Look to Stocks as a Guide to the Economy

Does the stock market lead the economy? Many traders think so.

Brad Comincioli and Illinois Wesleyan undertook a study to verify this in 1996.

Of course, there were other studies before. Pearce (1983) suggested that when investors are wealthier (in rising markets), they spend more, and thus economies do better. Conversely, falling markets thus precede recessions.

However, Pearce also points out that stock market also at times provides ‘false signals’. For example, the 1987 crash was followed by a boom into 1989.

Comincioli and Wesleyan found that the stock market does help predict the future economy. Changes in GDP were impacted by changes in stock prices.

None of this was new information really

In the 1920s, trader W.D. Gann knew about all this. He wrote in his book, Truth of the Stock Tape, in 1923 that…

  • Stock markets are nearly 6–12 months ahead of business conditions
  • First bond prices rise, then stocks advance, third comes the business boom.

He also wrote that in a stock market decline the following happens: stocks will be down 6–8 months while business is booming, because they discount the future business depression. They price in the recession before it’s apparent.

In the US, for example, the S&P 500 started its decline in Jul 2015. It finally bottomed in February 2016. By this point most investors and traders had given up after about eight months — just as Gann mentioned about 100 years ago.

Look at the chart below on how the US GDP fared in 2016. You can see the GDP bottom in Jan 2016.

Source: Trading Economics
Click to enlarge

For the final half of 2016, US GDP growth improved.

This of course happened on the back of US stock markets making new highs.

This was telling you in advance that corporate earnings were improving. It was telling you US payrolls were increasing, it was telling you US industrial output was rising, and that wages were growing.

Don’t underestimate the power in the ability to read a chart. The weight of money will always tell you the truth. Knowing some of the parameters that affect the economy is useful, but only watching the charts will tell you where things are moving to.

Although it closed slightly down on the last trading day of the year at 2238, total year to date return for the S&P 500 was a respectable 12.48%.

2017 should provide many opportunities for trading, both on the long and short sides.

The good news is out in Australia

A strengthening US will also drag our local market along with it. Let’s go back to the beginning of December last year. The main index of the Australian market, the All Ordinaries [XAO] fell to a low of 5384 on 5 December. Many commentators said at the time that earnings growth was flat and stocks were unlikely to rise.

In fact, the market ran up over Christmas and into the new year, to go over 5,800 points. It was a Christmas rally. The market has retraced slightly as of now.  But this week we got a taste of why the market rallied in the first place.

The Australian reports that Australia logged record LNG exports in November last year.  These massive LNG terminals are firing a new export boom for Australia. Our other major exports — coal and iron ore — are well up from their lows too. Chinese demand for raw materials has stayed a lot stronger than many people considered possible. Australia’s national income is now rising at the quickest pace in five years, according to the Australian.

Rising commodity prices may give some impetus for wage growth to normalise and come off historic low growth rates, as an expanding mining sector helps cause a slight tightness in the supply of labour.

The ‘good news’ is coming out in the press, but the market has already priced this in. That’s why beginners to the share market are often confused. They pick up the paper and see positive headlines. Except stocks go down! The market has priced in the mainstream news long ago, and is now reacting to trends and currents that will only become apparent later.

Regardless, Australia’s trade data is a very positive development overall. As we keep saying over at Cycles, Trends and Forecasts, the Aussie economy is on the up. Retraces and dips in the stock market are an opportunity to buy. For more on why that is, go here.


Terence Duffy,
Lead Researcher, Cycles, Trends & Forecasts

From the Port Phillip Publishing Library

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Terence Duffy is an analyst and chartist, specialising in researching economic trends and cycles.  His primary focus is housing and land affordability. But you can also depend on him to offer his unique analysis of stock market charts. As Terence will show you, the charts often forecast, well in advance, the good or bad news to come.

Money Morning Australia