People spend a lot of time talking about the so-called green shoots, and what’s a lagging indicator and what’s a forward indicator and when we should take are cues from the stock market, and when a second-derivative change is something worth having a party to us.
Following yesterday’s excitement following the consumer sentiment data, and our discussion on whether there was any merit to that, a reader sent us a section of a recent John Mauldin letter that seemed particularly relevant towards analysing the green shoots question.
The key is in looking at the revisions to past data, and recognising that in times of economic flux (when the economy is going from growth to recession or recession to growth) the initial numbers are most likely to be off and need significant revisions. That’s because all data collection is difficult and to some extent it has to be based on current trends — especially the initial numbers.
Thus, there’s a tendency for all data to be lagging. What we want to see our actual upward revisions to previous reports. These are the sure signs that the economy is turning, and that the initial trend-influenced numbers were underappreciating a real turnaround.
Here’s the whole thing from Mauldin:
Can I Have Some More of that Data, Please?
One of my regular reads is the blog The Big Picture. They featured a short piece by Michael Panzner this week. He put together some rather interesting data and then asked a question, which gives me an opportunity for discussing government data. Let’s see what he had to say, and then I will make my comments.
“Many market-watchers claim that U.S. economic statistics are increasingly being revised downward in subsequent periods, suggesting that the figures initially being reported by Washington are “puffed up,” so to speak, most likely for political purposes.
“Well, I went back and had a look at the differences between the reported and revised data for various series, including monthly retail sales, nonfarm payrolls, industrial production, and durable goods orders, to try and figure out if the cynics are right.
“Using data from Bloomberg, I calculated whether the revised data for each month was lower than the first-cut estimate. Then I tabulated 12-month running totals for each series to see if there has been some sort of systematic bias (in other words, whether the pattern of monthly downward revisions was trending higher instead of undulating up and down).
“To make the comparisons easier, I subtracted the 12-month tally as of May 2002 (an arbitrarily chosen date) from the monthly totals for all four economic series so that the starting point for each would be the same — zero.
“Based on a quick read of a graph of the data (see below), it does seem as though the pattern of negative revisions has been trending higher lately, especially during the past year or so, suggesting that the cynics may be on to something.
“That said, I am not a statistician, and the results may be nothing more than “noise.” There is also the possibility that my methodology is lacking (because, for example, the margins-of-error for each month’s data are relatively large, or because of certain quirks that crop up when an economy is in transition). Still, you gotta wonder…”
Actually, Mike (can I call you Mike?) your last thought is the correct one: “or because of certain quirks that crop up when an economy is in transition.”
Go back to 2003-04. Notice that the numbers of downward revisions in non-farm payrolls are negative in your graph? Remember all the talk back then about the “jobless recovery”? We can now look back and see there were a lot of jobs being created. They just did not show up in the early statistics. And look at the opposite reaction in industrial production: here they revised strongly downward for a the better part of two years, yet it turned out there was a production boom going on.
Was all this a conspiracy on the part of the Bush administration to make things look worse than they actually were? Hardly seems like rational political behaviour.
The “problem” comes from the methodology. There is no exact data for any of those statistics. They have to get as much data as they can and then make estimates. Part of the process of estimation uses previous trends. It is as if we were using past performance of a mutual fund or stock to project future returns. Even though we look at the past performance, we should know that past performance is not indicative of future results. Just look at some of the top-performing value-oriented mutual funds in the recent bear market, like superstar Bill Miller’s Legg Mason Value Trust fund (LMVTX), the after-fee returns of which had beaten the S&P 500 index for 15 consecutive years, from 1991 through 2005. It did rather poorly last year, even in comparison with the S&P, which was horrid. Past performance is interesting, but it can disappoint. And sometimes rather viciously.
Now, just as saying that a fund on average will produce a 10% return does not mean that it will yield 10% every year, neither do government statistics work that way. While the methodology for each series of data is different, they all are more or less trend-following. They take past relationships in the data they can gather and use them to estimate current numbers. And — this is important — on average and over longer periods of time, they are pretty accurate.
They will revise the data many times over the coming years, getting closer and closer to the actual numbers. For instance, I can’t remember exactly when, but it was several years later that we learned that we were already in a recession in the third quarter of 2000, at the very time most economists were calling for a robust economic future! (Except for your humble analyst, who was predicting a recession, and had been for some time because of the inverted yield curve, but that’s another story.)
But in the short run, at economic transitions they are going to get it wrong, because the backward-looking data is mean-reverting. But how else would you do it? One of the keys to economic transitions is to look at the direction of the revisions. Recently, the revisions have all been negative. Things are actually getting worse than the initial data suggested. And during the last recovery the data kept getting revised upward, especially six months and one year later.
(Picture via Zevotron)
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