Vector Investing

Story Notes:

• Worrying about issues potentially endangering economic growth by comparing today's numbers to the past is faulty reasoning. Instead, simply consider what's happening now in context.
• Large and diverse economies (such as the US) require huge dislocations to impede economic growth—most concerns like subprime and housing simply aren't big enough to matter.
• Vectors, a tool used by physics scientists and mathematicians, is a good metaphor for thinking about dangers to economic growth.

A vector is a common concept in the world of physics. Broadly speaking, a vector is a quantity characterized by a magnitude and a direction. In layman's terms, a vector is a force that will continue moving in the same direction until something knocks it off course. (Read more about vectors here: https://en.wikipedia.org/wiki/Vector_%28spatial%29.)

A good example is a moving car's velocity. A car moving in a straight line has a direction and also a magnitude (which is speed). If something is going to knock the car off the road, the impeding factor must be strong enough (of a great enough magnitude), or nothing much will happen.

We think vectors are a great way to think about economic growth. Consider this headline:

Mortgage Crash Hits New Home Sales
By Chris Isidore, CNNMoney.com
https://money.cnn.com/2007/09/27/news/economy/new_home_sales/index.htm?postversion=2007092712

The article implies the economy could slow or recess due to sluggish new home sales. But do new homes sales alone have the power (magnitude) to knock the economy off the road?

The article says, "Sales hit a 7-year low as lower prices can't clear out huge glut, new government report shows." Ok, great. But why would someone concerned with the aggregate economy care very much? And why would a comparison to seven years ago mean anything to us? What we really want to know is whether this is a big enough thing to derail the economy in the context of everything else going on right now.

The final reading of GDP for the 2nd quarter of this year clocked in at a 3.8% annual rate (according to the Commerce Department). Yet, the housing market was weak throughout that period. Clearly, a sagging residential market is not enough to derail the broader economy. Or, put another way, the force of the housing downturn (so far) isn't strong enough to change the economy's vector.

Sales of new single family homes declined in August to an annual rate of 795,000 and the median price of new homes was $225,700. So, if you completely wiped out new home sales (near improbable), it would be a $179 billion dollar hit to the economy. But US GDP is over $13 trillion. Thus, even a complete collapse in new home sales would crimp GDP less than 1.5%.

Thinking about new home sales is probably not a great way to judge economic health anyway. New sales are fine and good, but if we're truly worried about the economic health of the nation, shouldn't we care more about how the value of homes held up? (The media loathes reporting that number because aggregate home prices are actually climbing in the US for 2007.)

When we look at most economic fears in this light, we find very few are strong enough to dislocate a large economy like the US. Few realize the global economy (going back as far as we have data), has almost never been in recession. The bigger the economy, the more difficult it is to create a force with strong enough magnitude to throw the whole thing off course. The big economies of today are staggeringly well-diversified and thus able to sustain seemingly large blows and still move ahead.

The next time you see a headline proclaiming, "Housing Starts Worst in Seven Years" or anything similar comparing today's economy to a random date in the past, you can ignore it. All you need to know is whether that perceived bad thing is big enough to derail today's economy.

Note: MarketMinder has written copiously on past false fears for the economy and stock market such as subprime, credit crunches, carry trades, high energy prices, and many others. See our archives in the "Daily Commentary" section for more.