The Economy's Worse Than You Think

Ever notice that certain aspects of the economy are seasonal? For example, retail sales normally sag following the winter holidays' buying spree. And the pace of new home construction tends to falter in January and February, owing to bad weather.

As an investor, ignoring seasonality can pose a real hazard. I mean, would it be accurate to look at February data and conclude that stocks such as Amazon.com (Nasdaq: AMZN  ) and Pulte Homes (NYSE: PHM  ) were doomed by an emerging full-year trend? Of course not.

Thankfully, the official government number-crunchers apply seasonal adjustments to a variety of economic data. This gets a bit complicated, but in essence, they're aiming to remove from the data the effects of seasonal pops and drops, in hopes of identifying longer-run trends. Vastly simplified, that process involves comparing the current season to seasons in the recent past. If, for instance, economic activity for a certain period shows a nice spike, but that spike is less than the seasonal jump of recent years, then data would be seasonally adjusted to show an overall economic decline, and vice versa.

Mr. Market adjusts to the upside
In the past few weeks, some pretty fine-looking seasonally adjusted data has come out on housing starts and retail sales. Since then, stocks of homebuilders DR Horton (NYSE: DHI  ) , Lennar (NYSE: LEN  ) , and Centex (NYSE: CTX  ) have all had nice pops. In the retail space, even ailing companies such as Sears (Nasdaq: SHLD  ) and Target (NYSE: TGT  ) saw their stocks move to the upside.

Naturally, we cannot know exactly why those stocks behaved the way they did. But I can tell you that investors who altered their views on the basis of the economic data alone could be in for a nasty surprise.

The government gets optimistic
Unfortunately, there are potential pitfalls to the practice of seasonal adjustments. Because of flexibility in how and how much seasonal economic data is adjusted, government numbers can exhibit unwarranted optimism. On that note, Barron's columnist Alan Abelson recently wrote:

As Merrill Lynch's David Rosenberg … points out in a recent commentary, the official keepers of the books have been unusually aggressive in constructing seasonal adjustments for February's economic data. To illustrate, the seasonal adjustment for new-home sales was the strongest since 1982; for durable-goods orders, the strongest since they were first released in 1992; the retail-sales figures for February were flat (or, as David says, flattering) after such adjustment, but unadjusted fell 3%, the biggest drop on record. He also notes dryly that the 40,000 raw non-seasonally adjusted housing-start total for February "all of a sudden becomes a headline-adjusted annual rate figure of 583,000."

That analysis paints a decisively more cautionary picture than the stats that grabbed media headlines.

Balance your fundamentals
There are a couple of points to take away from this discussion. First, while the economy at large is still running the stock market, I counsel investors to remain balanced in their perspective. Swinging from focusing mainly on company fundamentals to investing solely on economic fundamentals -- which you may now see even more negatively -- will surely cause you to pass up many an opportunity.

Second, the majority of the companies that I mentioned above, from Target to Centex, are fairly economically sensitive. If you need to feel sure that the economy is back on track before you can comfortably put money to work in these or similar names, I recommend taking seasonally adjusted numbers with a grain of salt. Furthermore, the U.S. Department of Commerce and other agencies regularly release revised data, which often includes an adjustment to the seasonal adjustment. Patiently waiting for the government to get its math right could give you a more accurate read on the true state of affairs.

Read on for more questionable government actions:

Fool contributor Mike Pienciak does not hold shares in any company mentioned. Sears Holdings is a Motley Fool Inside Value pick. Amazon.com is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy gets its facts right the first time.


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