Another Compelling Case for Higher Equities

If there is one hidden stock market indicator that we like as much, if not more, than the M1 multiplier it is the Chicago Fed National Activity Index (CFNAI). The CFNAI is a weighted average of 85 monthly economic indicators. These indicators include such exciting names as inventory to sales ratio, industrial production and a plethora of purchasing managers indices.

The result is one of the most robust indicators of economic activity that we have seen. There are two simple ways to use the index. First, when the 3 month moving average falls below -0.70 there is a high probability that the economy has entered a recession. It was this indicator that was the basis for our analysis (months before the NBER official proclamation) which concluded the recession started in December of 2007.

The second common use for the index is as an inflation gauge; if the index rises above +0.70 two years into an economic expansion the likelihood of sustained inflation increases. However, these are not the only uses.

Looking at the 3 month moving average we can see that there have been seven times since 1967 that the index has dropped below -0.70 and each time a recession followed. Once the recession began the CFNAI typically continued to decline until it “spiked” downward. Once the CFNAI began to climb, the S&P 500 followed. The chart below tabulates the low of the CFNAI and the return on the S&P 500 at the 3, 6 and 12 month horizon.

Click to enlarge:

Five out the seven times the indicator began to turn up after a recession had begun and the S&P 500 posted substantial positive returns. The two instances when a rally did not develop at the 6 month time horizon were characterized by a decline on the S&P 500 in the first three months.

Click to enlarge:

Examining the 1982 and 2001 declines we find that in both instances the CFNAI turned lower less than 4 months after its initial bottom.

The most recent “spike” occurred in January of 2009. Seven months later, the June reading of the CFNAI (released July 21st) is still increasing. This bodes well for a sustainable rally for the S&P 500 for the next 6 months. Coupled with the spike in the equity risk premium, the case for higher equity prices becomes more compelling.

Disclosure: Long US equities

Comments

[Ryu Mei Co:]

It is because of all these indicators that are making this market so much harder to invest. Some are bullish, some are bearish..... I think it is better to stay clear of more indicators for now.

Jul 23 04:33 AM

[Steven Hansen:]

yah know, my articles center on economic analysis. i have compartmentalized my brain - economics and investing / trading.

economics goes with long term investing. find me a someone who is painting a bright economic future and i will show you a kool-aid drinker. except for players like buffett who swing such a big bat they must invest in bad times - this is the type of market that will eat a small investor alive.

trading is anticipation of market movement - up, down or sideways. you need to almost totally ignore the economic happenings and concentrate on making money. i think the market will rise - but this is not based on my view of the economy.

Jul 23 04:57 AM

[I need more...:]

This market still is best described as picking up dimes in front of a steamroller. Go ahead, but there is not one single piece of real economic data that supports higher stock prices. Sure, during earnings season, the shill headlines all scream, i.e. "Caterpillar beats by blah blah". Ah, but the key ratio is and will always be P/E, as in price/earnings, NOT price/expectations. But apparently the sheeple are just happy to beat expectations, some arbitraty bull-shit number made up completely as a whim. and "beating" said number is sufficient for pump city.
I am daily appalled at the pure ignorance of our populous, what we have become, not on just this issue but in general. We have money deducted form our paychecks( withholding, just numbers on a piece of paper- imagine if we had to deduct cash money every April 15, see it physically, and then hand it to the tax man. We just might pay more attention to the assholes we give it to, and how its spent), and we pay it no mind. We have money deducted from our paychecks ( just numbers on a piece of paper- but its tax-free, yay!- well, so far ), and its sent to somebody we guess, some really smart fund manager, to buy some really good shit we guess. Hey, "over time", that there money is working for us. Risk, you say? Huh, what the deauce, when did that happen? Point being, we send out good money to "invest" in a basket of companies we know absolutely nothing about. Dirty little secret here- neither do 90% of the fund managers.
Little wonder that every quarter these shill headlines about beating expectations-EXPECTATIONS folks- are met with such hurrahs and wonderment. It's insane when you think about it, but, alas alack, we the sheeple don't have clue one, its just too much bother to understand even the most fundamental aspects of the companies we own. Of course, we don't even know that do we? We don't even really keep track of the mutual funds we own, let alone what is in them.
And we wonder why Goldman et al plays us like suckers? Almost impossible not to. Shooting fish in a barrel is one thng, it would be like trying to avoid millions of sheep in the road driving at night.

Jul 23 07:36 AM

[Swashbuckler:]

Agree in general with Ryu Mei Co above---There are so many indicators and at all times there are many fine indicators that contradict each other. Regardless of that, I believe they can be very useful in helping assess the markets. IMO indicators may be useful to supplement an overall investment strategy, but I would not rely heavily on them in and of themselves.

Jul 23 09:25 AM

[friar tuck:]

hey i need more, i have an idea. since you're so smart, why don't you try public service for a living. you could wipe out the tax system all together. i know many wounded and dead veterans of this country's wars that would love to be paying taxes again. did you spend any time in the service to the country you live in? i know some people who pay more in taxes than i will ever make in a lifetime and they complain, like you do. you guys don't understand that most of us in this country would love to be paying $300,000.00 dollars a year in taxes. you def should run for some kind of public office as your ideas and attitude would serve you well. lol

Jul 23 10:18 AM

[Kup:]

The S&P was higher at the 12 month mark over the 6 month mark in only 2 of the 6 periods of that chart, not sure how that translates to an assumption of 6 months more of a sustainable rally. Is it solely based on the fact the indicator is still increasing?

Jul 23 10:53 AM

[Brian Kelly:]

Kup,

The fact that the indicator (CFNAI) is still increasing does bode well for a sustainable rally in $SPY, but of course one indicator cannot tell the whole story.

The massive amount of liquidity the Fed has pumped into the system has found its way to the equity market.


On Jul 23 10:53 AM Kup wrote:

> The S&P was higher at the 12 month mark over the 6 month mark
> in only 2 of the 6 periods of that chart, not sure how that translates
> to an assumption of 6 months more of a sustainable rally. Is it
> solely based on the fact the indicator is still increasing?

Jul 23 05:55 PM

[Mad Hedge F...:]

Sold to you. There is no doubt that the next trade from here in stocks is a sell. Buying NASDAQ on a 12th consecutive up day, the S&P 500 on the back of a 110 point move, and the Dow on top of a 1,000 point pop is not what great fortunes are made of. After stopping out of my own shorts in the 880’s, I have been holding back, holding back, holding back. See my warning not to sell too soon at www.madhedgefundtrader.... I have never been one to fight the tape. The only trader who is always right is Mr. Market. The earnings to support a full fledged bull market are not just there. Deleveraging worlds don’t support expanding earnings multiples. It all works for me because the more it goes up now, the bigger the fall later. Even the raging bulls are warning about a “W” shaped recession and another market dive in 2010. How finely do you want to trade this thing? It’s clear the big core shorts at the major hedge funds haven’t budged, and that most of the recent low volume action has come from day traders, momentum players and CTA’s. All we need now is for mom and pop to come in and ring the bell at the top. Is 2009 going to be replay of 2008? Is a “Sell in May and go Away” at www.madhedgefundtrader... to be followed by another October crash? If your friends’ long positions make money from here, just revel in their good fortune, and let them pick up the dinner check.

Jul 23 06:43 PM