Mutual Funds Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
-Past "Signals" Gone Awry
-What the Data Suggests Might Lie Ahead Now
-Over- and Under-Valuation Tend to Provide a Superior Investing Forecasting Tool
Many decisions by individual investors, as well as stock market forecasts by pros, are highly influenced by some of the most visible current data on the economy. If this data suggests the overall economy seems on good footing, people are typically more willing to invest; if the economic tone is currently below par, people tend to very cautious. The implicit assumption is that good data is conducive to a strengthening in stocks. On the contrary, if the data paint mostly a dreary picture, most assume it's not a good time to invest.
The data investors often key off of comes directly from the U.S. government. One one the most important inputs investors receive comes from none other than the US Federal Reserve's statements, both prior to and following meetings where government economic experts discuss the strength of the economy, and then make decisions on short-term interest rates. And "the Fed's" statements often contain predictive forecasts which go beyond actual data to suggest what conditions are likely to be in the future. Additionally, there are various important regular data releases put out by the government including Gross Domestic Product (GDP), unemployment, and consumer spending, all of which are afforded a high degree of visibility to the investment public.
It would certainly be reasonable to think that a collection of some of the most prominent economists in the country, not to mention the large cadre of government employees available to gather research data, would be a trustworthy source of reliable economic information. Likewise, one might also feel confident statistical data on the strength of the economy (GDP) and the other two key indicators of economic health mentioned above should provide a solid basis for assuming good, or bad, times ahead for the country, and as a likely consequence, the stock market.
In spite of the importance afforded to these releases, it is our opinion that at key turning points, this data can often mislead people, either into thinking stocks are relatively safe or that they should best be avoided.
It must be emphasized that the purpose of these data releases is never explicitly intended to predict where the stock market might be headed. But given the connection most people make between what is perceived as good data and good stock market prospects, it's not hard to see why the data often wind up being used that way.
A brief historical review of the major turns in the S&P 500 Index over the last 10 years seems to clearly demonstrate that the snapshot afforded by mainstream economic data may tend to give a completely false picture of what might lie ahead for stocks. Our review below, rather, suggests that such data failed miserably to give any inkling of huge moves ahead in the stock market which turned out just in the opposite direction as might have been predicted.
For each of the following key dates over decade, we summarize what might have appeared to lie ahead based on the then currently available data.
Stocks (i.e. the S&P 500 Index) had been in a long bull market through much of the 1990's which finally came to a halt starting in March 2000. Less than 3 weeks before the market turned, the Fed issued the following data in its "Beige Book" of current economic conditions:
"...(A)ppreciable expansion of economic activity during late January and February. The majority of [U.S. regional] districts reported strong growth during the survey period, with the remaining reports pointing to moderate growth or continued high levels of activity. Retail sales expanded significantly over their year-earlier levels. Gains in manufacturing output were widespread." (Mar 8, 2000)
Furthermore, concurrent data showed the following:
4th Q '99 Gross Domestic Product (GDP)
+7.4% (source: bea.gov)
Mar '00 Unemployment Rate
4th Q '99 Real Personal Consumption Expenditures
Based on this extremely strong data, it is no wonder that most people would have had relatively little fear of an impending bear market. Yet this is exactly what transpired.
The 2002-2002 bear market finally ended on Oct. 9 2002. We then were about to enter a bull market that would last for the next 5 years.
If you had been listening to the reports on the economy available during this 2002 transition with the intent of using the data to help you project what direction the economy was likely take, this is what you would have heard:
"Most Districts reported that economic activity remained sluggish in September and early October. Retail sales were weak across the nation, including some declines in motor vehicle sales from very high levels. Most Districts noted that manufacturing activity had declined or grown more slowly. (October 23, 2002 Beige Book)
3rd Q '02 Gross Domestic Product (GDP)
Oct '02 Unemployment Rate
3rd Q '02 Real Personal Consumption Expenditures
Your likely conclusion: The economy is weak (although not in as dire shape as it was in March 2009, below). Most who look to the economy's performance as a yardstick for stocks likely future performance might have taken this as a sign of continuing market trouble. But this is just the opposite of what happened.
