Economic Surprise Index Breaks Down

by: Paulo Santos

With Tuesday's news on the durable goods orders coming in well below consensus (-4% versus -1.4% expected, ex-transportation at -3.2% versus +0.2% expected), it's safe to say that when Citigroup (NYSE:C) recalculates its Economic Surprise Index for today, it will have broken down from its top formation.

And what's the Economic Surprise Index?

It's an index devised by Citigroup which intends to provide an objective quantitative measure of how strongly economic data is deviating from expectations. A positive reading indicates that economic releases have been beating expectations, whereas a negative reading implies that they have been coming in below expectations. The index is calculated daily, using the last three months of data together with a decay function to give less relevance to releases the farther they are from the present. Finally, the weight given to each release is derived from the impact that release usually has on forex rates.

Why is it important?

The Economic Surprise Index allows us to see trends developing where economic releases are consistently coming ahead or behind what's expected, clearing up much of the noise around the economic data. Trends thus become much easier to see in the overall economic context. We should be especially aware of extremes in the index, as it usually floats from extreme to extreme.

The index can work as an early warning sign both for impeding economic trouble, as it did last year when it topped out in early March or as an indicator of some kind of economic bottom, as was the case back in 2009, when it bottomed during January, indicating that no further economic erosion was forthcoming.

So what about now?

As I said in the beginning, with Tuesday's durable goods orders data, it's almost certain that the topping process - which had already begun in early 2012 - is complete. Wednesday, when the index gets updated, we should see a breakdown on its chart which now looks like this (source: Bloomberg):

click to enlarge

Click to enlarge


With economic releases on average starting to surprise on the downside, caution is warranted both in the stock market - S&P500 (NYSEARCA:SPY), Nasdaq (NASDAQ:QQQ), Russell 2000 (NYSEARCA:IWM) and regarding commodities (NYSEARCA:GSG), for which I've also pointed out other reasons to be careful about.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.