An Investor's Look at Early Cycle Indicators

by: Alhambra Investment Partners

There is no argument about the current economic situation. We’re in a recession and it is fairly deep. Investing, though, is about the future - not the present or the past. Investors will want to keep their eye on indicators which can give early signals of recovery. A number of these early cycle indicators have recently turned positive.

Monday morning, the manufacturing portion of the ISM was reported and it was up for the first time since June of last year:

This is important because in past recessions, the market has bottomed coincidentally with the ISM (I wrote a detailed post about this in November). More importantly, the indicator does not have to rise back above 50 (signaling expansion) for the market to improve. One month does not make a trend, but the ISM has to bottom somewhere and last month may have been it. Take a look at the ISM at the bottom of the 1974 recession:

And the stock market performance off that low:

The stock market bottomed in December 1974, just as the ISM was hitting bottom, and then rallied 35% by April 1,1975.

Looking at the 1980 recession:

Again, the stock market bottomed at the same time as the ISM manufacturing index. The 1981, 1990 and 2000 recessions show similar patterns with the stock market and the ISM bottoming within 3 months of each other. The 2000 recession was somewhat unusual in that 9/11 interrupted what was likely a bottom in stocks and the economy. While the post 9/11 period didn’t evolve into a full blown recession, there was a period of volatility in the economy that affected the market. The market tracked the ISM quite well bottoming with the ISM right after 9/11. The market and the ISM then peaked in early 2002 and both bottomed in early 2003. The bottom line here is that the ISM is a very good coincident indicator for the stock market.

Another place to get early signs of recovery is the commodity market. Obviously, as demand picks up from the depressed levels of the recession, commodity prices should respond. One caveat though: commodity prices can and do move independently of economic effects. We saw this last year as oil soared even as the recession unfolded. This can happen in an individual commodity due to a supply disruption or some other factor. It can also happen more generally in commodities as an asset class if the dollar is rising or falling rapidly. If we see general commodity prices rising (Gold and Silver are not as economically sensitive) it may mean inflation or it may mean future growth. Ideally what we would like to see as a sign of economic recovery is for commodity prices to rise without a significant move in the dollar.

Copper has bounced off its low:

Oil has also rallied some from the lows:

Neither of these commodities can be said to be in bull markets yet, but they do seem to have found some kind of bottom. Certainly they bear watching for clues about future growth. The Goldman Sachs Commodity Index also bounced from its low, but is now testing it again:

Obviously, the jury is still out on this, but if GSG holds the low, that would be a good sign about the future of the economy. The dollar has been rising of late, so the move in copper and oil may say something about future growth:

One last early cycle indicator to watch is the Baltic Dry Index. It has recently bounced off a low as well, but is still down a lot from its high:

I don’t know if the economy has hit its nadir yet and I am not making any investments based on that idea - yet - but these early cycle market indicators should give us a heads up when the time comes.