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Lighthouse Investment Management

Macro Report
Economic Indicators - US economy - November 2012

Contents
Introduction .................................................................................................................................................. 2 The past: oil & the Fed .................................................................................................................................. 3 The Lighthouse Recession Probability Indicator (LRPI) ................................................................................. 5 Annex: LRPI Components .............................................................................................................................. 8 Building permits ............................................................................................................................................ 8 Consumer Sentiment .................................................................................................................................... 9 Total Credit Outstanding............................................................................................................................. 10 Electricity Usage .......................................................................................................................................... 11 Consumer Confidence ................................................................................................................................. 12 Retail sales .................................................................................................................................................. 13 Manufacturing: Hours Worked ................................................................................................................... 14 Manufacturing: Orders ............................................................................................................................... 15 Miles Traveled ............................................................................................................................................. 16 Orders: Capital Goods ................................................................................................................................. 17 Electric and Gas Output .............................................................................................................................. 18 Manufacturing: Supplier Deliveries ............................................................................................................ 19 Gasoline ...................................................................................................................................................... 20

Macro Report - US economic indicators - November 2012

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Introduction
Recessions are bad for company profits and hence stock prices. Knowing when an economic slow-down looms can give important clues about asset class selection. Knowing it early is crucial for investment performance. In the US, recessions are "declared" by the NBER (National Bureau of Economic Research). The NBER defines recessions as a "significant decline in economic activity spread across the economy" (not, as often believed, as two consecutive quarters of negative GDP growth. Theoretically, a recession could happen without negative GDP growth, but it practically never has). The NBER takes it's time to date the beginning and the end of a down-turn; it announced the beginning of the last recession (December 2007) only on December 1, 2008 - one year later. By that time, the S&P 500 Index had fallen from 1,575 points to 741. Similarly, the end of the recession in June 2009 was announced on September 20, 2010 - more than one year later. By that time, the S&P 500 had already soared from 940 points to 1,142. Waiting for the NBER to declare beginning and end of recessions would have led to inferior investment results (the NBER is correct in taking it's time, since many economic indicators are being revised multiple times as preliminary data gets updated). Traditional leading indicators include values such as the stock market and the slope of the yield curve. However, the stock market does not seem very good at anticipating recessions, as the S&P 500 index marked an all-time high in mid-October 2007, a mere six weeks before the most severe recession of the last 8 decades began. The yield curve has historically been a very good warning sign of recessions, as the Federal Reserve Bank was forced to increase short-term rates in order to cool an overheating economy (thereby triggering a recession). However, with short-term interest rates near zero for the foreseeable future, the yield curve could only invert if long-term yields dipped into negative territory. While not entirely impossible (negative yields for up to 2 year maturities have been observed in German, Swiss, Danish and other government bond markets) it is very unlikely to happen in US Treasuries. Therefore, the slope of the US yield curve is unlikely to give any hints about a recession occurring under ZIRP (zero-interest-ratepolicy). Indicators published by other institutions, such as ECRI (Economic Cycle Research Institute), are proprietary and not transparent, giving investors only the choice to "believe-it-or-leave-it". The Conference Board Leading Indicator includes questionable values such as the S&P 500 Index, the slope of the US yield curve and M2 money supply (which we have found to have little correlation with economic cycles). Macro Report - US economic indicators - November 2012 Page 2

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As most recessions last rarely longer than a year, the economy usually had already exited a recession by the time the NBER declared it to be in one. Revisions to GDP growth render it useless for investment purposes; On August 28, 2008 (already 8 months into the "great recession"), Q2 2008 GDP growth was revised upwards from an initial +1.9% to +3.3%, triggering a 2% stock market rally. Later, growth was revised down to 1.3%, with the following quarters delivering -3.7%, -9.2% and -5.4% (quarter-on-quarter, annualized). The S&P 500 Index didn't see its level attained that day for another 2 1/2 years. Finding a reliable indicator for identifying recessions "real-time" would already be a great improvement over waiting for the NBER.

The past: oil & the Fed
Over the past 50 years, every recession was easily explained by two factors: oil and the Fed.

