How to Read Conflicting Economic Signals

Dr. Stephen Leeb submits:Short-Term Key: Neutral Long-Term Key: -8 (Neutral) It's no wonder many people find themselves confused about the economy. Two of the most reliable economic indicators we know are currently giving contradictory readings. Yet that discord offers us an important insight into where the opportunities for profit lie. The first of these indicators is the Commodity Research Bureau’s Raw Industrials Index, which is composed of a dozen or so basic commodities, not including oil. None of these commodities are traded on futures exchanges, but simply sold by producers to manufacturers. Because of that, their prices are not influenced by speculators. An uptrend in the Raw Industrials Index can indicate either growing strength in the economy (which creates higher demand for materials) or inflation (resulting from a weaker dollar or tightening commodity supplies). Currently, the Raw Industrials Index stands near 500, just 5% below its all-time high, which was set in early 2008, and very close to its peak set earlier this year. It's up more than 50% from its 2008 low – a remarkable and indeed historic gain. If an economist had to make his forecast based only on this one indicator, with no access to other data, he would have to conclude that American economic growth was strong and higher inflation was certainly a strong possibility. On the other hand, if our economist had access only to data on unemployment, he would reach a completely opposite conclusion. With initial claims for unemployment insurance near 500,000 and the unemployment rate near 10%, he would likely predict that the economy is headed for a double-dip recession. At no time in recent history have jobless claims risen this high without an economic downturn resulting. Indeed, downturns have occurred at lower levels of unemployment. Both these indicators have a history of being highly accurate predictors of economic growth. (Both are among the indicators that are subject to the least amount of revision.) Yet, they're pointing in opposite directions. Moreover, we've never seen them contradict each other to such an extent. So what's going on? AVOIDING MISERY IN TODAY'S ECONOMY It seems we live in a zero-sum world in which emerging economies, led by China, remain strong, while developed countries continue to suffer. China's growth has admittedly slowed to around 10%, yet that's nothing to sneeze at. China's government remains in firm control of its economy. Recent labor issues seem to be just part of a planned transition from an economy driven by investment to one driven by consumer demand, urbanization, and alternative energy. Then there's India, whose growth rate, many economists believe, will surpass China's within the next 2-3 years. Even if India's economy never reaches the size of China's, it will still place a huge demand for commodities on the world's shoulders. Other developing nations have strong growth rates as well. So unless there's some disaster buried in the path ahead, we are clearly journeying towards scarcer and more expensive commodities. This trend creates a drag on developed economies, which have to pay higher prices for everything from industrial metals to mundane substances like tallow, rosin, or burlap. So far, companies have responded to this pressure by cutting back on profit margins, delaying raises, and as the high level of unemployment claims indicates cutting back on staff. Lower incomes have been the result and that's why higher commodity prices have yet to make the CPI climb. It's also why U.S. economic growth has been weak despite what rising commodities indicate. In the past, economic growth in the developed world was the factor that drove commodity prices higher. Higher prices were not much of a problem, because growth created enough new wealth to more than compensate. The U.S. government could also regulate inflation by regulating growth. But today we have no control over commodity prices. They will rise even if growth stays low. We also have a simultaneous mixture of inflation and deflation. Commodity prices rise, while other assets like real estate or stocks go nowhere. So policy-makers in the Western world face a dilemma. Do they lean toward inflation or deflation? In 2008, they erred on the side of deflation, and we know the result. Over the long haul, we're pretty sure which direction policy-makers will favor. Recently, we found new support for our belief from a book by Carol Graham, Happiness Around the World: The paradox of happy peasants and miserable millionaires. Graham has a very distinguished academic background, and her book was recently reviewed extremely favorably in Science. The book summarizes all the recent psychological research on human happiness and applies it to economics. One important discovery Graham discusses is the fact that people in both developed and developing nations overwhelmingly prefer inflation to unemployment. In developed nations, unemployment impacts happiness by 4X as much as inflation. In developing nations, the ratio jumps to 8X. This makes intuitive sense as well. If you have a job, you can cope with rising prices. You can even hope for a raise. But when you're unemployed, even necessities become unaffordable. In light of this, we have to rethink the Misery Index. This index, developed in the 1970s, measures the misery of the American consumer by adding the unemployment rate to the inflation rate. Today, the Misery Index stands at a little over 10, which is pretty high. However, as Graham points out, unemployment should really be weighted 4X higher to give an accurate picture. That would put the Misery Index near 40. In fact, you can see this at work in our nation's psyche. No one is celebrating the fact that inflation is low, but everyone is up in arms about unemployment. Consequently, we expect our leaders will make solving the unemployment problem a top priority, even if it means letting inflation rise. This was apparent at the recent Fed meeting, where Mr. Bernanke decided to keep liquidity high and to remain ready to implement additional quantitative easing, should the economy weaken further. Our guess is that if the S&P dips below 1,000, quantitative easing programs will become much more aggressive. Make no mistake, more money will lead to more growth and probably a lot more inflation. A helicopter-drop approach to QE would dramatically devalue the dollar, but putting enough money in the system will get people spending, which will create new jobs. It may not begin next week or next month, but when the choice between inflation and deflation must be made, the Fed and the government will choose inflation. To do otherwise, would put their own jobs on the line. Incidentally, all this applies to Europe as well. We think both the UK and the EU will eventually be forced to abandon their austerity efforts in order to tackle unemployment. So we recommend investors own commodity stocks which will continue to benefit from growing global demand and any increase in inflation. Sure, they could take a breather now and then. But as long as people continue to hate unemployment worse than inflation, as long as growth in the developing world remains strong, commodity stocks are the place to be long-term.Complete Story »