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Could a weak consumer stall the economy?

Summary:
Preface: Explaining our market timing modelsWe maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade. The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”  My inner trader uses the trading component of the Trend Model to look for changes in the

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Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

Could a weak consumer stall the economy?

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

Rising household stress

The headlines look dire. CNN proclaimed that “40% of Americans can’t cover a $400 emergency expense”, according to the Fed’s annual Report on the Economic Being of US Households. Further research from Google Trends showed that interest in consumer items is tanking.
 

Could a weak consumer stall the economy?

In addition, searches for bankruptcy and financial reorganization spiked recently, indicating rising stress in the household sector.
 

Could a weak consumer stall the economy?

Last Friday’s release of consumer sentiment missed expectations and readings are continue to deteriorate.
 

Could a weak consumer stall the economy?

The economy is at or near full employment. Is this as good as it gets? Is this what prosperity looks like? What does this mean for policy makers?

For investors, the key question are:

  1. How stressed is the household sector; and
  2. Is this precursor to a bull market killing recession?

A household sector report card

To assess the financial status of the American household, let us first consider real retail sales, which is an important driver of economic growth. History shows population adjusted real retail sales has topped out before past recessions, and the latest data shows a possible plateau, but the jury is still out on that score. In the past, it takes about six months to confirm an actual peak in retail sales. The last peak occurred in November 2017, and the May 2018 data has not been reported yet.
 

Could a weak consumer stall the economy?

If consumer spending were to weaken, it would show up in the cyclically sensitive consumer durable sector. The report is also mixed. On one hand, auto sales appear to be rolling over after the most recent hurricane replacement spike.
 

Could a weak consumer stall the economy?

On the other hand, the housing sector appears to be still healthy. This cyclically sensitive sector has topped out ahead of past recessions, though it is enjoying a start of a demographic tailwind as millennials begin to enter the market and raise housing demand.
 

Could a weak consumer stall the economy?

That said, the weak performance of the homebuilding stocks relative to the market has to be regarded as disappointing for the housing outlook.
 

Could a weak consumer stall the economy?

Score retail sales and consumer durable sales growth as neutral. Real retail sales are trending up but may be plateauing, but the jury is still out. Auto sales are rolling over, but the housing sector remains strong, buoyed by positive demographics. The dire stories about a tanking consumer may be overblown.
 

The anatomy of consumer finances

Still, there is an element of truth that household finances are becoming more fragile. My analysis of consumer spending considers its underlying elements. It all begins with wage growth. While average hourly earnings have been rising steadily and annual growth now stands at 2.6%, the level of wage growth has been extraordinarily muted by historical standards. The unemployment rate is 3.9%, which was last seen in 2000, and before that, the 1960`s.
 

Could a weak consumer stall the economy?

One of the puzzle that has bedeviled economists and policy makers is the lack of wage growth in the current tight labor market. A number of explanations have been advanced, such as demographics, where retiring well paid Baby Boomers are replaced by younger and less well paid Millennials. Another is the rise of an employer monosony holding down wages. The following chart from the San Francisco Fed shows “wage rigidity”, or the percentage of employees who have received no wage increases. Even with the unemployment rate at 3.9%, the current level of wage rigidity is higher than the peak seen in the last cycle.
 

Could a weak consumer stall the economy?

Wage growth is the primary driver of consumer spending. As this chart from Political Calculations shows, median real household income has been flat since 2000.
 

Could a weak consumer stall the economy?

Still, households have other ways of coping in the face of stagnant pay increases. The first avenue of coping is to spend more by saving less.
 

Could a weak consumer stall the economy?

After drawing down savings, consumers could borrow to finance spending. The Fed’s flow of funds data shows that households are funding virtually all of their marginal expenditures with debt, up from 40% in 2013.
 

Could a weak consumer stall the economy?

Rising debt raises financial risk for households. An analysis of the credit card delinquencies shows that as interest rates rise, delinquencies are likely to rise to recessionary levels by next year.
 

Could a weak consumer stall the economy?

Despite the dire picture, household finances are not that dire as they seem. The latest update from JPM Asset Management shows that household debt ratios are still low, and their balance sheets are in good shape (annotations are mine). In other words, they have plenty of room to borrow if they want to.
 

