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

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

Is the reward for holding risky bonds material and distinct from the reward for holding stocks and the reward for holding longer term bonds? In their February 2015 paper entitled “Credit Risk Premium: Its Existence and Implications for Asset Allocation”, Attakrit Asvanunt and Scott Richardson measure and explore the predictability and diversification power of the credit (or default) risk premium associated with corporate bonds. They focus on the premium associated with creditworthiness of bonds by first removing the influence of duration/interest rates. They also test whether the credit risk premium diversifies the equity risk premium and the bond term premium. Using data for U.S. corporate bonds, the U.S. stock market, U.S. Treasury securities and economic indicators during 1927 through 2014 and for credit default swaps (CDS) during 2004 through 2014, they find that: Keep Reading

Do any of the various U.S. stock market size and value/growth styles systematically lead or lag the overall market, perhaps because of some underlying business/economic cycle? To investigate, we consider the the following six exchange-traded funds (ETF) that cut across capitalization (large, medium and small) and value versus growth:

iShares Russell 1000 Value Index (IWD) – large capitalization value stocks.
iShares Russell 1000 Growth Index (IWF) – large capitalization growth stocks.
iShares Russell Midcap Value Index (IWS) – mid-capitalization value stocks.
iShares Russell Midcap Growth Index (IWP) – mid-capitalization growth stocks.
iShares Russell 2000 Value Index (IWN) – small capitalization value stocks.
iShares Russell 2000 Growth Index (IWO) – small capitalization growth stocks.

Using monthly dividend-adjusted closing prices for the style ETFs and S&P Depository Receipts (SPY) over the period August 2001 through December 2014 (161 months, limited by data for IWS/IWP), we find that: Keep Reading

Referring to “Leading Economic Index and the Stock Market”, a subscriber inquired about using the Conference Board’s Leading Economic Index (LEI) for the U.S. to generate long-term U.S. stock market timing signals, as follows:  

“How about using the LEI in the following fashion?

Buy when the LEI rises by 1.0 % from its lowest point in the prior six months.
Sell when the LEI falls by 1.5% from its highest point in the last six months.

I used 1% as a buy because bear markets can end abruptly, not because I was torturing the data to confess. You could use 1.5% and I think still have robust results…changes in trend, which are rare, seem to be helpful. I bought the LEI data from the Conference Board and did some testing by hand using the above going back to 1969. I think I found some interesting results. …It gave early sell in 2006… The signal date was the date of the release… Most of the benefit of the trading system comes within the last 14 years.”

Using the monthly change in LEI data from archived Conference Board press releases during June 2002 through October 2014 (146 months), we find that: Keep Reading

How do the major components of U.S. stock market performance behave over time? In his October 2014 paper entitled “Long-Term Sources of Investment Returns and a Simple Way to Enhance Equity Returns”, Baijnath Ramraika decomposes long-term returns from the U.S. stock market (as proxied by Robert Shiller’s S&P Composite Index) into four components:

1. Dividend yield
2. Inflation
3. Real average change in 10-year earnings (E10)
4. Change in the Cyclically Adjusted Price-Earnings ratio (CAPE, or P/E10)

He further segments this decomposition by decade. Using his decomposition by decade for 1881 through 2010 (13 decades), we find that: Keep Reading

Can the U.S. stock market continue to deliver its historical return? In the preliminary draft of his paper entitled “A Pragmatist’s Guide to Long-run Equity Returns, Market Valuation, and the CAPE”, John Golob poses two questions:

1. What long-run real return should investors expect from U.S. equities?
2. Do popular metrics reliably indicate when the U.S. equity market is overvalued?

He notes that the body of relevant research presents no consensus on the answers to these questions, which both relate to long-term growth in corporate earnings per share. Recent forecasts for real stock market returns range from as low as 2% to about 6% (close to the 6.5% average since 1871), reflecting disagreements about how slow GDP growth, low dividends, share buybacks and the profitability of retained earnings affect earnings per share growth. The author introduces Federal Reserve Flow of Funds (U.S. Financial Accounts) and S&P 500 aggregate book value to gauge effects of stock buybacks. He also assesses the logic of using Shiller’s cyclically adjusted price-earnings ratio (CAPE or P/E10) as a stock market valuation metric. Using S&P 500 Index price and dividend data, related earnings data and U.S. financial and economic data as available during 1871 through 2013, he concludes that: Keep Reading

Are changes in the money supply usefully predictive of stock market behavior? In his September 2014 paper entitled “Does Money Supply Growth Contain Predictive Power for Stock Returns?”, David McMillan investigates whether changes in U.S. money supply reliably affect future U.S. stock market returns. He examines also whether any predictive power of money supply growth is independent of dividend yield, interest rates and other economic variables. He focuses on M2 money stock but also considers M1 money stock and the non-M1 components of M2 (saving deposits, small time deposits, retail money market mutual funds), M4 and the monetary base and its components (currency in circulation and reserves). He considers predictability horizons of one month, one year, five years, 10 years and 15 years. Using monthly data for stock index levels, dividends and earnings from Robert Shiller and seasonally adjusted money supply and other economic data from FRED during January 1959 through December 2012 (54 years), he finds that: Keep Reading

Is the U.S. stock market in a Federal Reserve-driven bubble that is about to burst? In his August 2014 paper entitled “Fed by the Fed: A New Bubble Grows on Wall St.”, Oliver Dettmann examines how shifts away from quantitative easing by central banks, and the introduction of rising interest rates, may affect current valuation levels of the U.S. stock market. He focuses on a discounted real earnings model, employing a range of optimistic, moderate and pessimistic scenarios. Based on estimates of S&P 500 real earnings growth and an implied earnings discount rate derived from a sample period of January 1974 through June 2014, he finds that: Keep Reading

Do the behaviors of the most widely accepted stock market factors (size, book-to-market or value, and momentum) vary with the economic trend? In the June 2014 version of their paper entitled “Macroeconomic Determinants of Cyclical Variations in Value, Size and Momentum premium in the UK”, Golam Sarwar, Cesario Mateus and Natasa Todorovic examine differences in the sensitivities of UK equity market size, value and momentum factor returns (premiums) to changes in broad and specific economic variables. They define the broad economic state each month as upturn (downturn) when the OECD Composite Leading Indicator for the UK increases (decreases) that month. They also consider contributions of six specific variables to economic trend: GDP growth; unexpected inflation (change in CPI); interest rate (3-month UK Treasury bill yield); term spread (10-year UK Treasury bond yield minus 3-month UK Treasury bill yield); credit spread (Moody’s U.S. BBA yield minus 10-year UK government bond yield); and, money supply growth. They lag economic variables by one or two months to align their releases with stock market premium measurements. Using monthly UK size, value and momentum factors and economic data during July 1982 through December 2012, they find that: Keep Reading