We have been pointing out for over a year now that the trend in the economic data has been negative and we’ve taken some grief for that as the stock market has marched higher. Jeff Snider, in particular, has been raked over the coals by some commenters (public and private) for his reporting on the negative trends as if he is somehow making things look worse than they really are. I’m not sure what that means; the data is what it is and Jeff is just telling it like it is. If you want someone to sugar coat things and tell you everything is okay when the data doesn’t support it, Jeff is not your man. Some of the criticism is political as supporters of the President see any negative reportage about the economy as a veiled slap at the President. Some of it is genuine opposition to our interpretation of the facts. Lastly, some of it has been confusion on the part of some readers about the difference between the economy and the markets which, in our opinion, are only correlated in the long run. So I want to spend at least part of this week’s commentary clearing up any confusion there might be about what we do here.

First and foremost, we are not political. I don’t think it is any secret that we are not fans of President Obama’s approach to the economy. We are believers in free markets and small government and while the President professes to believe in those things too, his actions say something entirely different. It has amazed me the degree to which the President seems to believe that centralized decision making is superior to the distributed decision making of a free economy. What makes it more amazing to me is that the President used the power of his network of supporters so effectively in getting elected.  His first campaign in particular was a model of decentralized decision making and demonstrated the effectiveness of an empowered network of individuals. In a sense, the President’s campaigns have been more free market than anything he has done in his official capacity as President.

We also happen to believe in rational regulations, something that has been missing in the economic equation for many a year through administrations from both parties. What we want are effective regulations and while size may not matter in some areas of life, we think it makes a big difference when it comes to regulating the economy. We could have written financial reform on a single sheet of paper and been more effective – and a lot tougher on the financial sector – than the thousands of pages produced by Dodd-Frank. We see size in legislative bills as indicative of the level of corruption and the influence of lobbyists. If we’re right about that, ACA and Dodd-Frank represent a new low for regulation, not a new high and both will have negative consequences for the long term health of the economy. Having said all that, we take the economic data as it comes our way. If it is good, we’re happy to report it as such. If it is bad, we don’t care who occupies the White House, we will report it that way. Despite how we may feel about the President and his approach to the economy, if it was working we’d be reporting it. As portfolio managers it does not benefit us in any way to see economic data through a political lens.

Second, we understand that there are disagreements about how to interpret the incoming high frequency data. If there were known, effective and agreed upon ways to analyze the data, the blogosphere would be a much less interesting place. What emphasis should be placed on any particular piece of data is a matter of interpretation and there are a lot biases that can skew one’s view. What we try to do is concentrate on the leading data, those reports that give us a hint about what is to come. We also look at the coincident and lagging data for confirmation that we are getting it right on the leading parts. We place more emphasis on production and investment since history tells us those are the parts of the economy that produce economic volatility. Consumption is, at best, a lagging indicator and for us it merely confirms what we see in the leading sectors. Which is also why we so vehemently disagree with current Fed policy aimed as it is at spurring consumption. If you have to classify us within the economic sphere, put us down as believers is Say’s Law which means we are not on board with the Keynesian view of the world.

Lastly, the economic data on which we report is only one part of how we manage assets. I have said this many times in the past, but it bears repeating: the economy is not the market and the market is not the economy. (We think Ben Bernanke could benefit from repeating that to himself several times a day.) We place at least as much emphasis on things like sentiment and supply/demand factors when it comes to allocating our and our clients’ capital. The global macro picture is important for long term considerations but what moves the market in the short to intermediate term is more about the emotions of buyers and sellers and what motivates them. In addition, markets are forward looking mechanisms where participants are trying to make assessments about an uncertain future. And while there is something to be said for the wisdom of crowds, everyone should have learned over the last decade or so that markets often get it wrong – in spectacular fashion. So there are times when we are, in our economic commentaries, pointing out that the incoming data is weak but are also invested to a greater degree than one might guess based on our economic view. There are also times when we might report on something positive about the economy and yet have a bearish view of the stock market.

