The Power of Prediction

Joe Namath was famous for many things. He, of course, was a superb athlete. But early in his career, he called attention to himself for a different reason: by accurately predicting victory over his opponent. Namath called for his upset of the 18-point underdog New York Jets against the Baltimore Colts three days before Super Bowl III was played in 1969. Although our business doesn’t entail competing directly against another man, woman or team, we do attempt to peer into the future by assessing the economy and market environment with historical indicators.

The Game Plan

When we look ahead for indications about the strength of the economy and markets, much of the data we use comes from surveys, known in our industry as “soft” data. These surveys mainly consist of asking people how they currently feel, how optimistic or pessimistic they are about the future and what actions they may take based upon their beliefs.

Recently, soft data have been incredibly strong and indicate that optimism is building. Since the U.S. presidential election, surveys measuring small business confidence and consumer confidence have consistently produced results near record highs. This positive sentiment, in theory, should bode well for growth going forward.

While survey data are always interesting, they mean little if they don’t ultimately translate into hard data, such as positive earnings, capital expenditures and retail sales. For example, improving business confidence often leads to an increase in capital expenditures (Figure 1). The tightness of this relationship can be measured by the correlation coefficient, which is measured on a scale of 0 to 1, with 0 meaning there is no correlation and 1 meaning there is perfect correlation. The correlation between business confidence and capital expenditures is 0.75, strongly supporting the claim that the two variables are linked. While there are short periods of time where these data series are not in sync, the similarity of their overall trends seems undeniable.

Although there is typically a lag between soft data and hard data, this time around has been different. Since the election, there has been an unusually wide gap between the improvements in soft data compared to corresponding hard data. As U.S. GDP continues to be lackluster, so do business capital expenditures and retail sales. Only corporate earnings, sometimes seen as the “ultimate” hard data, have shown continuous improvement since the election. 

Most pundits, including ourselves, blame the hard data malaise on the political backdrop, both globally and in Washington. Markets move on expectations, and following the U.S. election, those expectations called for reforms of the tax code, health care system, infrastructure and financial regulation. These hopes have yet to turn into reality, and given current conditions in Washington, we believe these reforms may not come until late 2017 or even 2018, and may be more watered down than what was originally proposed. The delay in reforms has caused us to lower our U.S. real GDP outlook for 2018 from 2.7% to 2.5%; however, we continue to maintain our GDP projection of 2.2% for 2017. 

Two-Minute Warning

As a strategist, it is important for me to stay on top of economic trends. But it is equally important to note how the market has behaved historically. I have noticed that when soft data are consistently strong but the jury is still out on the “hard” proof, markets display incredible patience as they wait for the hard data to catch up. Many investors, questioning the predictability of soft data, have been looking for a better entry point because they’re expecting the market to pull back, but that hasn’t happened.

Today’s equity market has been following the history books and acting accordingly, displaying remarkable resilience despite the many distractions of Washington. The markets have somehow shrugged off the headlines, waiting patiently for things to improve. Because we believe the lag between soft and hard data will soon begin to close, we have been leaning into markets since the election, rather than waiting for a pullback.

Touchdown

Despite the skepticism, Namath proved his ability to correctly predict his own future. Namath’s Jets handily beat the Colts in Super Bowl III. The final score was 16-7, with only a late touchdown by the Colts, with backup quarterback Johnny Unitas in the game, avoiding a shutout.

While the equity market could be vulnerable to a change in sentiment for a number of reasons, including the delay in policy reforms, other positive trends support our expectation for stocks to continue to rise. Strong jobs creation, low inflation and improving corporate earnings growth in the U.S., as well as encouraging economic data abroad, suggest that slow global growth will continue. So while it might take additional time for hard data to catch up to the more optimistic surveys, our belief is that the latest soft data will be just as good of a predictor as Namath.

 

 

 

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