The most recent, and most wealth destroying, bear market since the Great Depression started in Oct. 2007. But one could hardly have gotten a good idea it was about to happen from our sample of the most visible economic data available at the time:
"Anecdotal reports from the Federal Reserve Banks suggest economic activity continued to expand in all Districts in September and early October." (October 17, 2007 Beige Book)
3rd Q '07 Gross Domestic Product (GDP)
Oct '07 Unemployment Rate
3rd Q '07 Real Personal Consumption Expenditures
The above data, while not outstanding, was still quite good; no real warning signs here.
This is when the stock market finally did a complete about face and entered our current bull phase, featuring a 75% rise in little more than a year. But, at the time, the economy was still in a very severe recession and the outlook appeared pretty dismal according to the data available:"Reports ... suggest that national economic conditions deteriorated further during the reporting period of January through late February. ... Reports indicated weaker conditions or declines in economic activity... The deterioration was broad based, with only a few sectors ... appearing to be exceptions. Looking ahead, contacts from various Districts rate the prospects for near-term improvement in economic conditions as poor, with a significant pickup not expected before late 2009 or early 2010. (Mar. 04, 2009 Beige Book; emphasis added)
4th Q '08 Gross Domestic Product (GDP)
Mar '09 Unemployment Rate
4th Q '08 Real Personal Consumption Expenditures
Based on this economic data, many investors were content to stay out of, or reduce their commitments to, stocks. But, as stated above, drawing a negative conclusion from the data with regard to stock prices, at least for the following year and likely beyond, has proven to be very much the wrong strategy.
What the Data Suggests Might Lie Ahead Now
Our data sleuthing brings us to the beginning of March 2010. What is the mainstream economic data telling us now?
The Fed statement issued on March 16, 2010, following its latest Policy meeting reveals:"Information received since ... January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit...
...(E)conomic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
4th Q '09 Gross Domestic Product (GDP)
Feb '10 Unemployment Rate
4th Q '09 Real Personal Consumption Expenditures
Thus, the data are really very mixed, although definitely slanted toward signs of improvement. The most recent overall figure on economic growth (GDP) is outstanding, while the unemployment rate continues to be horrendous.
We have already seen that even when the data is clearly either quite good or bad, anyone making projections about the future direction of the stock market from that data is taking a giant (and likely, unwarranted) leap of faith: A relatively short time down the road, the result can be quite the opposite of what might be expected. Mind you, the data and the market's performance are not always out of sync. But, as shown above, there are obviously a number of times when accepting the apparent implications the data will blind you to other possible outcomes.
If it is hardly possible to make a reliable forecast even when the current data all line up on either on the positive or negative side, I would be highly reluctant to make a market forecast right now, at least a forecast based mainly on the data we have available from the Fed and these other highly significant economic statistics.
Over- and Under-Valuation Tend to Provide a Superior Investing Forecasting Tool
While certain economic data may be more or less useful for predicting the outlook for the economy, we have found that trying to forecast the direction of the stock market can best be accomplished mainly by considering over- vs under-valuation of stock prices. Thus, we find that our most useful forecasting tends to come from measures that imply not so much about the economy, but rather, whether stocks (or bonds) have become too highly priced, or are currently or under-priced.
Although we can never be certain about when turnarounds in prices will occur in the short term, we have continually seen that there is a reliable link between an asset category exceeding reasonable expectations for an extended period, and a point in the not-too-distant future where the excesses will be corrected. (See how this impacts our Apr. 2010 recommended asset allocations here).
To summarize: No matter how good the economic statistics appear to be, it turns out to be extremely hard to achieve good long-term returns unless your investments are purchased when they are not already over-valued. All this suggests that investors shouldn't just consider the economy, but rather, how far investors have already pushed stock prices up or down and whether such levels are sustainable going forward.