Using The OECD's Leading Indicators To Avoid Both Bull And Bear Traps

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 |  Includes: EEM, EWJ, FXE, FXI, FXY, SPY
by: Darrel Whitten

Given the unprecedented market volatility, the wide divergence in professional opinions about the Euro debt crisis, China’s economy, the U.S. economy and whether or not the Fed will introduce QE3, it's nice to have one or two “reality check” indicators as yardsticks to sift through the media hyperbole to judge whether current market sentiment and stock prices are over-reacting, or are underestimating the real, underlying fundamentals.

Any experienced economist/analyst/trader knows that stock prices lead economic and corporate earnings trends, and that is why stock prices are included in government measures of leading economic indicators. Stock prices over the short term however are noisy. As the economist Paul Samuelson once observed, “the stock market has predicted nine out of the last five recessions”.

That said, longer-term stock prices in aggregate have an almost one-to-one correspondence with upturns and downturns in economic growth. The downside is that the compilation and release of "leading" economic indicators takes time, creating a noticeable delay between their release and "real time" stock prices. For example, the OECD's (composite leading indicator, CLI) indices are released one month and a couple of weeks after the fact, e.g., the October reading was released on December 12.

However, because the CLI is a) readily available on the OECD’s web site, b) is designed to provide early signals of turning points in the economic/business cycle 6~9 months in advance of the actual turning point, and c) continues to trend in the new direction for several months or longer once the turning point is reached, it is useful in confirming or denying stock market turning points. The OECD’s monthly CLIs can therefore help you as an investor avoid both bull and bear stock market traps.

For example, the OECD CLI for the U.S. peaked in June 2007. While the S&P 500 peaked soon afterward in July 2007, it rallied to a new high after a short correction of about 8%, only to collapse some 56% by March 2009. In other words, the short rally from the brief selloff was a bull trap. Conversely, the S&P 500 peaked in April 2010 and sold off some 16%, but there was no confirming peak in the U.S. CLI. This time, the selloff was a bear trap that shook investors out of positions while the S&P 500 went on to rally some 33% to the April 2011 high.

click to enlarge

SP500 and CLIClick to enlarge
So where does the S&P 500 stand today versus its CLI? Since the April 2011 peak, the OECD, U.S., Euro area (17 countries) and Japan CLIs continue to deteriorate with no signs of a turning point. In other words, the developed nations are again slipping into recession. Meanwhile, the S&P 500 has apparently bottomed after an 18% selloff and gave us a Christmas rally that could very well be a bull trap. Until there is confirmation of a new uptrend from the U.S. CLI, this rally is suspect until further notice.

OECD CLI and S&P 500 Turning PointsClick to enlarge
Does the CLI work for other markets? Since the capital markets in the emerging economies are not as efficient as the U.S., the relationship between individual country CLIs and that country's stock market index seems to be generally looser, but still applies. In the case of the Shanghai Composite and the China CLI, the lags/leads in the Shanghai Composite vis-à-vis the CLI have been up to two months. The other conclusion that can be derived from the China and other BRICs CLIs is that the Euro contagion, in addition to indigenous factors, is visibly dragging down emerging economy growth as well, implying that this time, the emerging markets will not be spared from a global recession.

BRICs CLIsClick to enlarge

Disclosure: I am long FXI.