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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:

cfnai-spike-table

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:

cfnai_july_23_09

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

Source: Another Compelling Case for Higher Equities