On the following page you will see how the US central bank ("Fed") increased interest rates ahead of each of the last 9 recessions. The black line shows the absolute level of the Fed Funds rate; the blue line the increase from the prior post-recession low. Recessions are shaded in gray. Yellow dots indicate the beginning of a recession; green dots the end. The absolute level (black line) is usually on the right-hand scale, while percentage changes (blue line) are on the left-hand scale. Negative absolute numbers should be ignored as they are merely needed for better formatting. A significant increase in the price of crude oil can be found during 5 out of the last 6 recessions (see next page).

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Fed Funds rate: an increase between 2 and 4.5 percentage point from the previous low preceded every recession since 1954.

An increase in the price of crude oil of 75% to 100% preceded five out of the last six recessions.

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The Lighthouse Recession Probability Indicator (LRPI)
We looked at many indicators from every angle; some have to be smoothed to cancel out short-term "noise" in order to prevent false signals (we used mostly 3-months moving averages(. Some data does not give good signals unless you look at decline from recent peaks. Other data needs to be trend adjusted (number of miles driven, for example, benefits from rising number of cars and population). The following indicators have been tested for false positives (calling for a recession when there was none), missed recessions, the confidence it will work in the future and possible lead time:

"Rules" for each indicator define levels indicating a recession call. No two recessions are the same. Hard trigger levels are either too strict (missing some recessions) or too lose (giving too many false positives). We therefore created a "range". The lower ("strict") boundary is the level necessary to avoid false positives; the upper ("lenient") boundary is the level necessary to "catch" all recessions. A "high-quality" indicator will have a narrow range, and recessions will be called with high confidence. An indicator at the upper boundary will be awarded a 50% probability, increasing towards 100% at the lower boundary. The overall "Lighthouse Recession Probability Indicator" (LRPI) is a weighted mean of individual indicators. High confidence and timeliness of signal have been awarded higher weights (maximum: 3) then those with low confidence or tardiness (minimum: 1). On the following page you see the LRPI since 1971, predicting every recession (assumed once 40%-50% probability is exceeded).

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The Federal Reserve Bank of St. Louis publishes a recession probability indicator by Chauvet / Piger (black line). It is based on four inputs (non-farm payrolls, industrial production, real personal income and real manufacturing and trade sales). However, the most recent data point for Chauvet/Piger is usually three months old, while LRPI is constantly updated (1-2 months old data). You can see that LRPI (both the weighted and non-weighted version) begin to show first warnings signs much earlier than Chauvet/Piger. In a recent response to a blog post, Chauvet clarified that their indicator calling for a recession only "after exceeding 80% for a couple of months". Additionally, their indicator is "smoothed" as the raw data can reach 70% (2003/4) without being followed by a recession. Incidentally, the weighted LRPI (bold red line) does not deviate significantly from the non-weighted (dotted red line), speaking for the quality of inputs. On the next page we zoom in on the most recent recession.

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By coincidence, both Chauvet/Piger and the non-weighted LRPI put the odds for the US being in a recession at 20% for the month of August (last available point for Chauvet/Piger). The latest data point by LPRI (September) is 22% (non-weighted) and 13% (weighted). As some data for October has already come in, we can calculate a preliminary LRPI (weighted) by extrapolating missing data, resulting in an unchanged value of 13% (weighted). CONCLUSION: LRPI is a superior recession indicator, giving warning signs at early stages. The current level does not suggest the US economy to be at risk. However, a slight upwards trend in recent months calls for increased vigilance, especially should past data be revised downwards. It wouldn't take much to push several indicators through the upper boundary (50% probability), sending LRPI higher.

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Annex: LRPI Components
Despite the large effort that went into building LRPI we are completely transparent regarding inputs and calculation. Please find below charts for all contributors to the LRPI.

Building permits

Want to build a house? Need a permit! Any decline in permits of 25%+ from prior peak and you can bet on a recession. Missed the one in 2001 though. 2011 was a close call. Absolute level still below 1990/91 recession lows (despite US population growth from 250m then to 315m in 2012). Due to housing overhang unlikely to give boost to economy. Due to low level unlikely to do much damage to GDP either (should permits decline further).

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Consumer Sentiment

One false positive (2005), one miss (1981). 1980-1981 were back-to-back recessions, so let's not be too harsh about that. Decline of 25%+ from peak indicates recession. 2011 was a "close call", but currently out of the woods.

