Elliot Gue PFNewsletter .com
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Economists are famous for analyzing scores of obscure data points and putting their trust in certain pet indicators. But those who try to make sense of every economic release soon find themselves paralyzed by too much information.

As long-time readers know, I prefer to focus on a handful of simple indicators that have proven their worth time and again over the years. My favorite indicator of all is the Conference Board’s Leading Economic Index (LEI), a monthly release.

The LEI is composed of 10 different economic indicators; for those unfamiliar with those indicators, I provide a detailed explanation of each constituent here (28358).

The LEI isn’t infallible and is subject to revision; however, the year-over-year change in LEI has a long record of spotting turns in the US economy. Here’s a chart of the LEI year-over-year change going back to the 1960s.

Source: Bloomberg

The LEI turned negative in late 2007, indicating that the US had slipped into recession. Investors will undoubtedly remember that there were still plenty of economists predicting in late 2007 and early 2008 that the US would avoid a recession or that any contraction would be mild.

The plunge in the LEI through the first few months of 2008 indicated that such an outcome was unlikely.

This year, the LEI began to show some early signs of improvement in the spring and has put together four consecutive monthly gains of more than 0.5 percent. Most importantly, the latest data has pushed the year-over-year change in LEI back into positive territory.

This is the signal I’ve been looking for over the past several months; I suspect the US economy troughed in July, and we’re now seeing the beginning of an economic recovery.

Of course, I always like to look inside the LEI at the index constituents for further clues as to the health of the recovery. Earlier this year, I was worried by the fact that the most positive components of LEI were those controlled by the government.

For example, an explosion in the US money supply helped keep LEI from falling more sharply early in 2009. The government’s monetary machinations are hardly a firm foundation for long-term economic growth.

But the strength in LEI has broadened considerably over the past few months. Check out the chart below of the average work week.

Source: Bloomberg

This index measures the average number of hours production workers in manufacturing industries worked per week. The labor market is inherently sticky; managers are reluctant to outright fire workers early in an economic downturn and are slow to re-hire during upturns.

One of the first steps managers take to increase or decrease capacity is to simply adjust the number of hours its employees work.

During economic upturns, you’ll typically see the average number of hours worked rise a few months before you see actual new job creation. As the chart above indicates, we’re now seeing just that trend: Average hours worked has risen to 39.8 from a low of 39.4 hours in March.

This indicates some signs of life in the badly battered US manufacturing economy.

Another slightly more obscure indicator within LEI is vendor performance; see the chart below.

Source: Bloomberg

This index shows the speed at which companies receive deliveries from their suppliers. When delivery speed slows, this index rises.

If you’re a company producing a product and it takes longer for you to get supplies, it likely means your suppliers are struggling to meet demand and are experiencing delays. They may even be running up backlogs of unfilled orders as they attempt to find ways to boost production.

Clearly, the index of vendor performance has improved notably from record-low levels earlier this year. This indicates a further tightening in the supply chain.

In the most recent LEI release, six of the 10 indicators added to LEI, one was neutral and three declined. One of the biggest contributors on the downside was consumer expectations.

Source: Bloomberg

This indicator is mixed. On the positive front, consumer expectations have improved markedly since the beginning of 2009, undoubtedly helped by stabilization in the real estate market, a falling pace of job losses and a rising stock market.

However, consumer expectations slipped in the most recent report, and we’ve seen weaker-than-expected retail sales reports. This suggests the US consumer is rather sluggish; it’s highly unlikely consumers will soon return to the debt-financed spending spree fueled by the easy credit conditions that prevailed before 2007.

Because the consumer accounts for two-thirds of GDP, it will be difficult to see a robust recovery without growth in consumer spending.

Whenever I write a bullish piece on the US economy or markets, I receive plenty of e-mails from subscribers noting various economic negatives. The mood out there, at least among the individual investors I speak to, remains rather subdued, if not downright bearish.

As I explain below, I generally agree with most aspects of the bears’ case for the US market and economy. The issue is one of timing: The fact that the US faces plenty of longer-term challenges didn’t preclude a 50 percent gain in the S&P 500 since March, nor does it mean we won’t see further gains in the S&P 500 going into 2010.

In fact, short-term corrections aside, I continue to look for the S&P 500 to reach 1,200 by late this year or early in 2010.

But the recovery in the markets and economy is not like the recoveries after the 2001 and 1991 recessions. Rather, this recovery is a cyclical move within a secular bear market. The current market environment is more analogous to the late ’60s and ’70s than it is to the post-1982 bull market.

The chart of consumer expectations above highlights one of the key changes underway. In prior recoveries, the US has always been able to count on a massive surge in personal spending, often fueled by a willingness to take on debt, to help lift the economy from recession.

Sluggish retail sales and consumer expectations indicate that in this cycle Americans will be focused more on paying down debts and saving money than on profligate spending. Here’s another instructive chart.

Source: Bloomberg

This chart shows American’s debt service as a percentage of personal disposable income; this is the amount of money they must pay out each month just to stay current on their mortgages, car loans and credit cards. As you can see, this index soared in the ’90s and through to 2006, as Americans seemed always willing to borrow money in order to maintain spending even when incomes were stagnant.

But since 2006 that trend has reversed; consumers have actually been looking to reduce their debt loads amid the credit crunch. This indicator would have dropped even faster if not for the fact that personal disposable income growth has remained sluggish.

The best-case scenario is that this indicator continues to fall gradually over the next few years as consumers reverse the recent debt bubble.

Another key risk is the government.

Source: Bloomberg

This chart shows the total Chinese holdings of US government debt. One of the reasons the US federal government and consumers have been able to run massive deficits is that foreigners, notably the Chinese, have maintained an insatiable appetite for US bonds. That’s kept interest rates low even as the fiscal picture deteriorated.

Now, as the chart above illustrates, the world faces a ridiculous imbalance: Spending by the world’s richest nation is being financed by loans from a developing country.

The Chinese are already grumbling about the US dollar. And the US fiscal picture is deteriorating rapidly. The government has already spent considerable sums on stimulus and bailouts and now is debating an expensive health care reform agenda.

At some point, Chinese and other foreign holders of US government debt are going to demand higher interest rates and a better return on their investment. Rising interest rates in the context of sluggish economic growth and a deleveraging consumer is a major negative indeed.

Investors should now be focusing on the potential for a near-term cyclical recovery in the US economy and markets similar to the cyclical snap-backs of the ’70s. A disappointing pace of recovery and longer-term fiscal imbalances remain major risks, but this is a concern for next year, not the next few months.

For now, enjoy the rally.

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.