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The U.S. economy's health could serve as a leading indicator, and an understanding of it could help in hedging your portfolio. 70% of the U.S. economy is consumer spending. As long as we can understand the consumer, their spending patterns, and the likelihood of a cutback or a potential shock, we can get some idea of potential economical problems. The model is simple, very logical but still powerful. It tracks the health of the economy by analyzing three factors:

  1. Monthly savings rate of the U.S. population (the higher the savings rate, the better the cushion; the lower the savings rate, the more people are susceptible to a default).
  2. Growth in interest payments of the U.S. population (significant increases in monthly interest payments would mean the consumer is vulnerable to a default).
  3. Growth in personal income of the U.S. population (significant increases in the personal income of the people are not sustainable; if the economy turns and companies have to downsize, the immediate impact could be significant).

By back testing these three metrics on the S&P I found some very strong results. If the score of average growth in interest payments for last 12 months + average growth in personal income for last 12 months - average of last 12 months of savings rate multiplied by 2 is more than 13%, the market could be prone to a very significant crash.

When applied to the past decade, the model predicted the falls quite accurately. These indicators work well in a low savings rate environment but fail to function in a high savings environment (that's the reason savings is given more weight and is multiplied by 2). This makes sense, as the savings rate was high in '70s and '80s in the U.S., and even with the increase in loan growth and interest rates, the market didn't crash significantly. We only saw some modest recessions due to external events, but not due to the fundamental health of the economy. Also, the savings rate in the emerging markets is high (India: 25%-30%, China: 35%-40%) which gives a cushion to real estate in these markets, and hence we haven't seen a significant decline in real estate prices there.

(click to enlarge)

Though the market has run up too fast, the score has indicated a strong recovery. We might see some correction due to the fiscal cliff, which, if triggered, could have serious consequences for economic growth. However, the U.S. consumer has de-levered radically and is now slowly levering up. The deleveraging part of the score (average growth in interest payments for last 12 months) has been negative for the 45 months between October 2008 and June 2012. Only recently, in the month of July 2012, it turned positive. Personal interest payments have gone from their peak of $274 billion in the month of September 2007 to $172 billion as of the latest data of August 2012, a reduction of 37%.

Though the overall score is still negative, -2.8 as of August 2012, it's way below the vulnerable point of 13. I think there is a lot of room for the market to expand, but in the short term we may see some significant corrections. That would be an opportunity to buy. Eventually the animal spirits will kick in and technological innovations will create boom.

As Sir John Templeton said, bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. I think we are somewhere in the pessimism and skepticism stage, and in the long run we have a lot of room to grow. The model helps serve as a leading indicator.

Source: Is The Economy Vulnerable To A Fall Or Shock?