The U.S. economy is a very complex system, with indicators therefore ambiguous and difficult to interpret. To what degree do macroeconomics and the stock market go hand-in-hand, if at all? Do investors/traders: (1) react to economic readings; (2) anticipate them; or, (3) just muddle along, mostly fooled by randomness? These blog entries address relationships between economic indicators and the stock market.
October 8, 2015 - Economic Indicators, Political Indicators, Sentiment Indicators
Does measurable uncertainty in government economic policy reliably predict stock market returns? To investigate, we consider the U.S. Economic Policy Uncertainty (EPU) Index, introduced by Scott Baker, Nicholas Bloom and Steven Davis and constructed from three components: (1) coverage of policy-related economic uncertainty by prominent newspapers: (2) the number of temporary federal tax code provisions set to expire in future years; and, (3) the level of disagreement in one-year forecasts among participants in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters for (a) the consumer price index (CPI) and (b) purchasing of goods and services by federal, state and local governments. They first normalize each component by its own standard deviation prior to January 2012. They then compute a weighted average of components, assigning a weight of one half to news coverage and one sixth each to tax code uncertainty, CPI forecast disagreement and government purchasing forecast disagreement. They update the EPU index monthly with a delay of about one month, including revisions to recent months. Using monthly levels of the EPU Index and the S&P 500 Index during January 1985 through August 2015, we find that: Keep Reading
October 1, 2015 - Economic Indicators
Does expansion (contraction) of consumer credit indicate growing (shrinking) corporate sales, earnings and ultimately stock prices? The Federal Reserve collects and publishes U.S. consumer credit data on a monthly basis with a delay of about five weeks. Using monthly seasonally adjusted total U.S. consumer credit for January 1943 through July 2015 and monthly Dow Jones Industrial Average (DJIA) closes for January 1943 through August 2015 (871-872 months), we find that: Keep Reading
September 16, 2015 - Economic Indicators
The Inflation Forecast now incorporates actual total and core Consumer Price Index (CPI) data for August 2015. The actual total (core) inflation rate for August is a little lower than (slightly lower than) forecasted.
August 3, 2015 - Economic Indicators
Does the ratio of aggregate U.S. stock market valuation (MV) to U.S. Gross National Product (GNP) or Gross Domestic Product (GDP), the approximate value of goods and services produced by U.S. companies, reliably indicate stock market overvaluation? In their July 2015 paper entitled “Can Warren Buffett Also Predict Equity Market Downturns?”, Sebastien Lleo and William Ziemba investigate whether MV/GNP accurately predicts peak-to-trough declines of more than 10% in daily closes of the S&P 500 Total Return Index within a year. They consider: (1) a simple static model based on a 120% overvaluation threshold; and, (2) two dynamic statistical confidence models based on mean and standard deviation during a four-quarter rolling historical window. They consider both MV/GNP and the logarithm of MV/GNP (relating variable changes) as predictive variables. Using quarterly, seasonally-adjusted GNP and Wilshire 5000 Full Capitalization Price Index level as a proxy for MV (the limiting series) and daily level of the S&P 500 Total Return Index from the fourth quarter of 1970 through the first quarter of 2015 (177 quarters), they find that: Keep Reading
July 24, 2015 - Bonds, Economic Indicators, Strategic Allocation, Value Premium
The “Simple Asset Class ETF Value Strategy” seeks diversification across a small set of asset class exchanged-traded funds (ETF), plus a monthly tactical edge from potential undervaluation of three risk premiums:
- Term – monthly difference between the 10-year Constant Maturity U.S. Treasury note (T-note) yield and the 3-month Constant Maturity U.S. Treasury bill (T-bill) yield.
- Credit – monthly difference between the Moody’s Seasoned Baa Corporate Bonds yield and the T-note yield.
- Equity – monthly difference between S&P 500 operating earnings yield and the T-note yield.
