Tuesday, 16 October 2012

US ECONOMY (October 16th 2012): Capacity Utilization Rate

The US Capacity Utilization Rate is an indicator to be respected.

Very few monthly economic indicators show long term trends in the US economy quite as simply as the CUR. It is exceptionally useful for providing noise-free, long term bullish and bearish cycles in the US economy, when viewed on longer timeframes.

If I had to give a complete novice ONE MONTHLY INDICATOR to describe how the economy is broadly doing, without noise or complications, I'd give them Capacity Utilization.

While it isn't a leading indicator, it is simple to use, and simple to understand the main trend. As you can see below, it is very effective for identifying different phases in economic conditions.

Charts Courtesy of Forex Factory

On the first chart, we can tell from 2000 to 2012 how broad cycles of expansion, contraction and consolidation take place. Unlike some of our other favoured indicators for month-to-month analysis, there are very few anomalous results - and there is little in the way of hyperbole or hysteria. Just big, broad, smooth trends in the US economy, which anyone could use to determine economic trends.

As we pointed out, unlike our other favoured indicators, this one is not a leading indicator - but rather, serves as long term confirmation of economic trends, without much fuss. We would never use CUR for instance, to try and pick out what the market is doing this month or last month - the easiest way to understand it is to check it out and play with it yourself:

US Capacity Utilization Rate (Forex Factory Chart)


We can use US CUR as a confirmation indicator, to help us identify what part of the economic cycle we're in. We can use the trend to show us whether we want to be allocating capital towards businesses or not, via the equities market.

We know that over the course of several months, or even over a year, Capacity Utilization will consolidate at "mature" stages of a long term bullish or bearish cycle. It will also trend upwards, or downwards, in the middle of bullish or bearish cycles.

For instance, between 2006 and 2007, Capacity Utilization flattened out, before beginning to fall at the start of a new bear market. In 2002, like many economic indicators, it flattened out before recovering in 2003 - the start of a new bullish run for stocks. In 2009, it sharply turned around and confirmed we had entered a new expansionary bullish phase.

Only two months ago, in August, Capacity Utilization made new multi-year highs. However, in September and October, CUR fell quite sharply. At 78.0% and 78.3%, these are the two worst readings of 2012 so far.

What does this mean for our current cycle?

Well, pulling a chart up since 2009, the trend is clearly up. And while 78.0% and 78.3% are the worst two readings of 2012, they are still better than any number we saw in 2011. So we're clearly not in a confirmed bearish downtrend phase for the US economy at this time.

What it does mean however, that compared to January's 78.6% reading, the indicator has made zero progress in 2012 based on the last two readings, if the year ended now.

That compares with 2009: troughed at 68.1%, December reading at 71.5% (new trend high)
2010: January at 71.9% (the year low), December reading at 75.4% (the year high)
2011: January at 76.2% (the year low), December reading at 77.8% (2nd highest of year)

Considering Capacity Utilization was at 78.0% in November 2011, we can be suitably concerned that little progress has been made judging by September and October 2012's numbers.

We know it is not uncommon for this indicator to reflect weak medium term conditions, and 2012 has seen economic weakness from March throughout the summer. Given the advent of QE3, we would not be surprised to see CUR recover and make new highs in the coming months, and re-affirm the 2009 bullish trend. However, our point is, we'll have reasons to be worried if September/October's reading is not a blip.

If CUR does not continue making new highs, and plateaus at around this level, we would be concerned for the ongoing health of the 2009-present expansionary phase for US business conditions. At the very least we would have to acknowledge the maturity of the current cycle, perhaps similar to 2006.


This is somewhat trickier to discuss.

Being a % indicator, Capacity Utilization oscillates between values of 0 and 100, depending on how much industrial capacity is being utilised in the United States. It does not account for the efficiency, productivity or technology being utilised in that space, or the profit (in dollars) that each company is making.

Perhaps most importantly, it says nothing about the valuation of businesses, only the trend in an ongoing cycle.

So as a stand-alone investment tool, there are obvious limitations, something that stretches to plenty of economic analysis.

However - in this market from 2000 onwards - identifying and understanding these patterns has been crucial to allocating capital.

In the absence of technological advances, deregulation or other "secular bull market triggers", earnings-multiple valuations have been generally suppressed in stocks, while the Dow has ranged between about 7k and 15k.

Timing has been extremely important - and that timing has depended on effective analysis of economic cycles. The US Capacity Utilization Rate has been one of the most sound indicators out there during that time for identifying those bull and bear markets.

So, whilst we remain in that environment, we feel it is important that equity investors pay close attention to whether or not - over the course of 2012/2013 - the US Capacity Utilization Rate returns to its bull market trend of higher highs.

At Big Macro Picture, we'll keep you up to date with our analysis of this indicator, what it's telling us about global macroeconomic trends, and what it could mean for global equity markets.

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