Statistical Folly

Every quarter, we eagerly anticipate the GDP data to see if the long-awaited investment recovery is finally at hand. Our patience seems to have been rewarded: real nonresidential fixed investment enjoyed a 1.5% annualized increase in the fourth quarter after eight quarters of decline.

Hoorah! And yet…we must restrain our enthusiasm. The $4.5 billion increase is less impressive than it seems on first look, which means that the dismal 0.7% rise in real GDP is worse than it appears.

Before we go any further, we should point out, these are the “advance” estimates, and may be revised significantly; the “preliminary” estimates will be released on February 28. There’s always a trade-off between the risks of blabbering about data that may prove to be incorrect and waiting a few extra weeks until even fewer people care what happened in the fourth quarter. We’ve decided to blabber.

Most of the increase in nonresidential fixed investment came from spending on equipment and software. The largest subcategory here is technology. However, Northern Trust economist Paul Kasriel notes the unusual boost from transportation equipment spending, which increased at a 25% annualized rate. He then goes on to ask: “With the Arizona desert becoming a parking lot for excess commercial airliners, how likely is it that shipments of new commercial airliners will stay aloft in coming quarters? And as for light trucks, if demand for them is so strong, why are their manufacturers continuing to increase the sales incentives on them? In sum, the strength in fourth quarter business equipment spending appears to be a one-off event.”

Advance GDP Data: Not Partying Like It’s 1999

How about technology, then – is the boom back? Well, we’re not partying like it’s 1999 just yet. If we look at the subcategory that includes “information processing equipment and software,” we see that, in real terms, IT spending increased at an annualized rate of 3.95%. This is a volatile number, but even so, the growth is significantly slower than it’s been the last few quarters (e.g., the annualized rate of growth was nearly 13% in Q3). On a nominal basis, the slowdown is even more severe – fourth- quarter growth was only 0.9%.

How to explain the discrepancy? Prices in the equipment and software category (as well as in the technology subcategory) have been declining, on average, which would make real sales increase slightly even without a rise in nominal sales. But the rest of the increase, we must presume, is due to tinkering to account for quality improvements, i.e., so-called hedonic price adjustments. The result: a nominal increase of $407 billion in equipment and software spending is magically transformed into a $581 billion increase (again, these numbers are annualized). The $174 billion difference is rather significant when overall nonresidential fixed investment increased by a mere $4.5 billion. (We have not yet figured out how to adjust our personal incomes for quality enhancements, but we’ve got our best people working on it.)

The difference is noteworthy when comparing short-term growth in the real and nominal measures, but the impact is even more substantial in terms of the level of investment. In other words, investment is really a lot lower. Back in early 1996, real and nominal measures were approximately equal. But since then, the difference – or the statistical bonus added on to the nominal figures – has been climbing steadily and hit a new record in the fourth quarter.

The last bastion of technology optimism can be found, it seems, among the statisticians at the Commerce Department. There might be an argument for attempting to quantify the effects of quality improvements, but we’d suggest that doing so makes the statistical investment “recovery” something of a chimera.

Advance GDP Data: Government Spending Is not Real Investment

Another of our complaints about the GDP data is that they count a dollar of government spending the same as a dollar of real investment (or some other component). Imagine, for example, the difference between a business spending $1 million to open a new factory and the government taxing or borrowing to buy $1 million worth of cruise missiles (or worse, to open a new DMV office). The latter alternative is essentially what’s going on right now. Government spending contributed 0.86 percentage point of growth in the fourth quarter, or more than the 0.7% total growth, before offsetting declines in net exports and gross investment. (Personal consumption expenditures also contributed 0.67% in the quarter.)

We can also see the impact of government tinkering in the durable goods data for December: durable goods orders were revised lower to a 0.2% decline on top of the 1.3% drop the month before. Defense orders rose 16.6%, after increasing by 39% in November, while nondefense capital goods orders decreased for the year (more on this below).

The die-hard Keynesian will retort that jobs are created both by government and business investment. But there is a crucial difference. In the latter case, spending is the result of actual consumer preferences, or at least those preferences as perceived by businesses…and the increased capital also provides for future demand.

So the pundits can call what’s happening a recovery to their hearts’ content, and marvel at the power of fiscal stimulus to boost the economy. But until we see the hard evidence of an improvement where it really matters, in business capital investment, count us among the skeptics.

Regards,

Andrew Kashdan,
for the Daily Reckoning

P.S. We don’t want to give the impression that the economy is producing nothing but bad news these days. In fact, several manufacturing indices have been moving in the right direction. The widely watched Institute for Supply Management (ISM) index (formerly the National Association of Purchasing Management, or NAPM index) remained above the 50 level in January, which indicates expansion, but it was down slightly from December. In addition, industrial production growth and new orders for durable goods have shown nice increases over the past year or so (despite the downward revision in durable orders for the month of December).

