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Value Investing Strategy (Strategy Overview)

Allocations for August 2021 (Final)
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Momentum Investing Strategy (Strategy Overview)

Allocations for August 2021 (Final)
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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.

Personal Saving Rate and the Stock Market

Is public saving rate a leading indicator of the stock market? Arguably, an increase (decrease) in saving rate means a shift away from (toward) consumption, corporate earnings and associated stock value. The Bureau of Economic Analysis (BEA) releases seasonally adjusted Personal Saving Rate (PSR) monthly with a lag of about one month for initial release and two additional months for revisions. Using this series and monthly S&P 500 Index level during January 1959 through December 2020, we find that…
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Disposable Personal Income and the Stock Market

A reader asked: “Is disposable income a leading indicator of the stock market?” Arguably, an increase in disposable income could spur consumption, corporate earnings and associated stock values. The Bureau of Economic Analysis (BEA) releases seasonally adjusted Disposable Personal Income (DPI) monthly with a lag of about one month for initial release and two additional months for revisions. Using this series and monthly S&P 500 Index level during January 1959 through December 2020, we find that…

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Federal Deficit and Stock Returns

Does the level of, or change in, the annual U.S. federal deficit systematically influence the U.S. stock market, perhaps by stimulating consumption and thereby lifting corporate earnings (bullish) or by igniting inflation and thereby elevating discount rates (bearish)? To check, we relate annual stock market returns to the annual surplus/deficit (receipts minus outlays) as a percentage of Gross Domestic Product (GDP). We align stock market returns with deficit calculations (federal fiscal years, FY) as follows: (1) prior to 1977, we calculate annual returns from July through June; (2) we ignore the July 1976 through September 1976 transition quarter; and, (3) since 1977, we calculate annual returns from October through September. Using deficit data, augmented by actual GDP data for FY20, and returns for the S&P 500 Index (SP500) as a proxy for the U.S. stock market during FY 1930 through FY 2020 (90 years), we find that: Keep Reading

Do Copper Prices Lead the Broad Equity Market?

Is copper price a reliable leading indicator of economic activity and therefore of future corporate earnings and equity prices? To investigate, we employ the monthly price index for copper base scrap (not seasonally adjusted) from the U.S. Bureau of Labor Statistics, which spans multiple economic expansions and contractions. Using monthly levels of the copper scrap price index and the S&P 500 Index during January 1957 through November 2020 (nearly 64 years), we find that: Keep Reading

Testing Wilshire 5000/GDP as Stock Market Predictor

Is the Buffett Indicator, the ratio of total U.S. stock market capitalization (proxied by Wilshire 5000 Total Market Full Cap, W5000) to U.S. Gross Domestic Product (GDP), a useful indicator of future U.S. stock market performance? W5000/GDP clearly has no stable average value over its available history (see the first chart below), so using the level of the ratio as a predictor is not reasonable. To investigate, we therefore consider several variables based on W5000/GDP as predictors of W5000 returns at horizons up to two years, including:

  1. Quarterly change in W5000/GDP.
  2. Average quarterly change in W5000/GDP over the past two years (eight quarters).
  3. Average quarterly change in W5000/GDP over the past five years (20 quarters).
  4. Slope of W5000/GDP over the past two years.
  5. Slope of W5000/GDP over the past five years.

We consider two kinds of tests: (1) a linear test that relates past changes in these variables to future W5000 returns up to two years; and, (2) a non-linear test that calculates average next-quarter W5000 returns by ranked fifths (quintiles) of past changes in these variables. Using quarterly levels of W5000 and quarterly GDP lagged by one quarter to ensure availability during the first quarter of 1971 (limited by W5000) through the third quarter of 2020, we find that: Keep Reading

U.S. Economy and Equity Market Linkage Weakening?

