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Summary

  • The anomalous disconnect between the behavior of the American equity market speeding up and the performance of the country’s economy slowing down became increasingly obvious in February.
  • On the one hand, the exchange-traded fund SPY based on the S&P 500 rose to finish at an all-time high of $186.29 on a monthly basis.
  • On the other hand, my U.S. Economic Index, or USEI, founded on Institute for Supply Management data fell to a four-year low of 51.80, its most anemic level since 2010.
  • The Federal Reserve cited “severe winter weather” as a drag on the economy multiple times in its most recent so-called Beige Book, which was released Wednesday.
  • However, weather does not account for all the divergence between SPY and the USEI, especially during the period since the latter hit a record high level of 57.70 last August.

The American equity market and the national economy headed in different directions in February, as the SPDR S&P 500 ETF (NYSEARCA:SPY) advanced to an all-time-high monthly closing share price of $186.29 and my U.S. Economic Index (USEI) declined to a four-year low of 51.80.

As is widely known, SPY is an exchange-traded fund based on the S&P 500 large-capitalization stock index. As is not widely known, the USEI is the result of my effort to capture all U.S. economic activity in a single monthly figure founded on my torturing of Institute for Supply Management (ISM) manufacturing and nonmanufacturing numbers. (I have discussed the relationship between SPY and the USEI previously at both J.J.'s Risky Business and Seeking Alpha.)

All else being equal, I believe changes in the U.S. equity market mirror changes in the national economy. And vice versa. I monitor this continuous feedback loop between the stock market and the economy in a number of ways. One of them centers on comparing and contrasting the conditions of SPY and the USEI. The charts following illustrate these conditions in the wake of ISM's release of its latest manufacturing figures on Monday and its latest nonmanufacturing figures on Wednesday.

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

Happily, ISM has published the relevant manufacturing figures dating back to January 1948. Unhappily, ISM has published the relevant nonmanufacturing numbers dating back just to January 2008. The complete data set for the USEI thus encompasses only 74 months, as indicated by Figure 1.

During its first 60 months, the USEI 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. During its last 14 months, there has been a breakdown in this relationship, suggesting the continuous feedback loop between the market and the economy has been disrupted. As a result, the correlation coefficient for the USEI and SPY has dropped to 0.62, which is positive but weaker than it was previously.

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.

I believe the continuous feedback loop between the equity market and the economy was disrupted mainly by the Federal Reserve's current quantitative-easing (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 relationship between the stock market, as represented by SPY, and the economy, as represented by the USEI.

Of course, this change in character of the relationship could be reversed by the FOMC's decisions to taper the Fed's current QE program. The committee first announced it would cut its 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.

Figure 3: SPY And USEI Monthly Values, January 2013-February 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 breakdown in the relationship between the market and the economy during the past 14 months is depicted well by Figure 3. The sharp advance in the USEI over the June-August period did augur the sharp advance in SPY over the September-November period, but otherwise the continuous feedback loop between them appeared dysfunctional.

And this dysfunction has intensified during the most recent seven months. The USEI fell to 51.80 in February from its all-time high of 57.70 in August, a decline of 5.90 index points, or 10.23 percent, while SPY on a monthly basis rose to its all-time high of $186.29 in February from 161.98 in August, an advance of $24.31, or 15.01 percent.

Figure 4: USEI Monthly Mean And Median Values, 2010-2013

(click to enlarge)

Source: This J.J.'s Risky Business chart is based on proprietary analyses of ISM data.

The Federal Reserve cited the "severe winter weather" as a drag on the economy multiple times in its most recent "Summary of Commentary on Current Economic Conditions by Federal Reserve District," aka the Beige Book, which was released Wednesday.

It is likely both the Fed and its Beige Book sources are correct in identifying the weather as one reason for the current economic slowdown. But it is unlikely the weather is the only reason for it, given the slowdown appears to have begun six months ago.

Seasonality indicates there may be a speedup in the economy in March and April, as shown by the USEI data depicted in Figure 4. However, the same phenomenon suggests there might be a renewal of the slowdown thereafter.

Accordingly, I am adding not only the economic slowdown but also the accelerating divergence between SPY and the USEI to the list of risk factors commanding attention at present.

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: SPDR S&P 500 ETF Rises As U.S. Economic Index Falls