Spying the Green Shoots

A version of this article appears in the May issue of Morningstar StockInvestor.Click hereto learn more about StockInvestor.

The economy is in tough shape currently, and we are probably experiencing the worst recession since World War II, or very close to it. There are four metrics considered to be the gold standard regarding the health of the economy--industrial production, real income, employment, and real retail sales. All except real income are at their worst levels compared with the six previous recessions. When all is said and done, I expect that the economy will decline around 3% from its high in the third quarter of 2007 until the economy bottoms sometime in the second or third quarter of 2009. This would also be in line with the recessions of the mid-1970s and early 1980s, but far better than the 20%-plus decline reported during the Great Depression. Unfortunately, unemployment, a lagging indicator, is likely to peak later this year or even early 2010 at something like 9%-10%.

Some Early Positive Signs, but Still Fragile
We are seeing some signs that parts of the economy may be turning. However, we must strengthen our financial system and avoid a catastrophic auto industry shutdown for things to continue to improve. My analysis focuses on the positives--the so-called green shoots--because the negatives are well known and we are 17 months into this recession, the longest recession since the Great Depression. However, we would be careless not to acknowledge that the current situation is bad, especially regarding employment and the banking system. We are on a knife's edge too, with just one stupid policy decision or negative event potentially undoing our progress.

ISM New Orders Index Bottomed in December
One of our favorite indicators that has turned positive is the Institute for Supply Management monthly survey of new orders. This indicator has one of the longest lead times of the economic indicators we consider, with an average lead time of more than four months. The ISM New Order Index bottomed in December at 23, followed by two readings in the low 30s in January and February, and then moved all the way to 41 in March and 47 in April. The trend has clearly been positive for several months. I caution that this series can be volatile from month to month, but it feels like the economy has made the turn. Besides a great track record, I like this indicator as a leading one because it measures orders to be fulfilled in the future. And once that order is received, it might take a while to actually fill it. Therefore, it is prone to move before production and employment.

Initial Unemployment Claims Have Stabilized with Some Improvement
Although I am not a fan of employment numbers in general as a leading indicator, it appears that initial unemployment claims may have peaked. After doubling during the last two years, the four-week average of claims has dropped from 658,000 five weeks ago to 623,500 the week of May 2. Given that layoffs are halted first in a recovery (influencing initial claims), initial claims is a much better indicator than employment growth (that happens once managements feel comfortable that the turn is for real). The unemployment rate tends to peak even later because discouraged workers (who aren't included in the unemployment rate) pile back into the workforce.

Commodity Prices Stabilizing
Stable to improving commodity prices are another indicator that the economy might be turning. Not every commodity is showing increases, but oil at around $50 a barrel--up from a low in the mid-30s--is indicative of an improved demand environment. Given that oil is used by consumers and in industrial applications, it has broader implications than many other commodities. Copper, widely used in construction and manufacturing, has moved up more than 50% off its bottom. Commodities can make interesting indicators because prices are widely available daily and not subject to the revisions often facing more conventional indicators.

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