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Economic Composite Index Suggests Restocking Cycle Is Over

Submitted by Lance Roberts via STA Wealth Management,

Since the end of the financial crisis, the economy has ebbed and flowed between expansions and contractions. The contraction in economic activity during the financial crisis was followed by a surge in economic activity as inventories were restocked, and pent-up demand was filled.

The same occurred during, and following, the end of QE1 and the impact of the Japanese earthquake and tsunami and debt ceiling debate. The summer of 2012 saw a similar retreat as QE2 ended and the Eurozone crisis reared its head. The latest slowdown and acceleration followed the "polar vortex" in late 2013 and early 2014 which led to a surge in activity in the 2nd and 3rd quarters of 2014. This is shown in the chart below of the Economic Output Composite Index: (For details on construction read this)

We are now witnessing the next slowdown cycle as energy prices collapse and the "Polar Vortex Sequel" smashes cold weather temperatures across the country. Despite claims that falling energy prices are a boost to economic growth, the reality is that the declines in energy-related activity and employment combined with the shutdown of operations due to extremely cold temperatures is having a drastic effect on economic activity.

It is important to notice, that despite the "hype" of the mainstream media about the economic recovery, activity never rose past previous peaks in this cycle. The current decline was not unexpected as the detachment between sentiment surveys and underlying activity had to reconverge. I discussed this previously stating:

"Last Friday, I discussed the growing gap between economic reports particularly when they measure the same basic areas of the overall economy. For example, how can the Markit Manufacturing PMI Index be negative for three months while the ISM PMI has surged higher during the same period. Both cannot be right."

What we are finding out now is that they weren't.

Furthermore, a look at the extended history of the economic composite index, and comparing it to both GDP and the Leading Economic Index for validation, paints a very interesting picture. (The gold dots represent the start and end of QE1, QE2, LTRO, and QE3) Since the financial crisis ended, the economic composite index has remained confined to levels that have historically been associated with recessions in the U.S. economy. This goes a long way to explaining the weak wage and economic growth that has persisted since 2009.

Lastly, the chart below strips the economic composite index down to just the key purchasing manager regions and compares it to the ISM purchasing managers index.

The ISM index typically lags the EOCI-PMI by about one month which suggests that weaker ISM numbers are coming in the next couple of months. Furthermore, the recent divergence in the sentiment surveys like the ISM, as compared to durable goods and factory orders, is now being corrected.

The good news is that as the harshness of the cold winter passes, activity will likely once again pick up temporarily as pent up demand is filled. However, this is really no different that what happens following most winter periods.

With the Federal Reserve no longer intervening with liquidity injections, the question will be whether the ECB's QE program, slated to start next month, can pick up the slack and boost economic growth domestically.  The strong rise in the U.S. dollar has crimped the demand for exports and weakened corporate profitability, so success of the ECB's QE program is questionable at this point.

However, with market valuations now extended, the risk to the downside has increased markedly in recent months which makes it worth paying attention to this very broad measure of the U.S. economy in the months ahead.

While economic indicators make "very poor bedfellows" for managing portfolios, they do provide some indication as to the relative risk of owning assets that are ultimately tied to economic cycles. Despite commentary to the contrary as of late, economic cycles have not been repealed, and the current economy is likely running on borrowed time.

While there is currently "no sign of recession" on the horizon at the moment, it is worth remembering two things:

1) The largest draw downs in the stock market have occurred during economic recessions (33% on avg.), and;

2) Recessions are only seen in hindsight due to the historical revisions in the data.

As shown below, the NBER (National Bureau Of Economic Research) has only been able to date recessions well after they have begun. By the time that most economists/analysts figure out that a recession has started, it is far too late to act.

As I have said before, the real risk to investors is NOT missing out on market advances, but capturing the declines which destroys the long-term compounding effect of portfolio returns.