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Total Credit Outstanding

Most recessions have been accompanied by a reduction in the growth of debt. But, for the first time in 60 years, debt has actually shrunk in 2009. A meager 2% reduction caused a massive recession. The classic question of chicken and egg comes to mind: did the recession cause debt to shrink or did shrinking debt induce a recession? I have included the 1987 stock market crash (red triangle). A dramatic revelation dawns: the economy is so dependent on credit (debt) it cannot grow without additional debt. The weasels at the Federal Reserve Bank of St. Louis unfortunately provide data only once every quarter, with the latest available data point often many months old. To ensure timeliness for our LRPI we had to exclude this measure, however present it here for informational purposes.

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Electricity Usage

If you run a business you need electricity. Sure, weather has an impact (electricity use in the US peaks in summer due to air conditioning), but this thing seems to work. If electricity usage drops by 1% or more, it's a recession. Limited historic data, but no misses and no false positives.

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Consumer Confidence

The CB's Consumer Confidence is similar to the UoM Sentiment. Two false positives (1992, 2003), but it did catch all recessions including the ones in 1981/2 and 2001 (difficult for a lot of other indicators). 2011 was a "close call". Currently no red flag. Would have to decline to 45 to trigger recession call in 2013.

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Retail sales

US retail sales (excluding food services) have declined for three consecutive months (April, May, June 2012), visible as a small drop in the black line above. As Gary Shilling ("Insight") points out, these circumstances usually meant the economy was already in recession or entered one within three months. However, both August and September were strong. On top of that, July ($0.4bn) and August ($1.6bn) have been revised upwards. You would expect the opposite (downward revisions) to happen during a recession. This indicator currently gives 0% probability of recession.

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Manufacturing: Hours Worked

Before firing employees companies prefer to reduce their working hours. A drop in average weekly working hours in the manufacturing sector of 2% or more indicates a recession. Except for 1996. According to this indicator, the US economy is still sailing smoothly. However, it wouldn't take much to tip it into the red zone should the recent trend continue.

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Manufacturing: Orders

The Institute for Supply Management (ISM) regularly asks company executives about orders, sales, inventories etc. A level of 50 indicates "unchanged" (economy stagnates). The current decline from prior peak is not yet large enough to raise recession alarm. One false positive (1989).

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Miles Traveled

The US population increases approximately 1% per annum, so traffic increases constantly. If total miles driven grow less than 0.1% versus its own trend, you are likely to be in a recession (the unemployed drive less). The 2001 recession was missed. This indicator says we had a recession in 2011 (which is theoretically possible - we might not know it yet). The prolonged decline in miles traveled since 2007 is puzzling; the decline being deeper than the back-to-back recession 1980/81. Online shopping might have contributed to this trend. Unfortunately, the data is made available only with a time lag of three months. This, combined with lower confidence, made us exclude this indicator from the LRPI.

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Orders: Capital Goods

Defense and aircraft orders are lumpy and distort trends, so we exclude them here. "Medium" confidence in this indicator due to limited historic data. The "red zone" has been set at -4% to -2%. The 3-month moving average currently (September data) stands at -6%, giving a 100% probability of recession. This is probably the most worrying indicator for stock market bulls.

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Electric and Gas Output

Electricity production should be linked to economic growth. This indicator, unfortunately, had many false positives (1983, 1992, 1997, 2006), so confidence is "medium". Setting the trigger lower than -0.5% would eliminate false positives, but make you also miss some recessions. Regardless, electricity production suggests we are in a recession.

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Manufacturing: Supplier Deliveries

ISM manufacturing supplier deliveries: The current reading suggests a mild contraction. Multiple false positives (1985, 1989, 1995, 1998, 2005) muddy the water. Therefore, this indicator has been slapped with "low" confidence and a corresponding weighting.

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Gasoline

Cars need gas, and gas needs to be delivered to gas stations. Inventory effects are unlikely because of high turnover. "Low" confidence because of false positive (1996) and limited historic data. The recent decline is puzzling, and points to a recession. This indicator is related to "miles driven", confirming trends on one hand, but being redundant on the other. It has therefore been excluded from LRPI.

Any questions or feedback highly welcome.

Alex.Gloy@LighthouseInvestmentManagement.com

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