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Investors Shouldn't Panic About Retail Sales: The Seasonal Adjustment Process May Be Flawed


The SA process doesn't account for weather that deviates from "normal," so we may be misreading what we see in the market.

Falling equity values and rising bond prices (falling yields) are usually accompanied by the expectation of slowing economic growth, or even a recession. Such market behavior is what we have seen so far in April. Recent US economic indicators disappointed expectations, despite the fact that they were almost all higher than the prior month's counterparts. Weak data from China, no doubt, had a negative impact. And Fed manipulation of interest rate expectations also played a role. 

But is the economy really slowing? Wall Street takes the data pronouncements of the various government departments as gospel, but, as explained below, the seasonal adjustment process doesn't adjust for events, such as weather, that significantly deviate from "normal."

February data, while somewhat weak, wasn't devastatingly so, and most of March's data came in around expectations. For example, the Cass Freight Index (not seasonally adjusted, or NSA), a measure of monthly freight activity, was (as shown in the table below) weak in December and January versus a year earlier, but it sprung back in February and March to what the levels were a year ago.

  2012-13 2013-14
December 1.071 1.037
January 1.020 1.000
February 1.077 1.073
March 1.140 1.144
The Institute for Supply Management (ISM) produces two monthly macroeconomic indicators: the Manufacturing Index and the Non-Manufacturing Index. Both of these are seasonally adjusted (SA). The Manufacturing Index was 53.2 in February (anything above 50 means expansion) and 53.7 in March, significantly higher than its 51.3 January reading. Nevertheless, this indicator was below the 55-57 levels of last summer and fall.

The Non-Manufacturing Index showed a similar pattern, with March at 53.4, but well below the 59-62 range registered in the autumn. In both of the surveys in March, almost all of the several subindexes that make up each of these indicators showed expansion. The NSA freight index is higher than it has been in any March of the past four years, but the SA ISM indexes, while still showing expansion, are weaker than they were in last year's second half.

Could it be that the SA process itself is an issue that's clouding the underlying strength of the economy? After all, the SA process uses historical data to try to "normalize" economic indicators to get rid of seasonal issues such as holiday spending at year's end. As such, the seasonal factors measure an "average" seasonality over a period of time. We can think of the historical data as forming a normal distribution with the seasonal factor as the mean. If the distribution is tight, then the SA process does a good job in "normalizing" the data.

But if the distribution is wide with large tails (if events fall into one of those tails), then the SA process may itself be misleading. Since this past winter was one of the worst ever recorded in many parts of the country -- and was, at least by anecdotal reports, likely two standard deviations away from "normal" -- the SA data almost certainly understate the true underlying conditions. And so it's not surprising that the ISM indexes are showing up well below their levels of last fall.

The Department of Commerce puts out a monthly index of retail sales, officially known as "Retailer Sales." Both the SA and NSA series are published, so it's simple math to derive the seasonal factors. January was the worst month of the winter. The seasonal factors for the last four Januarys are as follows:

           2011: 1.111
           2012: 1.112
           2013: 1.099
           2014: 1.095

The NSA data are multiplied by this factor to get the SA data. Note that the January '14 seasonal factor is 1.5% less than that of 2011 or 2012. This seems strange. Do buying habits really change that fast? Perhaps this changing seasonal pattern of buying has been caused by Internet shopping.

But I digress -- what's really important is that we know that the weather had a huge impact, but it clearly isn't showing up in the seasonal factor, given that 2014's factor is essentially equivalent to 2013's. This would seem to indicate that the SA Retail Sales data for January were understated.

Let's look at the SA sales themselves:
  SA Sales: Bill $
October '13 $382.2
November '13 $382.8
December '13 $382.0
January '14 $379.6
The $379.6 billion in January sales are 99.4% of those of December; in fact, those SA sales are 2% above the SA $377.2 billion of January '13. Given the winter, January '14 SA sales look pretty strong. Now let's play some other "what-ifs":

  • What if the seasonal factor for January were the same as the one used in 2012? If that were the case, SA sales would have been $385.5 billion, a 0.9% increase from December. Such a gain is pretty substantial for this series.
  • What if, because of the weather, the seasonal factor was off by just 2%? That factor (1.117) would put SA sales at $387.2 billion, a month/month increase of 1.4%! Given the winter, a 2% impact on sales seems somewhat mild.
It should now be quite clear that the SA data can be quite misleading when the "season" significantly deviates from its norm -- in this case, severe winter weather. Wall Street, of course, takes these "guesses" as if they were scientifically precise, and it reacts accordingly. Data for March, April, and May (weather permitting) will confirm whether the data that was slightly weaker and didn't meet expectations was due to the harsh winter and seasonal adjustment issues or to an emerging economic slowdown. In my view, the odds favor the former. 
Historically, market corrections that aren't accompanied by either a recession or an exogenous disruptive event, are generally mild and short-lived. Today, with the Fed bending over backward to tell markets that interest rates aren't going to rise anytime soon, there's even more reason to take advantage of lower equity pricing.

Editor's Note: Dr. Robert Barone is a Managing Partner/Portfolio Manager of Universal Value Advisors.
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