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US Economy

Great Expectations

By Elliott H. Gue, on May. 14, 2015

The advance estimate of US gross domestic product (GDP) indicates that economic growth slowed to an annualized rate of 0.2 percent, down from 2.2 percent in the fourth quarter and 5 percent in the third quarter.

Investors who paid attention to the deterioration in US economic indicators weren’t blindsided by this swoon.

The slowdown complicates matters for the Federal Reserve by making it difficult to justify hiking interest rates for the first time since mid-2006.

In early November 2104, the futures market assigned a 56.6 percent probability that the US central bank would increase the federal funds rate at least once by its meeting on June 17, 2015.

Today, the same market assigns just a 1-in-5 chance of the Fed announcing a rate hike at next month’s meeting; in fact, futures imply that there’s a 50-50 chance the central bank will increase interest rates at all this year.

The Big Question

Does the current slowdown the beginning of a recession, or a temporary soft patch?

If weak GDP growth in the first quarter represents the start of a contraction, investors should gird themselves for a 30 percent to 40 percent downdraft in equity prices over the next 12 to 18 months.

However, if the US economy’s seasonal swoon is cut from the same clothe as the ones that occurred in the first quarter of 2011 and 2014, any pullback in the stock market would give investors an outstanding buying opportunity.

The risk of a 5 percent to 10 percent correction in US equities looks elevated for the next three months. But stocks should continue to rally over the next six to 12 months, making this modest pullback a gift for savvy investors.

Reading the Tea Leaves

Investors often assume that a winning strategy involves selling stocks when the economy weakens and buying when GDP growth strengthens. After all, economic growth drives corporate earnings, which, at least over the long term, influence stock valuations, dividends and total returns.

However, as we explained in Fear, Greed and the Purchasing Managers Index, the best buying opportunities usually occur when the economy is at its weakest.

We crunched the data and found that investors who bought the S&P 500 when the Purchasing Managers Index (PMI) for the US manufacturing sector slipped to less than 45 would have generated an average total return of more than 30 percent over the ensuing 12 months.

Unfortunately, these buy signals do not occur often.

The last time US PMI tumbled to less than 45 occurred in May 2009, six years ago. And prior to the Great Recession, PMI hadn’t sunk to this level since November 2001.

Although this economic indicator tends to remain below 45 for several months near the nadir of a recession, this index has flashed only two major buy signals since 2000.

The most recent PMI reading came in at 51.5—far from the levels that would indicate a recession and an opportunity to buy stocks. Elevated PMI readings—levels that historically have served as a good warning to pare equity exposure—have also become much rarer in recent years.

How to Use the Bloomberg US Economic Surprise Index

The Bloomberg US Economic Surprise Index compares economic data points from the past six months’ to analysts’ consensus estimates, with the most recent releases receiving a higher weighting.

When the index climbs, the US economy consistently surprises to the upside; a downtrend indicates that these numbers have failed to live up to the market’s expectations.

Strategy No. 1: Look for Divergences

In the short term, we look for divergences between the Bloomberg US Economic Surprise Index and the S&P 500. That is, if the Bloomberg Economic Surprise Index turns sharply lower while stocks continue to rally or hover around their highs, the market could be due for a pullback.

For example, between February and July 2011, the S&P 500 rallied to between 1,350 and 1,370 on three occasions, but failed to break through to new highs. Meanwhile, the Bloomberg US Economic Surprise Index plummeted from a high of about 0.9 to a negative reading of 0.6. This divergence preceded a 20 percent selloff in the S&P 500 that lasted from July to October 2011.

(Click graph to enlarge.)SURP and SPX 2010 and 2011

A similar pattern played out in early 2012, just before the S&P 500 suffered a 10 percent correction.

Strategy No. 2: Focus on Extremes

Over a six- to 12-month period, the Bloomberg US Economic Surprise Index offers its most reliable buy and sell signals at extreme values.

We examined monthly readings for this indicator all the way back to 2000, when the index debuted. Since its inception, the Bloomberg US Economic Surprise Index has ended eight months with a reading between negative 0.6 and negative 1.

An investor who bought the S&P 500 on these eight occasions would have posted an average total return of 1 percent over a three-month holding period—below the S&P 500’s average rolling three-month return of 1.5 percent.

In other words, these extreme readings have little value for short-term market timing; however, these buy and sell signals outperform over six- and 12-month holding periods.

SPX and ECSURPUS

If you bought the S&P 500 whenever the Bloomberg US Economic Surprise Index slipped to less than negative 0.6, your six-month total return would have averaged 14.4 percent. That’s almost f5 times the S&P 500’s average rolling six-month return since 2000.

The average return over a 12-month holding period is an impressive 25.3 percent, which easily beats the S&P 500’s average rolling 12-month return of 6.3 percent.

By the same token, extremely high readings in the Bloomberg US Economic Surprise Index provide an excellent sell signal for stocks; when this indicator climbs to more than 0.6, the S&P 500 has generated a negative return over the ensuing three, six and 12 months. However, the usefulness of this indicator fades over a 24-month holding period.

Over the past several years, the Bloomberg US Economic Surprise Index has flashed a number of profitable signals to buy and sell stocks.

For example, the index drifted to less than negative 0.6 and remained depressed through early 2009; investors who bought stocks over this period entered the market near its bottom, setting the stage for explosive returns.

And after the Bloomberg US Economic Surprise Index spiked to more than 0.6 in January 2011, the S&P 500 gave up more than 21 percent of its value between May and October 2011.

Implications for Today

Recent trends suggest that the S&P 500 could be in for a 5 percent to 10 percent correction over the next three months.

The Bloomberg US Economic Surprise Index has tumbled precipitously since last fall, while the S&P 500 has continued to hover near its high—just the sort of divergence that often precedes a short term pullback.

And although the S&P 500 hasn’t suffered a significant pullback this year, the index has gained 3.1 percent since December 2014 and failed to climb above a key resistance point at 2,125.

SURP and SPX 2014 and 2015

Today, the Bloomberg US Economic Surprise Index stands at negative 0.82. A reading in this range isn’t a strong buy signal in the short term, but does bode well for the stock market over the next six to 12 months.

Historical precedent suggests that when economic data disappoints, the subsequent recovery or downward revisions to analysts’ consensus expectations set the stage for more upside.

Behind the Data

These trends reflect a critical shift underway in the US economy.

Over the past 15 years, several engines have powered US economic growth, from the tech sector in the late 1990s to residential housing and creative financing in the mid-2000s to the recent shale oil and gas revolution.

These shifts don’t happen overnight or in a linear fashion; rather, the economy experience volatility and dislocations when one engine sputters and its replacement doesn’t fire on all cylinders right away.

For investors, this passing of the baton means that the stocks that outperformed in 2012 and 2014 likely won’t lead the next move higher—this onus will shift to another group of stocks.

This messy hand-off causes the wide divergence between economic data and the consensus estimates; analysts usually get it all wrong at crucial turning points.

Going Shopping

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