Elliot Gue PFNewsletter .com
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A cyclical economic recovery is underway, and the worst recession since the early 1980s will end by October.

No doubt this prediction will elicit plenty of e-mail traffic from those who will point out the numerous negatives facing the US economy over the next few years: increasing government regulation, lingering unemployment and, quite likely, higher taxes.

I’m keenly aware of these headwinds, and I suspect the coming economic recovery will be weaker than past expansions. However, the data clearly points to a recovery. Investors who linger on the negatives will miss the boat.

Regular readers of PF Weekly know that I follow the Conference Board’s Leading Economic Index (LEI). I explain this indicator in the Jan. 30, 2009 issue, Follow the Economy’s Lead, and have updated it every month since. This measure has a solid track record of flagging economic contractions and expansions, and currently it’s pointing to an imminent recovery.

The latest LEI reading showed a 0.7 percent jump over the prior month. In addition, the Conference Board revised the May month-over-month reading higher, from 1.2 to 1.3 percent.

As I've noted before, the two consecutive monthly gains of more than 1.0--logged in April and May of this year--have significant implications; this marks the first time that's happened in the history of the LEI index. Three consecutive monthly gains of more than 0.5 percent also occur relatively infrequently.

Since 1959 the LEI jumped more than 0.5 percent in three consecutive months on just 22 occasions. Clusters of LEI readings over 0.5 percent tend to occur in two economic environments: the middle of a strong economic expansion or a few months before or after the end of a recession.

For example, the LEI jumped 0.9, 0.6 and 0.5 percent in April, May and June 1975; these gains occurred just after the end of the vicious 1973-74 recession, a contraction that resembles the most recent economic decline in duration and magnitude.

Starting in May 2003, the LEI jumped more than 0.5 percent in nine consecutive months. This impressive string occurred long after the end of a brief recession in November 2001 but coincided with the start of a major run-up in the S&P 500 that began in the spring of 2003 and ended in late 2007.

The 2001 through 2003 cycle was unusual because stocks continued to fall long after the economy began to improve; the market was still wringing out the valuation excesses built up during the ’90s boom.

Rather than simply looking at the overall LEI, I usually review the performance of each component indicator. In particular, I prefer to see a broad swath of indicators carrying their weight rather than a single index pushing up LEI.

In June, seven of the 10 LEI components added to overall performance; positive contributors included an up-tick in building permits, a slightly longer workweek, and a fall in initial jobless claims.

Some will be surprised that the employment picture is actually positive for LEI. We’ve all read the headlines about the weak June employment report and the near double-digit US unemployment rate. However, it’s important to remember that the unemployment rate is actually a lagging indicator of US economic health.

The LEI considers initial jobless claims--the number of people filing for first-time unemployment benefits. Historical data for that number is tracked in the overall LEI.

As you can see, although the US unemployment rate continues to rise, and the June non-farm payrolls data was negative, the number of US initial claims has declined in recent months.

Another leading indicator that’s showing some encouraging trends is building permits, a measure of the number of new residential construction permits being issued around the US. If consumers are filling for building permits, it typically means they're planning construction projects. The filing for permits actually leads construction demand by several months.

Here’s a chart of US building permits.

Source: Bloomberg

Although the number of new building permits remains near a historic low, the index has started to swing to the upside. But we don’t necessarily want this index soar; a big rise in building permits would indicate a flurry of new home construction. The reason that home prices have been dropping in the US is that there are too many homes and too few buyers--a major increase in construction activity would add to that glut.

It is, however, an encouraging sign that this indicator has stabilized at a low level; this suggests that homebuilders may be seeing some light at the end of the tunnel.

There are other signs that the US housing market is beginning to normalize. The following chart tracks US existing home sales over the past few years.

Source: Bloomberg

Existing home sales remain in negative territory on a year-over-year basis, but it’s clear that sales have improved as the vicious credit crunch of late 2008 has receded.

For qualified borrowers, mortgage interest rates are exceedingly low. And although marginal subprime borrowers don’t have easy access to financing, it’s healthy that the residential mortgage market has become more rational.

