The stock market and economy move in the same direction over the medium-long term. That’s why you should focus on leading economic indicators to predict the stock market’s long term direction. Leading economic indicators start to deteriorate before a bear market begins.
But as I’ve said on the blog, what matters is the overall trend in the economic data. Temporary dips in the economic data are normal in every economic expansion. The economy never expands in 1 straight line.
This means that you shouldn’t panic when the economy starts to dip. Give it some time. If the economy continues to deteriorate consistently, then you know that the market’s long term direction is turning bearish. But if the economy starts to grow and improve again, then you know that the market’s long term direction is still bullish. The economy merely made a short term dip.
The stock market soared like never before in 1995. More importantly, it was a very consistent rally without many pullbacks. The stock market literally went up in a straight line.
But what people forget is that 1995 was not a “beautiful and quiet year” in which there were no problems. The economy actually dipped in the 1995! Readers of the Wall Street Journal would remember that the headlines were filled with “Economic Indicator XYZ missed expectations today” in 1995. It was hardly a “all clear” year.
You can see this via multiple popular economic indicators.
Here’s Industrial Production. Notice how it actually fell throughout 1995 while the stock market soared!
Here’s New Home Sales. Notice how New Home Sales fell from 1994 to early 1995. It continued to fall even though the stock market bottomed in December 1994.
Here’s Initial Claims. Notice how Initial Claims went up throughout all of 1995 to early-1996.
But the key point was that there was no SUSTAINED deterioration in the economic data. The economy deteriorated a little, and then it started to improve again.
That’s why investors and traders should focus on the SUSTAINED trends in the economic data. The stock market LAGS leading economic indicators, which means that you have enough time to see if a small economic deterioration will be sustained.
It’s not the second derivative
Some people assume that it’s the second derivative of economic growth that determines the stock market’s medium term direction. Not really.
*For those who don’t know, “second derivative” = the rate of change of the rate of change. It’s essentially whether the rate of economic growth is becoming FASTER or slower. It’s not just whether the economy is growing or contracting.
For example, the second derivative of Industrial Production = whether Year-over-Year Industrial Production growth is going higher or lower. You can clearly see that this doesn’t have much of an impact on the stock market’s long term direction.
Here’s the year-over-year growth in Industrial Production. Notice how it continuously fell from July 2010 to May 2011. The U.S. stock market went up during this time!
Notice how the stock market went up between 2 “significant corrections”! (The 2010 “significant correction” and 2011 “significant correction”).
This goes against what many Wall Street professionals espouse. To them, it’s whether:
Economic data is beating or missing expectations. They think that the expectations are already “priced in”.
And over the years, I’ve found the idea of XYZ being “priced in” to be inconsistent. You can’t use this thinking to trade consistently and profitably because the honest truth is that you don’t know if XYZ is “priced in” or not. Trying to guess what’s “priced in” and what isn’t “priced in” is just random guessing.
By the mainstream logic on Wall Street, the stock market should go down when the data “misses” expectations (because reality was already “priced in”). The stock market should go up when the data “beats” expectations (because the reality wasn’t “priced in”).
By this logic, the stock market should move in sync with the Economic Surprise Index, which looks at whether the aggregate economic data is beating or missing expectations.
Reality proves otherwise. Clearly the stock market doesn’t move in sync with expectations or what’s “priced in”.
The Economic Surprise Index sank throughout:
- Q2-Q3 2017
- Q1 2015
- Q1 2014
- Q1-Q2 2012
During this time, the stock market…
Soared nonstop in 2017
Was flat in Q1 2015
Went up a little in Q1 2014, although there was a 6%+ “small correction” along the way.
Went up from Q1-Q2 2012, although there was a “small correction” along the way.
As you can see, short term fluctuations in the economic data don’t have a consistent impact on the stock market. The second derivative of economic data doesn’t either.
Focus on the first derivative – is the economy improving or deteriorating? Don’t focus on “is the economy improving/deteriorating at a faster/slower rate”.