Premium valuations are relative to historical averages. How might this strategy react to increases in the Federal Funds Rate (FFR)? Using end-of-month values of the three risk premiums, FFR, total 12-month U.S. inflation and core 12-month U.S. inflation during January 1990 (limited by availability of specific FFR targets) through June 2015 (306 months), we find that: Keep Reading
June 26, 2015 - Economic Indicators, Momentum Investing
A reader suggested a review of the Decision Moose asset allocation framework of William Dirlam. “Decision Moose is an automated framework for making intermediate-term investment decisions.” Decision Moose focuses on asset class momentum, as augmented by monetary policy, exchange rate and interest rate indicators. Its signals tell followers when to switch from one index fund to another among nine encompassing a broad range of asset classes, including equity indexes for several regions of the globe. The trading system is a long-only approach that allocates 100% of funds to the index “having the highest probability of price appreciation.” The site includes a history of switch recommendations since the end of August 1996, with gross performance. To evaluate Decision Moose, we assume that switches and associated trading returns are as described (out of sample, not backtested) and compare the returns to those for the dividend-adjusted S&P 500 Depository Receipts (SPY) over the same intervals. Using Decision Moose signals and performance data during 8/30/96 through 6/5/15 (nearly 19 years), we find that: Keep Reading
May 20, 2015 - Economic Indicators
In the introduction to their 2015 book entitled Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy, authors Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo state: “Our purpose in writing this book is to provide a general overview of the Fed’s role in the financial markets, but, more important, to offer investors a road map that can be used in designing an investment portfolio that takes account of Fed policy. In detailing our road map for investors, we offer a rationale for each investment strategy along with empirical evidence supporting the efficacy of the strategy. Most important, the recommended strategies come with clear explanations and easy-to-follow descriptions of the processes needed to execute the strategies.” The essential Fed policy discriminator they use is whether monetary conditions are expansive (decreasing discount rate and decreasing federal funds rate), restrictive (increasing discount rate and increasing federal funds rate) or indeterminate (one rate increasing and the other decreasing). Based on their research, they conclude that: Keep Reading
April 30, 2015 - Economic Indicators
A subscriber suggested the Kansas City Financial Stress Index (KCFSI) as a potential U.S. stock market return predictor. This index “is a monthly measure of stress in the U.S. financial system based on 11 financial market variables. A positive value indicates that financial stress is above the long-run average, while a negative value signifies that financial stress is below the long-run average. Another useful way to assess the current level of financial stress is to compare the index to its value during past, widely recognized episodes of financial stress.” The paper “Financial Stress: What Is It, How Can It Be Measured, and Why Does It Matter?” describes the 11 financial inputs for KCFSI and its methodology, which involves principal component analysis and normalization. Is it useful for U.S. stock market investors? To investigate, we relate S&P 500 Index returns to values of KCFSI. Since KCFSI releases occur about eight days after ends of measured months, we use stock market data for the close on the eighth of each month (or the next trading day if the eighth is not a trading day). Using monthly data for KCFSI and the S&P 500 Index during February 1990 through March 2015 (302 months), we find that: Keep Reading
April 7, 2015 - Currency Trading, Economic Indicators, Gold
Do changes in the dollar-euro exchange rate reliably interact with the U.S. stock market and gold? For example, do declines in the dollar relative to the euro indicate increases in the dollar value of hard assets? Are the interactions coincident or exploitably predictive? To investigate, we relate changes in the dollar-euro exchange rate to returns for U.S. stock indexes and spot gold. Using end-of-month and end-of-week values of the dollar-euro exchange rate, levels of the S&P 500 Index and Russell 2000 Index and spot prices for gold during January 1999 (limited by the exchange rate series) through February 2015, we find that: Keep Reading
March 19, 2015 - Bonds, Calendar Effects, Commodity Futures, Currency Trading, Economic Indicators, Equity Premium
Does fourth quarter global economic data set the stage for asset class returns the next year? In their February 2015 paper entitled “The End-of-the-year Effect: Global Economic Growth and Expected Returns Around the World”, Stig Møller and Jesper Rangvid examine relationships between level of global economic growth and future asset class returns, focusing on growth at the end of the year. Their principle measure of global economic growth is the equally weighted average of quarterly OECD industrial production growth in 12 developed countries. They perform in-sample tests 30 countries and out-of-sample tests for these same 12 countries (for which more data are available). Out-of-sample tests: (1) generate initial parameters from 1970 through 1989 data for testing during 1990 through 2013 period; and, (2) insert a three-month delay between economic growth data and subsequent return calculations to account for publication lag. Using global industrial production growth as specified, annual total returns for 30 country, two regional and world stock indexes, currency spot and one-year forward exchange rates relative to the U.S. dollar, spot prices on 19 commodities, total annual returns for a global government bond index and a U.S. corporate bond index, and country inflation rates as available during 1970 through 2013, they find that: Keep Reading