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Summary

  • Both SPY and my U.S. Economic Index moved higher last month, even as the SPY-USEI correlation coefficient moved lower.
  • SPY climbed to an all-time monthly closing high share price, as it advanced on an adjusted basis to $187.01 from $185.47, a gain of $1.54, or 0.83 percent.
  • Founded primarily on Institute for Supply Management data, the USEI also expanded, to 53.18 from 51.80, an increase of 1.38 points, or 2.65 percent.
  • However, the SPY-USEI correlation coefficient dipped to 0.61 in March from 0.62 in February, a continuation of its long-term slide.
  • This decoupling of SPY and the USEI reflects a rupture between the equity market and the economy, one likely to be unsustainable.

A bridging of the gap between the absolutely strong American equity market and the relatively weak national economy was not evidenced by the relationship of the SPDR S&P 500 ETF (NYSEARCA:SPY) and my proprietary U.S. Economic Index (USEI) last month: From February to March, both rose, but the SPY-USEI correlation coefficient fell.

SPY climbed to another all-time monthly closing high share price, as it advanced on an adjusted basis to $187.01 from $185.47, a gain of $1.54, or 0.83 percent. Meanwhile, USEI also expanded, to 53.18 from 51.80, an increase of 1.38 points, or 2.65 percent. Nonetheless, the SPY-USEI correlation coefficient dipped to 0.61 from 0.62.

I built the USEI in an attempt to capture all U.S. economic activity in a single monthly figure to be employed in guiding my investing and trading. I constructed it primarily using Institute for Supply Management (ISM) manufacturing and nonmanufacturing numbers, as mentioned in the blog post that introduced the USEI at J.J.'s Risky Business. ISM released its latest manufacturing figures Tuesday and its latest nonmanufacturing figures Thursday.

It appears obvious to me that changes in the stock market eventually mirror changes in the economy, and vice versa. However, SPY rose on an adjusted basis to $187.01 in March from $161.27 in August, a gain of $25.74, or 15.47 percent, while the USEI fell over the same period to 53.18 from 57.70, a loss of 4.52 points, or 8.27 percent.

This break in the continuous feedback loop between the market and the economy actually began appearing in comparisons of the data sets documenting the SPY-USEI relationship even earlier than last August, but I mention it here because the USEI reached its record high level that month.

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

(click to enlarge)

Note: The SPY adjusted monthly closing-price scale is on the left, and the USEI monthly value scale is on the right.

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

ISM has published the relevant manufacturing figures dating back to January 1948, but it has published the relevant nonmanufacturing numbers dating back just to January 2008. Accordingly, the complete data set for the USEI encompasses only 75 months, as depicted in Figure 1.

During its first 60 months, the USEI acted primarily as a leading indicator and secondarily as a coincident indicator of SPY's upward and downward movements. Over its last 15 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 SPY-USEI correlation coefficient on an apples-to-apples basis dropped to 0.61 this March from 0.75 in December 2012. Analysis of the complete data set leads me to posit the relationship is strongest three months out, with the correlation coefficients employing multiple offsets currently being calculated as follows: one month, 0.62; two months, 0.64; three months, 0.65; and four months, 0.64.

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

(click to enlarge)

Note: The SPY adjusted monthly closing-price scale is on the left, and the USEI monthly value scale is on the right.

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

I believe the continuous feedback loop between the equity market and the economy was disrupted mainly by the U.S. Federal Reserve's current quantitative-easing (QE) program, which was announced in the wake of a Federal Open Market Committee (FOMC) meeting Sept. 12-13, 2012.

Immediately before and after this advent of the Age of QE3+, there was an observable positive correlation between the stock market and the economy that was not only stable but also strong, with the SPY-USEI coefficient calculated as 0.75 each of the six months from July to December.

Figure 3: SPY And USEI Monthly Values, October 2012-March 2014

(click to enlarge)

Note: The SPY adjusted monthly closing-price scale is on the left, and the USEI monthly value scale is on the right.

