Lighthouse Investment Management

Macro Report
Economic Indicators - US economy - March 2013

Contents
Summary ....................................................................................................................................................... 2 Introduction .................................................................................................................................................. 3 Fed Funds Rate.............................................................................................................................................. 7 Crude Oil ....................................................................................................................................................... 8 Construction: Building permits ..................................................................................................................... 9 Employment: Non-Farm Payrolls ................................................................................................................ 10 Employment: Jobs Gained / Lost ................................................................................................................ 11 Employment: Initial and Revised Non-Farm Payrolls.................................................................................. 12 Consumer Sentiment: University of Michigan Survey ................................................................................ 13 Consumer Confidence: Conference Board Survey ...................................................................................... 14 Total Credit Outstanding............................................................................................................................. 15 Electricity Usage .......................................................................................................................................... 16 Retail Sales .................................................................................................................................................. 17 Manufacturing: Hours Worked ................................................................................................................... 18 Manufacturing: Orders ............................................................................................................................... 19 Transportation: Miles Traveled................................................................................................................... 20 Orders: Capital Goods ................................................................................................................................. 21 Output: Electricity and Gas ......................................................................................................................... 22 Manufacturing: Supplier Deliveries ............................................................................................................ 23 Transportation: Gasoline Consumption...................................................................................................... 24 Inflation: Consumer Price Index.................................................................................................................. 25 Inflation Expectations ................................................................................................................................. 26

Macro Report - US economic indicators - March 2013

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Summary
February 2013 highlights: • • • • The likelihood of recession remained at 7% Output by electric and gas utilities is the only variable remaining in recession territory Retail sales continue to grow at mid single-digit rates Average monthly employment growth slowed further from 167k to 164k

March 2013 trends: • • Final UoM Consumer Sentiment came in at 78.6, contrasting with initial reading of 71.8 Preliminary CB Consumer Confidence dropped significantly from 68.0 to 59.7

CONCLUSION: • Based on our set of 13 weighted indicators the probability for US recession remains low.

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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. In the US, the beginning and the end points of 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). 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). 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. Macro Report - US economic indicators - March 2013 Page 3

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

Unfortunately, this does not have to be the case going forward. Due to impotence of monetary policy at the lower zero bound and rapidly increasing government debt the Fed might not be able to raise rates in the foreseeable future. A recession might hence happen without prior tightening by the Fed. We looked at many indicators from every angle; most had to be smoothed to cancel out short-term "noise" in order to prevent false signals (we use 3-months moving averages). Some indicators do not reveal useful 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 table on the following page shows indicators we have tested. Our criteria: • • • • false positives (calling for a recession when there was none) false negatives (missed a recession) confidence it will work in the future and lead / lag time

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No two recessions are the same. Trigger levels can be 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). The Federal Reserve Bank of St. Louis publishes a recession probability indicator by Chauvet / Piger (black line). It is based on four inputs Macro Report - US economic indicators - March 2013 Page 5

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(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 months old data). You can see that LRPI shows first warnings signs much earlier than Chauvet/Piger. In a recent response to a blog post, Chauvet clarified their indicator calls 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. Their indicator initially showed a recession probability of 20% for August 2012, only to be revised down to 1.7% six months later. Verification of LRPI: We set 40% as threshold for the LRPI to indicate a buy (recession probability <40%) or sell (>40%) signal. Transactions have been done at the monthly closing price of the S&P 500 following the month for which the signal occurred (in order to accommodate time lag):

An investor using the LRPI as a trading tool would have suffered only one loss of 7% (August 1980) while avoiding the dot-com crash (2001) and the 'great recession' (2008-2009). The system creates no unnecessary churn. While the control group ('buy-and-hold') would have created a higher return (with higher volatility) this might be due to the test period coinciding with one of the longest bull markets in history (1982-2000). Annex: LRPI Components Please find charts for all contributors to the LRPI on the following pages.

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Fed Funds Rate

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. An increase between 2 and 4.5 percentage points from the previous low preceded every recession since 1954. 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.

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Crude Oil

An increase in the price of crude oil of 75% to 100% preceded five out of the last six recessions. Close call in March 2011 and February 2012. Currently not a red flag.

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Construction: 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 again).