After all, many of the subprime buyers who purchased homes during the mortgage boom weren’t qualified or able to afford the loans they were taking on. These poorly underwritten loans were the epicenter of the credit crunch and subsequent economic contraction.

Another factor driving sales is the decline in home prices. Falling house prices makes buying a home more affordable. Granted, an unusually large number of the sales we’ve seen in recent months have been foreclosures, houses seized by lenders when the original borrowers failed to service their debt. Foreclosed homes typically transact at a discount to market value.

But there’s a bright side to the trend of rising foreclosures. Although the banks usually lose money in the deal and the borrowers lose their home, foreclosure sales do help to clear the nation’s housing market.

In a foreclosure, the home in question essentially passes from weak hands to someone who can afford to stay in the home. Not a pretty picture perhaps, but it represents the invisible hand of the market at work.

This confluence of low mortgage rates and falling home prices and the corresponding up-tick in existing home sales is beginning to clear some of the inventory overhang. The chart below depicts this progress.

Source: Bloomberg

This chart indicates the number of months’ worth of residential housing supply available in the US market. Economists calculate this figure by dividing the number of unsold homes by monthly home sales. (Sales are seasonally adjusted to account for the fact that the spring is prime time for US home sales.)

The inventory of unsold homes currently stands at 9.6 months. This is well above the normal range of five to six months, but the indicator is moving in the right direction and is well off its high of around 11 months.

The housing market will likely take some additional time to normalize; however, it isn’t unreasonable to say that the worst is over for residential housing. In fact, the pace of national home price declines continues to moderate, and prices are actually rising in some markets.

Source: Bloomberg

This chart shows the year-over-year decline in home prices for the 20 largest metropolitan areas in the US. House prices are still falling year-over-year at a rate of about 18 percent. But the pace of that decline appears to have bottomed out earlier this year and is now moderating. And the year-over-year comparisons will continue to improve through the summer and into the fall; I expect the rate of decline in the Case-Shiller Index to continue to moderate.

It’s also important to note that the data are somewhat skewed by a few particularly weak markets--namely, Las Vegas, Miami and Phoenix. And prices actually increased between March and April in nine of the 20 largest metropolitan statistical areas; home values in Dallas led the way on the upside, advancing 1.7 percent, prices in Cleveland were up 1.2 percent, and Denver and Washington likewise performed well.

There’s an old saw on Wall Street that the most expensive words in the business are “this time it's different.”  I’m certainly not willing to fight historical trends: This evidence further supports my running hypothesis that the US recession will end either late this quarter or early in the coming quarter.

A few analysts recently published reports suggesting that the recession may have already ended; based on historical trends in monthly LEI data, there’s some weight to this argument. But I regard the year-over-year change in the LEI--not month-to-month movements--as the best means of identifying the start and end of a recession; over the past four decades, this methodology has proved its validity.

The graph below tracks the year-over-year change in LEI.

Source: Bloomberg

The LEI is currently down about 1.2 percent from a year ago. This is well off the lows set late last year and in early 2009 but is still consistent with a mild contraction in economic activity.

It will probably take another month or two for this year-over-year index to turn positive. From my perspective, August or September is the recession’s most likely end point. 

Elliott H. Gue is editor of Wall Street Winners the premier monthly growth newsletter designed to manage investor’s portfolio risk. Mr. Gue examines the market sector by sector to find the industries with big tailwinds and avoid investing pitfalls. Mr. Gue uses both top-down and bottom-up approaches to search the global stock and currency markets for strong intermediate-term trends, picking investment vehicles accordingly.

Mr. Gue is also editor of Trading Floor Pro and a research analyst for Personal Finance, where he specializes in global equity and debt markets and also has broad interests in technology and sector investing.

He has worked and lived in Europe for five years, where he completed a Master’s degree in Finance from the University of London, the highest-rated program in that field in the U.K. He also received his Bachelor’s of Science in Economics and Management degree from the University of London, graduating among the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that business school.