Third Quarter 2010 GDP Revision

The revision to third quarter 2010 GDP was released last week. The original estimate, 2.0%, was revised up to 2.5%, a more "respectable" number than the original. In the first release of each quarter's GDP number, inventories, exports, and imports are all approximated. Subsequent months will use available data to eliminate the "educated guesses" contained in the first estimate. That was the case for today's release. Here is a story discussing the GDP release.

As the official GDP releases represent somewhat "stale" data, we can approximate what they will entail using real-time data from asset markets, which has been a central theme of my classes. To do this, go to StockCharts.com and on the middle right select the PerfChart (this stands for Performance Chart) that deals with the sectors of the S&P 500. To save you time and effort, here is the link.

PROCEDURE:
First, choose a bar chart at the bottom left (second button from the left). Then, move the slider (bottom right) to cover the exact time period you desire. Here, I have used the third quarter of 2010.

ANALYSIS:
Observe which sectors have performed better than the S&P 500 index (i.e., outperformed the overall market). This occurs when the S&P 500 button at the top left of the chart is selected.

For the third quarter of 2010, clearly the most cyclically sensitive sectors outperformed the market, with the exception of Financials. Overall, this is a reflection of the growth that occurred during that quarter. Had the defensive sectors (i.e., Consumer Staples, Health Care, and Utilities) outperformed, this would have signaled a potentially weakening economy.

Can this analysis be used to help predict the GDP report before it is actually released? The answer is yes. Asset markets, one of which is the stock market, are leading indicators, which means they tend to move in advance of changes in other parts of the economy. So, current changes in leading economic indicators tend to signal future changes we can expect to observe in the overall economy.

What is the stock market (and its sectors) telling us about the fourth quarter rate of economic growth? The second chart (click to enlarge) shows market performance since October 1. Other than Energy and Consumer Discretionary stocks (which themselves are cyclical), the remainder of cyclical indicators are performing less well than they did in the third quarter. The apparent message is that economic growth in the fourth quarter will be slower than it was in Q3, or spotty at best in comparison.

There are two things that should be noted. First, there is no indication that economic growth will become negative in Q4. Second, the slowing of economic growth these sectors seem to be indicting also affects the defensive sectors, so they are more negative than they were in Q3. The greater under performance utilities may also reflect an expectation of somewhat higher interest rates in the near term (i.e., (public) utilities like electric companies tend to pay high dividends which become less attractive when interest rates are expected to rise). Part of this no doubt reflects ongoing worries about the US housing market and the economic stability and solvency of several European countries as well (Ireland, Portugal, Spain, Italy, and Greece, sometimes referred to as the PIIGS, using their first letters). Will economic weakness in Europe weaken the recent momentum the US has been experiencing? The market apparently believe that this is likely.

Let me suggest that you continue to follow the sectors as we move farther into the fourth quarter and see what the market is suggesting. We won't get the initial Q4 GDP data until late in January, so this should be informative in advance of the formal data in January (that will be stale at that point).

After "The" Employment Report

As you know from class, the September employment change was essentially in line with expectations. Payroll employment for the prior two months (July and August) was also revised significantly higher. Most notably, the original employment change for August, a 4,000 decline, was erased. The revised August employment number is an increase of 89,000. Along with this, the unemployment rate rose slightly to 4.7%, and average hourly earnings rose by a greater-than-expected 0.4%.

Hopefully, you took the time to perform the practice exercise in advance of this report. The markets viewed this as a strong employment report. The perceived (key word!) likelihood of a recession dropped noticeably as the result of today's data.

- The stock market liked the report a great deal. It was not too high as to preclude further Fed rate cuts, but not so low that it might have indicated we were in the early stages of a recession. Read a story about this.
- The bond market didn't like this at all -- both significant employment gains and the "hotter" than expected wage gain raised the inflation flag. Here is a story about this. Examine the yield curve to see how the bond market ultimately reacted. Clearly, the yield curve got steeper, indicating the expectation of stronger upcoming growth and inflation.
- The oddity today was the foreign exchange market. Normally, we would assume that the greater perceived economic growth and higher interest rates would both strengthen the US Dollar. However, by day's end, the dollar had weakened further. Read about this. It might have been profit taking by currency traders and the overall perception that the direction for the US dollar is still down. Where is the bounce (support)?

Following what I did in yesterday's posting, I revisited the Market Carpet at StockCharts.com. This time, I looked at the most recent 10 days (not the entire time since the Fed rate cut). The "carpet" below is what pertains (click to enlarge):
Now look at the sectors that have performed the best over the period of this carpet, the last 10 days. All (no exceptions) are cyclically sensitive sectors (look at the bottom right). The leader is Financials. This sector had taken a beating after the financial worries in August. But, with recent data showing that the commercial paper market is improving and possibly stabilizing, there was some "make-up" momentum. Generally, however, it is desirable to see both the Financial and Consumer Discretionary sectors outperforming other sectors.
So, over the past 10 days, the equity market has signaled expectations for an improving level of economic activity. None of these sectors would have performed so well had there been substantial recession concerns. For extra credit (due at the beginning of class on Wednesday), replicate this market carpet (look at yesterday's post for how to do this) but for the 14 days since the last rate cut. Print out the carpet and bring it to class.

Finally, look at the sectors that underperformed: Utilities; Health Care; and Consumer Staples. All of these are defensive sectors, that outperform when recession worries accelerate, but underperform when recession fears abate, as has been the case recently.