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Economic Indicators

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.

Interest Rates and Utilities

A reader noted and asked: “In a recent article at MarketWatch, Michael Kahn claims that utilities have bond-like sensitivity to interest rates, with the advice that ‘cutting back on exposure to utilities…makes sense, despite their high dividend payouts.’ Do you agree?” To check, we consider the Utilities Select Sector SPDR (XLU) as a proxy for utilities and both 10-year Treasury note (T-note) and 13-week Treasury bill (T-bill) yields as proxies for long-term and short-term interest rates, respectively. Using weekly, monthly and quarterly closing levels of dividend-adjusted XLU, dividend-adjusted S&P 500 SPDR (SPY), T-note yield and T-bill yield over the period December 1998 (limited by XLU inception) through March 2010, we find that: Keep Reading

Perfect Sector Rotation

Is the conventional wisdom that stocks of certain sectors outperform systematically during specific stages of the business cycle correct, and exploitable? In the December 2009 update of their draft paper entitled “Sector Rotation across the Business Cycle”, Jeffrey Stangl, Ben Jacobsen and Nuttawat Visaltanachoti test the value of sector rotation by assuming that an investor anticipates U.S. business cycle stages perfectly and rotates sectors in accordance with conventional wisdom. The baseline business cycle consists of five stages across the peaks and troughs of economic activity declared by the National Bureau for Economic Research (NBER). The baseline conventional wisdom on sector rotation comes from Standard & Poor’s Guide to Sector Investing. Using monthly industry returns, market returns and Treasury bill rates for 1948-2007 (10 business cycles), they find that: Keep Reading

Credit Standard Changes and Future Stock Market Returns

Do credit conditions systematically affect stock market behavior? In the March 2010 draft of their paper entitled “Credit Conditions and Expected Stock Returns”, Sudheer Chava, Michael Gallmeyer and Heungju Park investigate whether changes in bank lending standards (net percentage of banks reporting tighter standards for commercial and industrial loans in Federal Reserve Board’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices) lead U.S. stock market returns. Using data from this survey from the first quarter of 1967 through the fourth quarter of 2008 (publicly available well before the end of the reported quarter) and contemporaneous returns for the broad U.S. stock market, they conclude that: Keep Reading

Do TIPS Work?

Are Treasury Inflation Protected Securities (TIPS), for which the Treasury adjusts the principal based on the Consumer Price Index for all urban consumers (CPI-U), effective as an inflation hedge? In their September 2009 paper entitled “A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?”, Michelle Barnes, Zvi Bodie, Robert Triest and Christina Wang evaluate the progress of the TIPS market toward providing: (1) consumers with a hedge against real interest rate risk; (2) holders of nominal bonds with a hedge against inflation risk; and, (3) everyone with a reliable indicator of expected inflation. Using inflation rate and bond yield data available since the introduction of TIPS in September 1997, they conclude that: Keep Reading

Hedging Against Inflation

How can long-term investors best hedge against inflation’s erosion of purchasing power? In their April 2009 paper entitled “Inflation Hedging for Long-Term Investors”, Alexander Attie and Shaun Roache assess the inflation hedging properties of traditional asset classes over different investment horizons. Using total return indexes for several asset classes from initial data availability (January 1927 at the earliest) through November 2008, they conclude that: Keep Reading

Outperformance Based on Three Macroeconomic Indicators

Can the right macroeconomic indicators help investors beat the market? In their August 2009 paper entitled “Predictive Signals and Asset Allocation”, Hui Ou-Yang, Zhen Wei and Haochuan Zhang identify three predictive indicators for returns on the S&P 500 Index (SPX) and 2-year U.S. Treasury notes (T-note) and derive signals from these indicators to specify an outperforming dynamic allocation to SPX futures and T-note futures. The three indicators are: (1) the credit standard from the quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices; (2) the percentage change in the daily Baltic Dry Index (BDI); and, (3) the change in the 2-year constant maturity swap (CMS) rate. They generate weights for the two futures (up to 200% each) at the end of each month from rolling 36-month regressions of indicators and past monthly asset returns. Using data for July 1990 through June 1993 to determine initial weights and data for July 1993 through June 2009 for testing (a total of 228 months), they conclude that: Keep Reading

Employment Growth and Stock Returns

Is there a reliable relationship between U.S. employment and the U.S. stock market? In their August 2009 paper entitled “The Stock Market and Aggregate Employment”, Long Chen and Lu Zhang study the interactions between the stock market and the labor market. Using quarterly returns for the S&P 500 Index and quarterly data for employment and other economic indicators over the period 1952-2007, they find that: Keep Reading

Stock and Bond Returns Correlation Variability

Stocks and bonds are two of the most frequently considered asset classes in asset allocation strategies. How stable is the correlation between stock returns and bond returns? In their December 2008 paper entitled “The Dynamic Correlation between Stock and Bond Returns”, Thomas Chiang and Jiandong Li apply rolling regressions to analyze variations in the correlation between stock market returns and bond market returns. Using daily returns for the Vanguard Total Bond Market Index Fund (VBMFX) and the Vanguard Total Stock Market Index Fund (VTSMX) as proxies for their respective markets over the period 6/20/96 through 6/30/08, along with contemporaneous U.S. economic data, they conclude that: Keep Reading

Following the “Hot” Economic Indicators

In the absence of solid theory, can an adaptive empirical model successfully infer which economic indicators are driving near-term equity investor/trader behavior? In other words, can a model that continually reselects the current best economic indicators predict stock returns? In her October 2008 paper entitled “Equity Premium Predictions with Adaptive Macro Indices”, Jennie Bai uses time-varying combinations of a large number of economic variables to predict excess (relative to one-month Treasury bills) stock returns. Specifically, she iteratively selects the best macro index of economic indicators according to empirical measurement of the out-of-sample (training interval) power of competing indexes to predict stock returns. Using monthly datasets for 100 economic indicators, one-month Treasury bill (T-bill) yields and returns for a broad value-weighted stock index spanning January 1960 through November 2006, she concludes that: Keep Reading

Asset Allocation Driven by Four Economic Phases

Is there an effective way to enhance allocation of investment funds across asset classes according to economic conditions, from either a risk or a return perspective? In their January 2009 paper entitled “Dynamic Strategic Asset Allocation: Risk and Return Across Economic Regimes”, Pim Van Vliet and David Blitz present constant-risk and return-maximizing asset allocation strategies driven by four economic states: expansion, peak, recession and recovery (see the first chart below). Using data for four U.S. economic indicators (credit spread, earnings yield, Institute for Supply Management manufacturing index and unemployment rate) and returns for eight mostly U.S. asset classes (equities, bonds, cash, small-capitalization stocks, value stocks, growth stocks, credits and commodities) over the period 1948 through 2007 (60 years), they conclude that: Keep Reading

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