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

Because of the historical lags in the effects of the Fed's monetary policy, the change in character of the relationship between the equity market, as represented by SPY, and the economy, as represented by the USEI, was not apparent in the data until January 2013, when the SPY-USEI correlation coefficient dipped to 0.74.

However, this profound change in the character of the relationship has been amply illustrated by the data since then, with the SPY-USEI correlation coefficient actually negative at -0.30 when calculated for the past 18 months alone, as shown in Figure 3. Weird? You bet.

Figure 4: USEI Monthly Values, 2014 Versus 2010-2013 Mean

(click to enlarge)

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

SPY was comparatively strong during the first quarter: It rose on an adjusted monthly closing-price basis to $187.01 from $183.88, a gain of $3.13, or 1.70 percent.

However, the USEI was comparatively weak over the same period: Its level fell in each of Q1's three months when compared with the mean value for it based on data from the first four full years of the current expansion. The February figure of 51.80 was especially interesting, the lowest reading since the 51.41 number recorded in February 2010.

The Fed has attributed the current economic slowdown partially to the impact of severe winter weather in multiple regions of the U.S., with FOMC saying in its most recent statement March 19:

[G]rowth in economic activity slowed during the winter months, in part reflecting adverse weather conditions.

Figure 5: USEI Monthly Values, 2014 Versus 2010-2013 Median

(click to enlarge)

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

The USEI also looked pretty anemic in Q1 by another metric: Its level was lower in each of the three months when compared with the median value for it based on data from the first four full years of the current expansion. Meanwhile, its historical mean and median values indicate April has been the kindest month for the economy during these four years.

Similarly, my analysis of SPY adjusted monthly closing prices during its first 20 full years (i.e., between 1994 and 2013) shows April also has been the kindest month for the S&P 500-based exchange-traded fund over this period when measured by its mean monthly values.

The history of each data series thus independently provides support for my contention that the equity market is close to a top, regardless of whether the duration of its status as such is short (fewer than three months), intermediate (between three and six months) or long (more than six months).

The Bottom Lines

Seasonality analysis shows there may be a speedup in the economy this month, and the same analysis shows there might be a renewal of the slowdown in it thereafter.

On the one hand, the anomalous disconnect between the economy and the equity market, as reflected by the continuing decline in the SPY-USEI correlation coefficient during the past 15 months, indicates the state of the economy has had either no relationship or a negative relationship with the stock market over this period.

On the other hand, FOMC's actual multiple cuts in the Fed's current QE3+ program have reduced its rate of monthly asset purchases to $55 billion in April from $85 billion in December and the committee's projected multiple cuts in the program may reduce this rate to $0.00 by the end of this year.

I believe the relationship between the economy and the market will become increasingly more normal than abnormal in such an environment and that I will be able to observe this normalization via my monthly monitoring of the SPY-USEI correlation coefficient (i.e., I anticipate an inflection point when it moves not downward but upward).

At the same time, I expect a period of adjustment when either the economy would have to do comparatively better (less likely) or the market would have to do comparatively worse (more likely) than each has respectively done during the past 15 months, which would be behavior similar to that observed in relation to the completion of the Fed's QE2 program.

The conclusion of the Fed's QE2 program almost three years ago is associated with SPY's 2011 bear market, when on an intraday basis the ETF dipped to $107.43 on Oct. 4 from $137.18 on May 2, a drop of $29.75, or 21.69 percent. I suspect that this was not a coincidence.

Analyses of the assets on the consolidated Federal Reserve Bank balance sheet and the share prices of SPY during the Age of QE3+ led me last month to estimate the ETF could reach a long-term peak in the area of $197.36, as reported in "SPY, MDY And IJR At The Fed's QE3+ Market Top."

And I have found nothing in the most recently revised data series associated with the SPY-USEI relationship to challenge that estimate.

Related Reading

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

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

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: The S&P 500 And U.S. Economic Index Continue Decoupling