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LEI Farce


Over the years government economic statistics have provided guidance for investors as to how the economy is doing. Although they are for the most part backward looking, markets react as if they can predict the future.

These reactions used to be fairly short lived, for only the market itself through its millions of participants, some of which "know" the inside information, quickly turn perception through buying and selling.

I have a strong belief, however, that the government's influence over markets and the economy has grown dramatically as the Federal Reserve has grown in importance. This influence has grown slowly over time, as an ever expanding money supply has increased debt dramatically. That debt introduces new risks and requires more management, a la more Fed intervention. They have made themselves a necessity.

Government used to be laissez-faire when it comes to business and the economy, allowing capitalism to heal itself through cycles of recession and expansion. No more.

Part of this influence has been strengthened by a systematic changing of how economic statistics are calculated. A relentless "massaging" as the ever-intrusive Fed has led to the mantra, "you can't fight the Fed".

In the early 1990's when the savings rate was zero and began to "worry" the markets, the government simply changed the way it was calculated. Miraculously, the savings rate was positive once again (several of my economist friends have told me that the change was for the better, but I don't buy it).

Our calculation of GDP and inflation through hedonics lends a positive tilt to the numbers. I wouldn't mind it so much if other countries did the same, but we are the only major industrial country on earth that calculates these numbers this way. Our economy thus looks stronger and more stable than others.

And now the government is at it again.

One of the components used to calculate the Leading Economic Indicator figure is the yield curve: as the yield curve flattens, this variable causes the figure to weaken. This makes intuitive sense as a flattening yield curve indicates a weakening economy. The Fed's own work shows this to be empirically true as well. The Cleveland Fed produced a study in April 04 that took data back to 1875 and concluded, "This paper has shown that the stylized fact that the yield curve predicts futures growth holds for the past 125 years, and robustly across several specifications."

Now the Fed wants to eradicate their own work and change things:

"The Conference Board said today it would use a new method starting in July to calculate the contribution of the yield spread, or the difference between short- and long-term bond rates. "`We're not changing the component,'' said Ken Goldstein, chief economist at the Conference Board. ``We're changing how we calculate it.'' 'The Conference Board says the yield curve will now pull the leading index down only when the federal funds rate is higher than the 10-year Treasury yield, an uncommon situation."

So the conference board is going against not only 125 years of economic history, but also the conclusions of the Fed itself.

I will leave it to readers to digest this latest morsel from the Fed as I am far too nauseous to comment further.

One last fact though...40-45% of SP500 earnings are derived from financial companies, companies that don't make much money (if any) when the yield curve is flat.
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