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Employment: Non-Farm Payrolls

The number of people on "payroll", or employed, is a good proxy for the health of the economy. You can see the long "valleys" of lost payrolls after recent recessions compared to earlier ones. A decline of more than 1% from previous peak payroll level indicates a recession. There have been no misses and no false positives; even the "tricky" back-to-back recessions in 1980 and 1982 have been called correctly by this indicator. However, not all jobs are equal; only 47% of all working-age Americans have full-time jobs. Since 2007, six million full-time jobs have been lost, but 2.5 million part-time jobs gained. Part-time jobs often come without "benefits" such as health insurance. From peak employment (Q1 2008) to Q1 2010 1.2 million "higher-" wage jobs (median hourly wage $21-54) have been lost; in the subsequent 2 years only 0.8 million have been recreated. While almost 4 million mid-wage jobs ($14-21) have been lost, only 0.9m have reappeared. Among lower wage jobs ($7-$14), 1.3 million have been lost, but 2 million gained. The current monthly payroll growth of 164,000 (12 months average) indicates zero probability of recession. Macro Report - US economic indicators - March 2013 Page 10

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Employment: Jobs Gained / Lost

Zoomed-in view:

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Employment: Initial and Revised Non-Farm Payrolls

This chart shows monthly changes in employment as initially reported (black dotted line), the revised number (thick black line) and the difference between the two (green/red chart, right hand scale). During the last recession (we didn’t know we were in one yet), monthly employment numbers were revised downwards by up to 273,000. In Q3 2008, revisions were -159k, -190k and -273k (that’s before Lehman happened). Any increase in employment below 300k has no statistical significance as it is within the margin of error. Yet many investors base their view of the economy on those numbers.

• •

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Consumer Sentiment: University of Michigan Survey

The University of Michigan, together with Thompson-Reuters, conducts more than 500 telephone interviews twice a month to gauge consumer sentiment, with a reference point from 1964 set to 100. A preliminary mid-month survey is followed up by a final one towards the end of the month. The indicator had one false positive (2005) and one miss (1981; the 1980-1981 recessions were back-toback, so let's not be too harsh about that). A decline of 25%+ from previous peak indicates a recession. 2011 was a close call. The final reading for the month (78.6) came in higher than the preliminary number (71.8). We are using 3-month smoothed numbers as the series is quite volatile. This indicator does not deliver any warnings signs currently.

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Consumer Confidence: Conference Board Survey

The Conference Board, an independent business membership and research association, is conducting a survey of consumer confidence by mailing out surveys to more than 3,000 randomly selected households. The cut-off date for a preliminary number is the 18th of the months. The final number includes all surveys returned after that date. The indicator had 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". This indicator's initial reading for the month (59.7) showed a distinct deterioration from the prior month (68.0). No red flag currently.

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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: economic growth is dependent on credit (debt) growth; without additional debt, growth is impossible. Unfortunately, data becomes available only once every quarter, with the latest data often many months old. To ensure timeliness for our LRPI we had to exclude this measure, however present it here for informational purposes. In Q4 2012, TCMDO was growing at a $2.9 trillion rate over the last 8 quarters (versus revised 2.7 trillion in Q3)). TCMDO-to-GDP has increased to 355% (Q3: 352%, Q2: 354%, previous peak was 385% in Q1'09).

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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. Close call towards the end of 2011. Currently no red flag.

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Retail Sales

After a three consecutive months of decline (April May, June 2012), US retail sales (excluding food services) have resumed their previous growth trend. Recent months have been revised upwards. You would expect the opposite (downward revisions) to happen during a recession. January numbers have been revised upwards by $0.7bn. While the annual growth rate (blue line) has slowed down, the indicator currently gives 0% probability of recession. After very strong numbers in October and November 2012, the 3-month annualized rate of growth has slowed down to 5%. Increased spending without any growth in real income must be financed by dipping into savings, or, in most cases, increased borrowing. Car sales, growing at 11% annualized rate over the last 3 months are still an important driver of retail spending, obviously benefitting from lower interest rates and abundant credit.

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Manufacturing: Hours Worked

Companies prefer to reduce employee's working hours rather than firing them straight away. 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.

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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). One false positive (1989). The ISM index improved substantially in February (57.8 versus 53.3) after briefly dipping into dangerous territory (December 2012). Currently no warning sign. March data are due to be released on April 1st.

