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Summary

  • SPY and my U.S. Economic Index both moved higher in April, while the SPY-USEI correlation coefficient was flat for the first time in seven months.
  • SPY hit another all-time monthly closing high share price on an adjusted basis, as it ascended to $188.31 from $187.01, a climb of $1.30, or 0.70 percent.
  • Based mainly on data provided by the Institute for Supply Management, the USEI advanced to 55.16 from 53.18, a gain of 1.99 points, or 3.74 percent.
  • Meanwhile, the SPY-USEI correlation coefficient held steady at 0.61, indicating a bridging of the gap in their relationship may be under way.
  • Previous data suggested the decoupling of SPY and the USEI reflected a rupture between the equity market and the economy.

The observable rift between the absolutely strong American equity market and the relatively weak national economy did not widen last month, according to data on the relationship of the SPDR S&P 500 ETF (NYSEARCA:SPY) and my proprietary U.S. Economic Index: From March to April, both rose, while their correlation coefficient was flat.

SPY hit another all-time monthly closing high share price on an adjusted basis, as it ascended to $188.31 from $187.01, a climb of $1.30, or 0.70 percent. USEI advanced to 55.16 from 53.18, a gain of 1.99 points, or 3.74 percent. And the SPY-USEI correlation coefficient was stable at 0.61, the first time it did not dip since October, when it was 0.69.

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 last Thursday and its latest nonmanufacturing figures this Monday.

It appears evident to me changes in the stock market eventually mirror changes in the economy. And vice versa. However, I believe anomalies in this historical relationship began to develop in the wake of the U.S. Federal Reserve's current quantitative-easing program, which is discussed in "SPY, MDY And IJR At The Fed's QE3+ Market Top."

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

The USEI's complete data set encompasses just 76 months because ISM has published the relevant manufacturing figures dating back to January 1948, but the nonprofit organization has published the relevant nonmanufacturing numbers dating back only to January 2008 (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 past 16 months, there has been a breakdown in this relationship, suggesting the continuous feedback loop between the market and the economy has been disrupted.

Overall, the SPY-USEI correlation coefficient on an apples-to-apples basis plunged to 0.61 in 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 its correlation coefficient currently at 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 primarily by the U.S. Federal Reserve's current quantitative-easing (QE) program, which was announced after a Federal Open Market Committee (FOMC) meeting Sept. 12-13, 2012.

Immediately before and immediately 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 in 2012.

Figure 3: SPY And USEI Monthly Values, October 2012-April 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.

Historically, there have been lags in the effects of the Fed's monetary policies, so 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 evident in the data until January 2013, when the SPY-USEI correlation coefficient dipped to 0.74.

This change in character has been easily observable since then, however, with the SPY-USEI correlation coefficient negative at -0.22 when calculated for the past 19 months alone (Figure 3). Nonetheless, this latest number actually represents progress in the move toward normality and away from abnormality in their relationship: I calculate the SPY-USEI correlation coefficient as -0.30 for the 18 months from October 2012 to March 2014, as mentioned in "The S&P 500 And U.S. Economic Index Continue Decoupling."

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.

April marked the end of a comparatively strong period and May marked the beginning of a comparatively weak period in the U.S. economy during the four full years of its current expansion, according to a seasonality study of the monthly mean and median values of the USEI calculated over the period from 2010 to 2013 (Figure 4).

Combining this seasonal tendency in the economy with the apparent incipient restoration of the SPY-USEI relationship leads me to believe the stock market could be in for a period of adjustment, especially given the conditions described in "SPY Coppock Guide: Away From Bullishness, Toward Nonbullishness as of March 31, 2014."

Figure 5: 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.

Comparatively speaking, the USEI was an underachiever (by a lot) in the first quarter of this year as measured by its mean monthly values between January and March (Figure 5). However, it was an overachiever (by a little) in April. I employ the USEI primarily as a market indicator, but I use it secondarily as an economic indicator (at least in terms of direction). As a result, I was happy with its early signaling of the god-awful Q1 gross domestic product report released by the U.S. Bureau of Economic Analysis on April 30.

Figure 6: 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 was an underachiever in Q1 as measured by its median monthly values between January and March, while it also was an overachiever in April (Figure 6). Seasonality analysis indicated there would be a speedup in the economy last month, and the same analysis suggests there could be a renewal of the slowdown in it this month.

In any case, the apparent beginning of a move toward normality and away from abnormality in the relationship between SPY and the USEI is welcome to all those who find wisdom in the words of Denis Healey, the retired politician in the U.K.:

It is a good thing to follow the first law of holes: If you are in one, stop digging.

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.

Disclosure: I am long SDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.