However, we need to provide a little perspective. We can’t merely look at the shape of the graph and pronounce a strong recovery. That would be misleading. Both indicators are just now rising above the zero line, so it’s only a matter of stopping the bleeding at this point. A longer- term graph would show that both measures have merely recovered to a growth rate in the bottom of a range going back to the early 1990s. Of course, any improvement is certainly better than the alternative, but the upturn is not yet the self-sustaining recovery that everyone has been hoping for.

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It seems your editors are having a bit more time than they’d like to ponder the value of modern communication…or perhaps not. Perhaps they are simply enjoying well-earned, albeit involuntary vacations.

In any case, Addison remains buried under snow in the Northland, while Paris-Nicaragua communications with Bill have not improved. Bill did manage to get a short note through to Paris, however (more below).

In the meantime, here’s Eric Fry with the latest news from Manhattan for you…

Eric?

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Eric Fry, reporting from New York…

– Bin Laden is back and Mr. Market is annoyed. The elusive terrorist – that would be bin Laden, not Mr. Market – spewed more of his extremist blather across the airwaves yesterday, which seemed to unnerve investors a bit. The stock market tumbled yet again, as the Dow fell 77 points to 7,843 and the Nasdaq lost one point to 1,295.

– Speaking of extremist blather, Senator Jim Bunning boldly stared down Alan Greenspan yesterday and suggested that the chairman “go home and retire”. Bunning unabashedly blamed the revered chairman for failing to head off the stock market bubble. From time to time, the Daily Reckoning has accused Mr. Greenspan of similar failings, but we displayed the good breeding to speak ill of Mr. Greenspan only when his back was turned. Bunning, by contrast, leveled his criticisms directly at Mr. Greenspan, face-to-face.

– Bunning’s harsh remarks were the political equivalent of the “high and tight” fastballs he threw during his two decades in major league baseball…Nice pitch, Jim! Several Daily Reckoning readers have dispatched emails to us recently asking why gold stocks have been performing poorly of late, despite a still-strong gold price.

– There is no one-size-fits-all answer to the question. The bearish explanation is that gold stocks lead the gold price, both on the upside and on the downside. Therefore, the fact that gold stocks are heading south indicates that gold itself is likely to retreat soon. The bullish explanation is that the gold stocks merely “got ahead of themselves”. Therefore, they’re correcting a bit before launching their next major move higher…In other words, who knows?

– Markets zig and markets zag, and we suspect that gold and gold shares will both zigzag their way to higher prices over the coming years. Therefore, the belt-and-suspenders sort of gold bull should probably buy both gold shares and the metal itself. Investing in physical gold can be a bit problematic, but it’s getting easier all the time. A Strategic Investment subscriber informed editor Dan Denning that the Perth mint in Australia would soon offer a brand new gold-based security.

– “Gold Corporation, a statutory authority of the Government of Western Australia and operator of The Perth Mint, today announced its intention to issue a new gold investment product,” the company’s press release announced.

– “The Perth Mint Gold Quoted Product (“PMG”) would be a gold bullion product tradable on the Australian Stock Exchange (“ASX”) and aimed at Australians seeking a convenient way to invest in physical gold…The non- leveraged PMG would be fully backed by gold owned by Gold Corporation, and its ASX price is intended to track closely the international spot gold price.

– “The Corporation said a PMG holder would have the right to exercise the PMG and call for physical delivery of the underlying gold at any time before the PMG’s expiry.

– “A Product Disclosure Statement will be made available to investors on release of the PMG. Gold Corporation expects The Product Disclosure Statement to be released by 28 February 2003. Interested investors should read the Product Disclosure Statement, which will be available at www.perthmint.com.au on the release date.”

– We are not recommending this particular gold derivative, nor vouching for its safety, or lack thereof. We’re merely passing the information along…

– Most folks know that Nasdaq stocks have suffered more than their S&P 500 counterparts, ever since the market bubble burst in March 2000. At last count, the Nasdaq has lost a stunning 75% of its peak valuation, compared to the S&P 500’s 46% loss. Incredibly, despite the tech-laden Nasdaq’s wicked collapse, technology stocks remain one of the stock market’s most expensive sectors. That’s because earnings in the tech sector have tumbled even faster than share prices. In many cases, as we now know, the “pro forma” earnings produced by many a tech company during the bubble years amounted to little more than “vaporware”. Predictably, the vapor evaporated, but the rich valuations remain.

– Today, based on the flattering Wall Street convention known as “operating earnings”, technology is still one of the most expensive sectors in the stock market. “The tech representatives in the S&P 500 are trading at 24 times expected 2003 earnings, compared with about 16 times for the index as a whole,” Barron’s Michael Santoli observes. “Given that these stocks remain more volatile and therefore potentially risky, paying a premium for them strikes some as perverse, a vestige of New Economy exceptionalism.”

– Maybe not “perverse”…just stupid.

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*** Lost in the wilds of Rancho Santana, Nicaragua, your editor managed to send us the following note:

“Has the war with Iraq begun? Is the dollar still worth something? Has a new bull market been started?

“Still mostly cut off from the wonders of modern communications here in Nicaragua…we don’t know. But as the days go by, we care less and less.

“So, we promise not to write again until our vacation is over, next week.”

Bill Bonner