Could a weak consumer stall the economy?

Liz Ann Sonders at Charles Schwab has created a Consumer Stress Index to measure the state of household finances. The latest readings indicate that consumer stress is rising, but readings are not in the danger zone yet.
 

Could a weak consumer stall the economy?

Oh, and the headline about 40% of American households who can`t cover a $400 emergency expense? While the absolute level is still worrisome, the same Fed survey shows that the trend has been steadily improving.
 

Could a weak consumer stall the economy?

Moreover, the percentage of survey respondents who report that they are “finding it difficult to get by” has been falling as well.
 

Could a weak consumer stall the economy?

A growing financial divide

Does this mean the ominous headlines about deteriorating consumer finances are overblown and it’s time to sound the all clear? Not so fast!

Detailed analysis an picture of bifurcated consumer finances and rising household fragility that will haunt the economy in the next downturn. The Atlanta Fed’s wage growth tracker captured this effect. People with high skill sets consistently enjoyed higher wage growth compared to the rest of the population. Remember your math, a consistently higher wage growth will lead to an acceleration in wealth differences over a lifetime.
 

Could a weak consumer stall the economy?

While the relationship is less clear, skill sets can be proxied by education levels.
 

Could a weak consumer stall the economy?

The Fed’s annual Report on the Economic Being of US Households tells a similar story of a financial divide is by education. Survey respondents were asked if they were “doing okay financially” and results increased steadily as education levels rose.
 

Could a weak consumer stall the economy?

The flip side of the coin shows the respondents who were unable to fully pay the current month’s bills. We can observe a marked deterioration by education, and within each educational grouping, by race.
 

Could a weak consumer stall the economy?

What about the American Dream and the idea of America as the land of opportunity? If education is the great equalizer, then the future looks problematical. Survey results show that parental educational attainment affect their children’s education levels.
 

Could a weak consumer stall the economy?

In conclusion, aggregate statistics of household finances indicate that while consumer stress is rising, they do not constitute a danger signal of looming recessionary conditions. However, aggregates don’t tell the entire story, and further detailed analysis shows a bifurcation of household finances that will exacerbate the magnitude of the next downturn, and create longer term political problems in the United States.
 

The week ahead

Looking to the week ahead, positive macro momentum is holding up this market. The latest update from FactSet shows that forward 12-month EPS continues to surge upward.
 

Could a weak consumer stall the economy?

Other nowcast indicators are flashing bullish readings. The Philly Fed coincident state indices rose in 45 states, and the three month diffusion index was up in 49 states out of 50 (via Calculated Risk). Other elements of the Philly Fed indices are also upbeat (see Bear markets simply don’t start this way).
 

Could a weak consumer stall the economy?

From an intermediate term technical perspective, the outlook is bullish. This chart from OpenInsider shows that insider selling usually exceeds insider buying and rarely do the two lines cross. In the last two instances where the two lines have intersected, downside equity risk was minimal.
 

Could a weak consumer stall the economy?

The OpenInsider buy signal was confirmed by the weekly summary of insider activity from Barron`s.
 

Could a weak consumer stall the economy?

Shorter term, the SPX remains in a short-term no-man’s land between Fibonacci retracement levels of 2700 and 2740, with further resistance at 2800. Until either the bulls or bears can demonstrate sufficient resolve to break either of these levels, my inner trader is leaning slightly bullish but he is playing a waiting game.
 

Could a weak consumer stall the economy?

Small cap stocks, as measured by the Russell 2000, remains the market leaders as they staged upside breakouts to fresh highs and the index has held above the breakout level. However, the relative performance chart (bottom panel) shows that small caps are in the middle of an upward sloping relative uptrend channel and have little information about short-term direction. My inner trader is still watching for a test of the channel as a possible buy signal.
 

Could a weak consumer stall the economy?

Stock prices are likely to grind higher into the summer months, and my inner investor is bullishly positioned. My inner trader has partial long market positions, and he is prepared to add to them on pullbacks.
 

Disclosure: Long SPXL
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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