Stock Market Is The Leading Indicator

Includes: SPY
by: Dorsey Wright Money Management

By Mike Moody

I am constantly aggravated by economists on CNBC who discuss their outlook for economic growth and then attach their market forecast. If the economy is good, the market is supposed to be good too. The fact is that things work the other way around. The S&P 500 is one of the leading economic indicators. You might be able to predict the economy from the stock market, but you can’t do it the other way around. In that respect, CXO Advisory has performed a public service with their recent article on the Leading Economic Index and the stock market.

Their approach is exemplary. First, they examine the correlation between the Leading Economic Index (LEI) and the stock market the following month. It’s actually fairly high, with a correlation coefficient of 0.39. Then they point out the first big problem: the LEI is reported with a big lag. So, they re-examine the correlation between the LEI and the stock market after the data is actually released. Suddenly the correlation coefficient drops to 0.10. (With an r-squared of 0.01, there is effectively no predictive power.)

Well, maybe it predicts the market better at a longer time horizon—so they check that too. Here’s the correlation chart using calendar months:

Source: CXO Advisory (click on image to enlarge)

Lo and behold, the stock market leads the LEI by about a month. As CXO says:

The strongest indication is that stock returns lead LEI changes by one month.

You can safely ignore economists trying to forecast the market, even with supposedly leading data. In price there is knowledge—and the market knows better what is going to happen with the economy even than the leading indicators.