Cutting Through The Noise

Small Business Looking Large

Small Business looking large

Cutting Through the Noise - a financial blog by Bill Martin, CFA

I was all set to write about the headwinds and tailwinds impacting the markets going forward, when up popped an economic number that made me double take.  I typically create a mosaic of economic indicators for a sense of the economy’s future direction, but sometimes a particular number moves so much that requires focused thought and analysis. January’s NFIB Small Business Optimism number is one of those number’s.

 Now, I don’t want to give the impression that I am an outright Bull… I like to think I maintain a balanced view with an eye toward finding underappreciated opportunities.  Sometimes investment opportunities arise from caution and sometimes from optimism. 

I focus on this chart because small businesses, which are defined as companies with fewer than 100 employees, now make up 67% of all new jobs in the country.  As small businesses go, so goes the economy.  With all market participants watching so many economic numbers so closely, it’s important to focus on data that can actually make a meaningful impact on the underlying economy.  For example, although consumers comprise about 70% of all spending, the hyper-watched consumer confidence number is known to be fickle and more a reflection of the direction of stock prices.  That indicator is what I would call “noise” and is unlikely to be of much help foretelling the direction of the economy.  As another example, notice how Small Business Optimism last peaked in 2004-2006, well before any hints of the Great Recession were being picked up by other data.

The Small Business Optimism Index is comprised of 10 equal weighted factors that breakdown different aspects of capturing the outlook for a small business.  The recent "jump" in the SBO Index score for December (released in January) was driven primarily by the following 3 factors in descending order:  1.  Expect Economy to Improve  2.  Expect Higher Real Sales  3.  Now a Good Time to Expand.  Taken together, the magnitude of the scores in these three areas clearly point to more optimism heading into 2017.  

What we see in the chart is that the Small Business Optimism Index (SBO Index) has just popped to the positive more than at any other time in the 21st Century….by a long shot.  Small businesses are feeling as optimistic as they were during the strongest years of the housing boom, several years prior to the bust.  Business optimism is so important because it is often in response to expected profit.  That expected profit can lead to increased jobs and higher wages, which all lead to creating more demand.  Lather, Rinse and Repeat.  That is how an economy tries to break out of the slow-growth doldrums. 

Importantly, the SBO Index tends to get the larger trends in the economy correct.  It is not infallible, no single economic statistic is that good.  However, as you can tell, I think this number bears watching.  This level of breakout could be something that will bubble up and reverberate throughout the economy and propel us higher through other messy situations that arise, or it could just be a head fake (see mid-2008).   

The reason for the bounce is quite clear.  Small businesses are optimistic about the prospective cuts in de-regulation and costs that are on the horizon in the new administration.  A word of caution… we have traveled this path before, only to find that sometimes regulation is necessary and can be a governor for going too far in one direction.  Do you remember way back to 2008 and the lexicon of CDO’s, toxic mortgages, sub-prime loans and liar loans?  Yeah, that happened. 

That said, for today, many businesses and market participants are choosing to only see the positives in the prospective changes coming from the new administration.  As such, for now, we will just celebrate this one number.  However, as famed private equity investor, Howard Marks, likes to say…

“Sometimes the market interprets everything positively and sometimes it interprets everything negatively”. 

These strong leanings can create opportunities!

I’m now off to a small, informal gathering with former President of the Philadelphia Federal Reserve, Charles Plosser.  Charles was often one of the more hawkish (inflation fighter) members during his time on the Federal Reserve Board.  This should be fun, interesting and hopefully provide some insights for next month’s blog.

Here’s to sifting through the data in search of nuggets to help us get it more right than wrong, sooner rather than later…