This is a horse I shot repeatedly in the Spring of 2011. I thought that it was troubling that the economy was turning out considerably poorer than the economists had expected while stocks were shrugging it all off. That is, the economists were optimistic about the economy and they were being disappointed. The chart I showed then is pictured below, and, in hindsight–naturally–this should have been a screaming sell signal. Stocks were going sideways whilethe economy was weakening.
On a daily, and perhaps weekly, basis, security prices reflect a whole host of influences, not the least of which are fear and greed. Over longer periods of time, however, security prices and trends should reflect fundamentals, and the most basic fundamentals are the economy–or economies. So, generally, stocks should rise as the economy improves and fall as it deteriorates. Non-fundamental factors can trump fundamentals for quite some time, however. One thing should be added at this point. The Surprise Index can rise while the economy is deteriorating if it’s doing better relative to economists’ forecasts.
In the chart below I’ve freshened up the chart–and complicated things by reversing the order of them. The top panel shows the Citigroup U.S. Economic Surprise index, while the bottom panel shows the S & P 500 as a proxy for stocks. I’ve divided the chart into three zones and will proceed to spill more electronic ink than necessary to explain the zones and the possible implications of where we are now, which is zone C.
- Zone A – in this zone everything is as it should be. The economy is doing better than economists expect. As that plays out economists will be forced to raise their estimates for the economy, which eventually translate into improved overall earnings for companies that comprise the economy.
- Zone B – all is not right. In this zone economists –for at least three months–overestimate the strength in the economy, yet stocks don’t reflect it, although the flattened trajectory seems to acknowledge that something isn’t right.
- Zone C – stocks play catch up, as talk of recession heats up. On August, The Economist magazine features the cover below, where recession is lurking just below the surface. Note, though, that in this zone the economic surprise index has turned up.
So, if a falling Economic Surprise Index heralded a decline in stocks, is it possible that a rising index might herald a rise in stocks? Maybe the gradual upward trajectory of the line suggests that a recovery in stocks won’t be vigorous, but if nothing else this should tell us that economic Armageddon or Financial Crisis 2.0 is not yet upon us. That’s sort of how we have portfolios structured at present. Within a modestly overweighted portfolio structure our portfolios are positioned defensively.