The earnings cycle is widely followed by economists and some long-term investors, but traders often overlook the state of the economy when they develop their market opinion. This is unfortunate because stock prices do tend to fall during periods when earnings are falling and the economy is contracting, and rise in an economic expansion when earnings are rising. The chart below helps illustrate that idea.
The Federal Reserve maintains about 55,000 economic data series, including prices of the S&P 500. All of its charts show recessions with vertical grey bars, making visual analysis easier.
The chart above shows the 52-week rate of change (ROC) in the price of the S&P 500. We can see that stock prices did decline during every recession, and the annual ROC actually turns negative during recessions. The ROC has not fallen below zero for a significant time period while the economy was growing since 1990. This relationship is interesting, but does not directly lead to a trading strategy because we never know we are in an official recession until months after it starts.
The next chart illustrates how economic data can be used to develop trading strategies. It shows the 52-week ROC for new orders of durable goods (the green dashed line) and the 52-week ROC for the S&P 500 (the solid blue line). Durable goods are items that are designed to last, like refrigerators in your home or equipment that is used in factories.
New orders for durable goods indicate that factories will be working in the future to meet those orders, and an increase in new orders now should signal an increase in economic activity later.
The visual relationship between the economic data and the S&P 500 is strong, and backtesting confirms that there is a great deal of value for traders in the durable goods data.
When the ROC of durable goods is negative, we are in a bear market. Unfortunately, we can only test the past 20 years since durable goods data only goes back to February 1992. However, holding stocks only when the ROC of durable goods is positive would have doubled the gains of a buy-and-hold investor and would have avoided all market losses greater than 15%. Right now, the ROC of durable goods is above zero but declining. It is worth watching this indicator for a sell signal.
Several technical indicators are often combined to form a trading strategy and traders that use economic analysis also often use several indicators. One of the most complex indicators combines 85 different data series into a single indicator. This is the Chicago Fed National Activity Index, an indicator that is actually close to recession levels now.
A simpler model that I maintain combines durable goods orders, the Institute of Supply Management manufacturing index, and the spread between investment quality bonds and 10-year Treasuries. That model is also close to recession levels.
Based on the economic data, it is a good idea to use tight stops on long positions. It is also a good time to begin adding short positions to your trading portfolio. Unless the economy regains some strength in the next few months, we are very likely in the final days of a bull market.
Traders should use several indicators in their buy and sell decisions, and economic indicators should only be one of the inputs. Simple economic indicators can help identify whether we are in a bull or bear market and they should be followed by almost all traders.