Which brings me to the title of this week’s commentary. I just returned from a week long trip to visit our accounts in the Carolinas and the feeling I get is that there has been a change in the economy over the last few months that may not be being picked up in the economic statistics just yet. I also recently had a discussion with a good friend of ours in the construction industry in South Florida that confirms what I heard on the trip. On the trip I heard repeatedly that things started to change several months ago and that projects that had been on hold are now being put in motion. From real estate development to small manufacturers, all said the change started 3 or 4 months ago. The change is particularly obvious in real estate development. One common theme is that private equity and hedge funds are providing the funding that once came from the banks. One of our contacts on the commercial lending side of the banking business tells us he is willing to lend but can’t find any takers. The traditional forms of financing, the transmission channels Jeff talks about a lot, are being bypassed by the shadow banking of private equity.

There is also a distinct change in the mood of the people I spoke with on the trip. They are still somewhat skeptical of the economy and complain about increased regulations (I heard more about Obamacare on this trip than anything else) but they are also increasingly moving ahead regardless. That would seem to confirm what we’ve seen in the confidence surveys recently. One word of warning though is that consumer confidence is at best a coincident indicator and high confidence is most often associated with tops in the economy rather than bottoms. However, as Doug has pointed out, the current levels of confidence are still well below the long term average so maybe this has more to run.

Just as interesting was the feeling about the stock market. I didn’t find anyone who was throwing caution to the wind with regard to stocks and if anything the general consensus was that it had gone too far, too fast. From a contrarian standpoint, that might be a good thing and we’ve seen similar changes in the sentiment surveys recently. The AAII poll has been unusually volatile of late with swings between overly bullish and overly bearish happening in weeks rather than months or years. As a comment on the emotional nature of the stock market, the contrast between the confidence shown about the economy and the complete lack of it in the stock market was stark.

We will be watching the incoming data very closely over the next few weeks and months to see if this “on the ground” view of the economy starts to show up in the official statistics. For now, we continue to see a deterioration in the data particularly in regard to the production side of the economy and also confirmed to some degree on the consumption side. We are still worried about incomes, savings and investment. We are also concerned about the rapid rise in housing prices in some parts of the country and question whether it is sustainable. We do think that any contraction in prices at this point would not necessarily be a bad thing since, with interest rates ticking higher recently, affordability could be becoming an issue.

We are also still quite concerned about the global economy and the hyperactivity of central banks which we believe raises the risk of some kind of nasty accident in markets. The slowdown in China, along with the recent rise in the US Dollar (although that is looking less of a problem recently) has obviously had an impact on emerging markets and other areas of the world dependent on high commodity prices. A friend of mine asked me at the beginning of the year what my biggest concern was and my response was Asian Crisis II. What I meant by that was a repeat of the late 90s crisis, focused in Asia, but really an emerging market crisis. The rapid changes in capital flows are wreaking havoc on these economies once again and I don’t believe their accumulation of foreign reserves are as big a buffer as their governments seem to think. Brazil is ground zero where foreign reserves have been run down pretty rapidly trying to defend the Real.

Finally, we still see stocks as richly priced and remain conservatively invested with more cash than normal. A better economy, if it is realized, may actually be the trigger for a deeper correction in stock prices as Fed largesse is withdrawn. While we don’t believe QE has been the primary driver of stock prices per se, there are certainly a lot of market participants who do believe it, so its withdrawal is likely to have an impact. We’ve got an FOMC meeting this week that may shed some more light on the Fed’s plans and we expect Bernanke to take pains to soothe the market. He can’t be happy with the back up in interest rates and the recent volatility in stocks. If he really believes in the wealth effect – and all indications are that he does – then he wants people to at least believe that the wealth created by the stock market is more than ephemeral.

One last note: if we are seeing an upturn in the economy – especially if based on real estate development – we think it is  likely that the new investment will be revealed in time as malinvestment due to the price distortions of Fed policy. Of course, as I’ve said many times, malinvestment when it is happening just looks like investment so the economic statistics may improve while it is going on. It will only be in retrospect that the private equity funds find out they shouldn’t have been building more new condos in South Florida. In other words, if the economy does break out to a higher growth rate, it isn’t the type of activity we think is sustainable or desirable in the long term. We still need significant supply side reforms and with a dysfunctional political system seem unlikely to get them anytime soon.

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.