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Executive summary:

  • A disconnect between the American equity market and the country's economy can be found in the relationship between the SPDR S&P 500 ETF (NYSEARCA:SPY) and the U.S. Economic Index (USEI).
  • The fissure between the exchange-traded fund based on the S&P 500 large-capitalization equity index and the proprietary metric based on Institute for Supply Management data became apparent last year.
  • The anomalous schism between the stock market and the economy seems unsustainable, especially given the U.S. Federal Reserve's actual and projected moves to tighter from looser monetary policies.
  • As a result, one anticipates the continuous feedback loop between the two may reassert itself as the Fed goes on tapering its current quantitative-easing program.

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The SPDR S&P 500 ETF (SPY) has risen like the phoenix from the ashes of its last bear market, soaring to a cyclical intraday high of $184.94 on Jan. 15 of this year from a cyclical intraday low of $107.43 on Oct. 4 of 2011, an advance of $77.51, or 72.15 percent. And, of course, it is completely conceivable the exchange-traded fund based on the S&P 500 large-capitalization equity index could hit another cyclical intraday high as soon as this month.

It is an article of faith (and statistics) at the home office of J.J.'s Risky Business that changes in the U.S. economy are mirrored by changes in its equity market. And vice versa. I monitor this continuous feedback loop between the economy and the stock market in a number of ways. One of them centers on comparing the condition of the proprietary U.S. Economic Index with the condition of the nonproprietary SPY. (I introduced the USEI in a "You Got to Know When to Hold 'em" blog post a while ago.)

First combining Institute for Supply Management (ISM) manufacturing and nonmanufacturing figures and then slathering on a special sauce, I whipped up the USEI in an attempt to capture all U.S. economic activity in a single number I can employ to guide my investing and trading. Similar to the ISM megasector metrics themselves, a USEI level above 50.00 indicates expansion, while a USEI reading below 50.00 suggests contraction.

The USEI came in handy before, during and after the 2011 bear market in SPY and its underlying index. However, a disconnect between the USEI and SPY surfaced last year, when I believe the relationship was skewed by the U.S. Federal Reserve's current quantitative-easing (QE) program.

Figure 1: SPY And USEI Monthly Values, January 2008-January 2014

(click to enlarge)

Source: This J.J.'s Risky Business chart is based on proprietary analyses of ISM data and Yahoo Finance adjusted monthly share-price information.

The complete data set for the USEI encompasses just 73 months, as indicated by Figure 1. Basically, ISM's relevant manufacturing figures date back to January 1948, but its relevant nonmanufacturing numbers date back only to January 2008. Therefore, I did not believe I had enough information to build the USEI until early 2010.

I was happy with the USEI's behavior during the ensuing three years, when it acted primarily as a leading indicator and secondarily as a coincident indicator of the upward and downward direction of both SPY and its underlying index. However, I have been unhappy with my proprietary metric's performance as such an indicator since January of last year.

Even so, I have calculated the correlation coefficient for the USEI and SPY as 0.65 over the short life of the metric, which is both positive and strong.

Figure 2: SPY And USEI Monthly Values, January 2008-December 2012

(click to enlarge)

Source: This J.J.'s Risky Business chart is based on proprietary analyses of ISM data and Yahoo Finance adjusted monthly share-price information.

Before the broken link between the American equity market and the country's economy manifested itself last year, there was a strong positive correlation between the USEI and SPY over the first 60 months of my metric's existence, as suggested by Figure 2.

I believe the breakdown in this relationship was primarily caused by the Federal Reserve's current QE program, which was announced in the wake of a Federal Open Market Committee (FOMC) meeting on Sept. 12-13, 2012.

Factoring in the historical lags in effects of monetary policy, I think the launch of the Fed's current QE program is principally responsible for the change in character of the continuous feedback loop between the stock market and the economy last year.

Figure 3: SPY And USEI Monthly Values, January 2013-January 2014

(click to enlarge)

Source: This J.J.'s Risky Business chart is based on proprietary analyses of ISM data and Yahoo Finance adjusted monthly share-price information.

If there were any relationship between the American equity market and the national economy in 2013, then my comparisons of the USEI and SPY failed to spot it, except when the sharp rise in the former during the June-August period prefigured the sharp rise in the latter over the September-November period, as shown by Figure 3.

And the USEI was not the only one of my proprietary metrics to misbehave last year, with the Securities Market Credit Risk Rank also performing poorly, as mentioned in "NYSE Margin Debt Hits Record $444.93 Billion In December: Risk Rank At No. 1" and elsewhere at Seeking Alpha.

However, I believe both metrics may soon begin delivering their respective goods again, with the biggest reason being the FOMC's decisions to taper the Fed's current QE program. The committee first announced it would cut its aggregated monthly asset purchases to $75 billion in January from $85 billion in December, and it then said it would trim them to $65 billion in February from $75 billion in January.

Also reflecting the FOMC's bias toward tightening and away from loosening monetary policy was the following passage in the recently released minutes of the committee's Jan. 28-29 meeting:

"A few participants raised the possibility that it might be appropriate to increase the federal funds rate relatively soon. One participant cited evidence that the equilibrium real interest rate had moved higher, and a couple of them noted that some standard policy rules tended to suggest that the federal funds rate should be raised above its effective lower bound before the middle of this year."

Fedspeak has taken many forms since the construction of the USEI, but I believe this is the first time in those four years it has sounded anything like that at an FOMC meeting.

Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author's best judgment as of the date of publication, and they are subject to change without notice.

Source: Assessing The SPDR S&P 500 ETF With The Aid Of The U.S. Economic Index