How connected are principal measures of U.S. economic activity and U.S. stock market performance? In their October 2020 paper entitled “Has the Stock Market Become Less Representative of the Economy?”, Frederik Schlingemann and René Stulz model and measure relationships between market capitalizations of U.S. publicly listed firms and their contributions to U.S. employment and Gross Domestic Product (GDP). They estimate employment contribution directly based on firm reports, with modeled adjustments. They measure contribution to GDP based on firm value-add, approximated as operating income before depreciation plus labor costs (with labor costs often modeled). They also try other ways of measuring value-add. Using annual non-farm employment and GDP data for the U.S., annual employment and value-add data for U.S. publicly listed firms and annual stock prices for those firms during 1973 (limited by firm employment data) through 2019, they find that:

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Combining Economic Policy Uncertainty and Stock Market Trend

A subscriber requested, as in “Combine Market Trend and Economic Trend Signals?”, testing of a strategy that combines: (1) U.S. Economic Policy Uncertainty (EPU) Index, as described and tested separately in “Economic Policy Uncertainty and the Stock Market”; and, (2) U.S. stock market trend. We consider two such combinations. The first combines:

  • 10-month simple moving average (SMA10) for the broad U.S. stock market as proxied by the S&P 500 Index. The trend is bullish (bearish) when the index is above (below) its SMA10 at the end of last month.
  • Sign of the change in EPU Index last month. A positive (negative) sign is bearish (bullish).

The second combines:

  • SMA10 for the S&P 500 Index as above.
  • 12-month simple moving average (SMA12) for the EPU Index. The trend is bullish (bearish) when the EPU Index is below (above) its SMA12 at the end of last month.

We consider alternative timing strategies that hold SPDR S&P 500 (SPY) when: the S&P 500 Index SMA10 is bullish; the EPU Index indicator is bullish; either indicator for a combination is bullish; or, both indicators for a combination are bullish. When not in SPY, we use the 3-month U.S. Treasury bill (T-bill) yield as the return on cash, with 0.1% switching frictions. We assume all indicators for a given month can be accurately estimated for signal execution at the market close the same month. We compute average net monthly return, standard deviation of monthly returns, net monthly Sharpe ratio (with monthly T-bill yield as the risk-free rate), net compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key strategy performance metrics. We calculate the number of switches for each scenario to indicate sensitivities to switching frictions and taxes. Using monthly values for the EPU Index, the S&P 500 Index, SPY and T-bill yield during January 1993 (inception of SPY) through September 2020, we find that:

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Economic Policy Uncertainty and the Stock Market

Does quantified uncertainty in government economic policy reliably predict stock market returns? To investigate, we consider the U.S. Economic Policy Uncertainty (EPU) Index, created by Scott Baker, Nicholas Bloom and Steven Davis and constructed from three components:

  1. Coverage of policy-related economic uncertainty by prominent newspapers.
  2. Number of temporary federal tax code provisions set to expire in future years.
  3. Level of disagreement in one-year forecasts among participants in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters for both (a) the consumer price index (CPI) and (b) purchasing of goods and services by federal, state and local governments.

They normalize each component by its own standard deviation prior to 2012 and 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 index monthly at the beginning of the following month, potentially revising recent months. Using monthly levels of the EPU Index and the S&P 500 Index during January 1985 through September 2020, we find that: Keep Reading

CPI and Stocks Over the Short and Intermediate Terms

Do investors reliably react over short and intermediate terms to changes in the U.S. Consumer Price Index (CPI), a logical measure of the wealth discount rate? Using monthly total and core (excluding food and energy) CPI releases (for all items, not seasonally adjusted) from the Bureau of Labor Statistics (BLS) and contemporaneous S&P 500 Index opens and closes during mid-January 1994 (earliest available CPI release dates) through mid-September 2020 (321 releases), we find that: Keep Reading

Asset Class ETF Interactions with the Yuan

How do different asset classes interact with the Chinese yuan-U.S. dollar exchange rate? To investigate, we consider relationships between WisdomTree Chinese Yuan Strategy (CYB) and the exchange-traded fund (ETF) asset class proxies used in the Simple Asset Class ETF Momentum Strategy (SACEMS) and the Simple Asset Class ETF Value Strategy (SACEVS) at a monthly measurement frequency. Using monthly dividend-adjusted closing prices for CYB and the asset class proxies during May 2008 (when CYB is first available) through August 2020 (147 months), we find that: Keep Reading

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