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Summary

  • SPY and my U.S. Economic Index moved in different directions for the second consecutive month, but the divergences appear to be within historical parameters.
  • In June, SPY advanced to an all-time-high monthly closing share price, and the USEI declined.
  • In July, the converse happened: The USEI rose to a record high, and SPY fell.

The correlation coefficient between the nonproprietary SPDR S&P 500 ETF (NYSEARCA:SPY) and the proprietary U.S. Economic Index climbed higher in July for the first time in 11 months. Its move to 0.63 from 0.61 indicates the SPY-USEI relationship is continuing to normalize in the wake of the Federal Open Market Committee's multiple actions to taper the amount of the Federal Reserve's asset purchases on a monthly basis to $25 billion in August from $85 billion in December.

Last month, SPY contracted to $193.09 from $195.72, a loss of -$2.63, or -1.34 percent, while the USEI expanded to 58.50 from 55.91, a gain of 2.59 points, or 4.63 percent.

Aka quantitative easing, the Fed's massive purchases of agency mortgage-backed securities and U.S. Treasury securities led to anomalies in the continuous feedback loop between the American equity market, represented by SPY, and the economy, represented by the USEI, as described in "SPY, MDY And IJR At The Fed's QE3+ Market Top."

These anomalies in the SPY-USEI relationship appear to be dissipating, as suggested in "SPY And U.S. Economic Index Behaviors Diverge In June."

I built the USEI in an effort to encapsulate all U.S. economic activity in a single monthly figure I could employ in guiding my investing and trading. I founded it mainly on 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.

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

(click to enlarge)

Note: The SPY adjusted monthly closing share-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 share-price information.

ISM reported its July manufacturing statistics Friday and nonmanufacturing stats Tuesday. It said its manufacturing PMI of 57.1 percent was the metric's highest level since April 2011 and its nonmanufacturing NMI of 58.7 percent was the metric's highest reading ever. (N.B.: SPY's last bear market began in May 2011.)

The nonprofit organization originally known as the National Association of Purchasing Agents has published the relevant manufacturing figures since January 1948, but it has published the relevant nonmanufacturing numbers since just January 2008. As a result, the complete data set for my USEI covers only 79 months. I calculate the SPY-USEI correlation coefficient as 0.63 during this period (Figure 1). It had been steady at 0.61 for the four months between March and June.

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

(click to enlarge)

Note: The SPY adjusted monthly closing share-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 share-price information.

During its first 57 months (i.e., before the dawn of the Fed's Age of QE3+), the USEI acted primarily as a leading indicator and secondarily as a coincident indicator of SPY's upward and downward movements. I calculate the SPY-USEI correlation coefficient as 0.75 over this period (Figure 2).

Immediately before and immediately after the dawn of the Age of QE3+, this same statistic quantified 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, USEI Monthly Values, October 2012-July 2014

(click to enlarge)

Note: The SPY adjusted monthly closing share-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 share-price information.

During the past 22 months (i.e., after the dawn of the Fed's Age of QE3+), there was a breakdown in the SPY-USEI relationship, indicating a disruption in the continuous feedback loop between the equity market and the economy. (As a result of this disruption, I now consider the USEI solely as a coincident indicator of SPY's movements.)

I calculate the SPY-USEI correlation coefficient as 0.19 over this period (Figure 3). The comparable numbers were 0.03 a month ago, -0.07 two months ago, -0.22 three months ago and -0.30 four months ago. Collectively, these statistics suggest progress in the move toward normality and away from abnormality in the SPY-USEI relationship.

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.

The USEI was an underachiever to a significant degree in 2014's first three months and an overachiever to a significant degree in the year's most recent three months when compared with the relevant mean values compiled for the months between January and July during the first four years of the current expansion (Figure 4).

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 was an underachiever to a significant degree in 2014's first three months and an overachiever to a significant degree in the year's most recent three months when compared with the relevant median values compiled for the months between January and July during the first four years of the current expansion (Figure 5).

Figure 6: USEI Monthly Values With 3-Month And 12-Month SMAs

(click to enlarge)

Note: The current expansion began in June 2009, according to the Business Cycle Dating Committee of the National Bureau of Economic Research.

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

I employ the USEI not as an economic indicator but as an equity-market indicator, as I basically emulate Goldilocks in the contemporary retelling of "The Story of the Three Bears" by attempting to determine whether economic conditions are too cold, too hot or just right for the stock market.

On the one hand, the USEI's attainment of a multi-year low of 51.80 in February and an all-time high of 58.50 in July could be interpreted as too cold and just right, in that order (Figure 6).

On the other hand, the index's record-setting performance last month also could be interpreted as too hot because of its underlying factors' likely effect on Federal Reserve policies.

At this moment, the Fed has no U.S.-based economic rationale to delay the anticipated announcement of the end of QE3+ in October or the expected announcement of the beginning of its interest-rate hikes in April.

And, along a similar line, the European Central Bank did not take any action Thursday to ensure the world would be kept awash in liquidity while the Fed continues its move to tighter from looser monetary policies.

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: The author is long SDS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.