing?  Inflation. The government reduced the deflator (a gauge of inflation) used in this latest calculation of GDP from 1.4% in Q3 to 1.1% in Q4. 

 This is extremely interesting since commodity inflation is the newest thing occurring that no one is discussing.  After falling 12% in 2013, the CRB Index of commodities is up 5% already in 2014.  Here’s a breakdown of a select list of commodities needed in everyday life.  I outline the performance in 2013 versus 2014 year-to-date:

·         Milk – unchanged in 2013, up 24% year to date.  That’s new.

·         Coffee- down 25% in 2013, up 13% in 2014.  That’s new.

·         Corn – down 38% in 2013, up 3% in 2014.  That’s new.

·         Sugar- down 7% in 2013, up 1% in 2014.  That’s new.

·         Cattle – up 0.7% in 2013, up 5.5% so far in 2014.  That’s new.

Let’s put it all together.  Consumption is up and now accounts for more than 50% of US GDP while disposable income and savings are falling.  Inflation that matters, not the inflation number the government chooses to use but the inflation that is a tax on the consumer such as milk, coffee, corn are all accelerating higher. 

 What do you think?  Is US growth going to accelerate higher from here or continue to slow?  What are the markets telling us?

 My “slow US growth” market index, which consists of utilities, REITs, gold and Treasuries, is up 4.27% year-to date. This compares very favorably to my “high US growth” market index, consisting of technology, financials, basic materials and US small caps, which is down 3.43%. 

 I discussed the US growth slowing at length in the January 20 report where I introduced these indices.  The spread between the two is accelerating from 209 basis points wide on January 20 to 770 basis points wide today.  At the margin, that’s new.

 I anticipate that investors will become more and more aware that US growth is slowing and they will continue to position their assets accordingly.  As such, I would expect the slow growth index to continue to outperform the high growth index on a relative basis.