Stocks markets – anticipating improved growth?

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This article is a combination and updated version of two posts published separately a few weeks ago.

Stock markets have been heading north over the past few weeks while market commentators question the health of the world economy and especially the situations in the U.S. and China. But who is right and who is wrong? This very question prompted me to look at the ability of stock markets to anticipate the fortunes of the underlying economies.

The methodology I applied was to calculate Monthly Smoothed Annualized Growth Rates (MSAGR for short) of the major representative stock exchanges and compare that with leading indicators of the respective economies where possible. To calculate the MSAGR I compute a weighted index on the basis of increased weights for the past 12 months instead of using a simple moving average. The most recent value therefore carries a significantly higher weight than that of the first month of the past 12 months. The weighted index is then smoothed by calculating a 4-month moving average of the weighted index. The month-on-month growth rate is then calculated and annualized.

In the graph below, I have depicted the MSAGR of the S&P 500 Index against the 12-month momentum of the USA Composite Coincident Indicator and it appears that the MSAGR of the S&P 500 leads the coincident indicator and therefore the U.S. economy by approximately four months.

Sources: I-Net; Plexus Asset Management.

What is remarkable is that in all instances when the MSAGR fell below zero, growth of the U.S. economy as measured by the coincident indicator declined approximately four months later, except in 1994 when the MSAGR only briefly turned negative.

As in 1994 the MSAGR briefly turned negative in August this year at -1.17% but bottomed and soon moved to positive territory again. The message I am getting is that the slowdown in growth of the U.S. economy in recent months is something of the past and that the first quarter of 2011 will show improvement. It is clear that those at the Fed are heavily influenced by the trend in the stock market and therefore felt strongly about implementing QE2 to prevent the ship from sinking.

The Eurozone displayed characteristics similar to those of the S&P 500 Index and MSCI World Index in US dollars. The zero line is of utmost importance. When the MSAGR of the Eurozone breaks decisively into negative territory it heralds a drop in economic activity approximately four months hence. A few months ago (in September) it came precariously close but rebounded, indicating that the leading indicator of the Eurozone has likely gained momentum.

Sources: I-Net; Plexus Asset Management.

Germany was the stalwart in the Eurozone, though. Although the Dax’s MSAGR trended down, it never came close to zero.

Sources: I-Net; Plexus Asset Management.

Elsewhere in the Eurozone things did not look rosy. Even France’s relatively strong economy became extremely vulnerable as indicated by the stock market’s smoothed growth rate. The MSAGR of the CAC 40 appears to have bottomed and is heading for positive territory.

Sources: I-Net; Plexus Asset Management.

The outlook for the economies of the so-called PIIGS, the Eurozone’s problem children, is dire, though. Greece’s stock market prices are anticipating a deep recession.

Sources: I-Net; Plexus Asset Management.

A similar picture is evident for Ireland.

Sources: I-Net; Plexus Asset Management.

Italy’s stock market is holding up reasonably well, indicating that the economic outlook is less bad than anticipated.

Sources: I-Net; Plexus Asset Management.

Although the smoothed growth rates of the stock markets in the Iberian Peninsula indicate contraction of the economies in Portugal and Spain, it is relatively shallow and appears to have hit bottom.

Sources: I-Net; Plexus Asset Management.

Sources: I-Net; Plexus Asset Management.

The MSAGR of the FTSE 100 briefly dropped to below zero but staged a strong rebound, indicating that the market is anticipating stronger economic activity in coming months.

Sources: I-Net; Plexus Asset Management.

In the Far East investors in the Japanese stock market are significantly less optimistic than the momentum of the official leading indicator suggests. However, the stock market’s smoothed growth rate is heading for positive territory again.

Sources: I-Net; Plexus Asset Management.

Using the same algorithm, I calculated the MSAGR for the MSCI World Free Index in U.S. dollars and compared it to the 12-month momentum of the OECD Leading Indicator. While there is a close relationship between them, the MSAGR of the MSCI World Free Index is in fact more reliable than that of the OECD Leading Indicator. It was especially evident in 2002 when the OECD Leading Indicator’s momentum turned positive while the MSAGR stayed in negative territory and therefore did not fall into the trap of the double-dip in global economic activity. In fact, since the start of last year the MSAGR of global stocks has led the OECD Leading Indicator’s momentum.

Sources: I-Net; Plexus Asset Management.

My MSAGR of the MSCI Emerging Market Index in U.S. dollars had a solid uptrend that started when the Asian crisis ended at the end of 1998 but collapsed in 2008 with the Lehman saga.

The MSAGR of the MSCI Emerging Markets Index in U.S. dollars follows the same trend as that of the MSCI World Free Index in U.S. dollars. The growth is more elevated, though, and indicates the stronger growth in emerging economies compared to mature economies. It is interesting to note that unlike mature markets the MSAGR of emerging markets did not bottom in negative territory recently.

Sources: I-Net; Plexus Asset Management.

In South America the Argentine bourse is anticipating stronger economic growth in the near future.

Sources: I-Net; Plexus Asset Management.

The Brazilian market players do not share the optimism of their Argentine partners, though.

Sources: I-Net; Plexus Asset Management.

It is no wonder the Brazilians and Russians are crying foul about the strength of their currencies!

Sources: I-Net; Plexus Asset Management.

The smoothed growth rate of India’s stock market has resumed an uptrend into positive territory.

Sources: I-Net; Plexus Asset Management.

Commentators are still focusing on the extremely weak OECD Leading Indicator for China and the potential effect thereof on the Chinese stock market. The MSAGR of the Shanghai Composite Index has bottomed in negative territory, though. It indicates to me that yes, economic growth is likely to slow in the next few months but it will be short-lived as the smoothed growth rate of the Index is again approaching positive territory.

Sources: I-Net; Plexus Asset Management.

Looking at my home country, South Africa, it is evident that the MSAGR of the South African stock market in local currency (rand) terms leads the economy as measured by the momentum of the SA Coincident Indicator by approximately four months. The MSAGR therefore points to the slowdown in growth of the SA economy bottoming in the final quarter of 2010 and activity strengthening in the first quarter of 2011.

Sources: I-Net; Plexus Asset Management.

Bottom line: The stock market is probably right regarding an improved global economic outlook for the first quarter of 2011. Overbullish sentiment can turn quickly, though. With a number of black swans on the radar I will be keeping a close watch on the MSAGRs of the different markets.

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