More on Market Math - Economic and Inflation Indicators

After the first two installments of "What's the Message from the Market Math," you should know that it doesn't pay to "Fight the Fed" and you have some tools to make sure you don't "Fight the tape." Now it's time to make sure you've got a good handle on the market's external influences.

As was mentioned yesterday, one of the most important lessons investors can learn is that using a "weight of the evidence approach" is superior to pinning your financial future on a single indicators.

There are no guarantees in the investing game. However, staying in tune with the message coming from what have historically been the important drivers of stock prices will go a long way toward helping you achieve success. For our clients, that means making hay while the sun is shining during bull market runs and then trying not to get our heads taken off when the bears attack.

So far, we've talked about the two biggest, long-term drivers of stock prices: monetary conditions and the state of the tape (the trend and momentum of stock prices). Today we're going to start exploring what we call "external factors" including the economy, inflation, sentiment, and valuation. So, let's get to it, shall we?

External Factors: The Economy

One of the big mistakes investors made in 2013 was to invest based on the current state of the economy. While this may be hard to hear, taking such an approach displays an almost complete lack of understanding as to how the stock market works. Remember, the market is a discounting mechanism that looks forward, not back. Thus, it is important to recognize that what is happening in the economy right now is usually (but not always - especially during crisis environments) already priced into the market and should have little to no bearing on where you should invest.

It probably won't surprise you to learn that we rely on a mathematically driven model to guide us in this area. The model combines 15 different economic indicators into a single composite model. Since 1965, when the model has sported a positive reading, the S&P 500 has advanced at an annual rate of 23.7 percent. And when the model has been negative, the S&P has fallen at a rate of -23 percent. As such, this is a pretty darn good model to pay attention to.

Before we get to the current reading of the economic model, first understand that this is a model built for the stock market - and not a model designed to tell us how the economy is doing. While the two aren't necessarily mutually exclusive, it is much more important to know how economic indicators impact the stock market than to try and predict the rate of GDP.

In other words, the key to understanding how to tie economic data to stock market investing is to recognize that it is the outlook for the economy that is important - and not what happened last month. Remember, in the stock market, something that everyone knows isn't worth knowing!

What Does the Economic Model Say?

Currently, our favorite economic model is neutral. However, this isn't a bad reading. Since 1965, the S&P has gained ground at a rate of 10.3 percent per year when the model has been neutral, which is a bit better than the average gain of the market itself. It is also worth noting that the model is currently rated as very high neutral and that it wouldn't take much to turn it positive again.

External Factors: Inflation

To be sure, it's been a while since anyone had to worry about inflation. In fact, it's been just the opposite problem - deflation - that has been the primary focus of Mr. Ben Bernanke and his merry band of central bankers. Bernanke and company have basically done everything in their power to help keep the U.S. from falling into the type of deflationary spiral that has kept Japan's economy in the dumpster for decades. And so far at least, it looks like Bernanke has succeeded.

However, as the saying goes, those who ignore history are doomed to repeat it. Thus, investors should remember that in the past, when inflationary pressures have been high, stocks have performed quite poorly. And as you might surmise, when inflationary pressures are low, stocks have tended to provide rather handsome returns.

Given the current global macro environment, it is probably a safe bet that investors won't have to deal with inflation any time soon. However, stranger things have happened and a spike in oil is always a possibility.

What Causes Inflation Anyway?

On that note, it is probably worth mentioning that commodity inflation alone does not cause inflation. No, it is wage inflation that REALLY impacts the consumer price index. So, while it may sound boring, be sure to take a peek at the price pressure data contained in the jobs numbers.

The bottom line here is that this is probably an indicator that you may not need at the present time. But you may want to stick in your back pocket and keep it handy for the time when the inflationary environment shifts again.

What Does the Inflation Model Say?

Like the economic model, the inflation model is built to help manage the stock market. The model includes more than 20 individual indicators measuring changes in such things as commodities, producer prices, CPI, industrial production, etc. Since 1962, when the model has signaled that inflationary pressures are low, the stock market has gained at a rate of 13.2 percent per year. And then when the model suggests inflationary pressures are high, stocks have declined at a rate of nearly -6 percent per year. So, this is a spread worth paying attention to.

Currently, the Inflation model is positive, albeit by the skinniest of margins. For now, this is a plus for the bulls. However, if we start to get even a whiff of inflation in the economy, this could quickly become a major headwind for stocks.

Next Time...

Next up are the areas of investor sentiment and valuation. Stay tuned...

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