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Transportation: 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, car pooling and workfrom-home jobs 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. In March, historic data has been revised going back for years, denting confidence in this indicator futher.

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Orders: Capital Goods

Defense and aircraft orders are lumpy and distort trends, so we exclude them here. We have "medium" confidence in this indicator due to limited historic data. The "red zone" has been set at -4% to -2%. February non-defense durable goods ex-aircraft orders came in at $65.8bn, down from $67.6bn in January - the highest since 53 months (for which I have no good explanation). However, defense and aircraft orders are more than twice as much as the rest. Any cuts in defense spending and problems with Boeing's 787 model affect total orders, with repercussions for many suppliers. So I wouldn't get too excited about the non-defense ex-aircraft data.

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Output: Electricity and Gas

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. Recent data has seen quite some revisions of up to 2.5% magnitude. Regardless, electricity production suggests we are in a recession. It is currently the only of 13 indicators giving a warning signal.

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Manufacturing: Supplier Deliveries

Multiple false positives (1985, 1989, 1995, 1998, 2005) muddy the water. Therefore, this indicator has been slapped with "low" confidence and a corresponding weighting. Recent surveys hovered around the 50-point mark. The current reading suggests a slight growth in manufacturing supplier deliveries. March data is due to be released on April 1st.

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Transportation: Gasoline Consumption

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 harsh decline in 2012 is puzzling, but seems to recover since March 2012. It is no longer giving a recession warning. 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.

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Inflation: Consumer Price Index

• • •

Headline CPI-U ("consumer price index for urban consumers") is currently rising at a 2.9% annualized rate (previously: -0.7%) based on the last 3 months (seasonally adjusted). Core CPI-U (excluding effects from food and energy prices) is currently rising at a 2.2% (previously 1.9%) annualized rate based on the last 3 months (seasonally adjusted). Those "spikes" have happened before. However, a couple of those monthly spikes combined can quickly work themselves into the official (year-over-year) inflation numbers and cause concern over monetary stability.

Conclusion: • The Fed is targeting a "core" inflation (ex food and energy) rate of 2% (+- 0.5% points). Both headline and core inflation rates are currently at exactly 2.0%.

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Inflation Expectations

• • • • • • • •

Real yield = nominal yield minus inflation You can resolve the formula for [inflation = nominal yield minus real yield] We use Treasury bonds for nominal yields, and TIPS (Treasury Inflation Protected Securities) for real yield. The break-even rate of inflation is the rate at which it does not matter if you bought Treasury bonds or TIPS (return would be the same). The resulting implied inflation rates for over the next 5 (red) and 10 (blue) years are printed in above chart. If you know the average rate over 10 years, and for the first 5 years of those 10 years, you can derive the expected rate of inflation for years 6 to 10 (green). The "expected" rate of inflation is not a forecast; it may or may not come true. Market expectations change. Changes in the expected rate of inflation are of interest due to a high correlation (over 75%) to changes in the S&P 500 Index (see next page).

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• •

The current data point (red) is the farthest away from the regression line since the beginning of 2012 Assuming historic correlations remain valid this suggests that either the stock market is overextended or inflation expectations will have to catch up substantially.

Any questions or feedback highly welcome. Alex.Gloy@LighthouseInvestmentManagement.com

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Disclaimer: It should be self-evident this is for informational and educational purposes only and shall not be taken as investment advice. Nothing posted here shall constitute a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. You shouldn't be surprised that accounts managed by Lighthouse Investment Management or the author may have financial interests in any instruments mentioned in these posts. We may buy or sell at any time, might not disclose those actions and we might not necessarily disclose updated information should we discover a fault with our analysis. The author has no obligation to update any information posted here. We reserve the right to make investment decisions inconsistent with the views expressed here. We can't make any representations or warranties as to the accuracy, completeness or timeliness of the information posted. All liability for errors, omissions, misinterpretation or misuse of any information posted is excluded. +++++++++++++++++++++++++++++++++++++++ All clients have their own individual accounts held at an independent, well-known brokerage company (US) or bank (Europe). This institution executes trades, sends confirms and statements. Lighthouse Investment Management does not take custody of any client assets.

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