To achieve this, we calculated the 18-month change in the above indicator and set a “crash line” at -1.0. The adjustment improves the indicator’s value, indicating an investor should reduce equity exposure sooner than the unchanged index would suggest.
At the same time, using a -1.0 reading eliminated the false exit signals. There is an element of “data mining” here and we would not recommend using this indicator as a “precision instrument.”
However, it does show that these three standardized data points are fairly good coincident indicators of the economy and, using an 18-month change and a filter, do offer reasonably good warnings when one should reduce exposure and when a market pullback is a mere correction. We use the period since 1997 because it makes the data easier to observe.
But, we did look at data from 1980 and the performance is similar. As we would expect, the indicator did not help at all during the 1987 crash, confirming that its usefulness is as a gauge of the interaction between equities and the economy, not as a pure market indicator.
What is it telling us now? The economy is doing well enough that market declines will probably not be more than normal pullbacks. Of course, this sort of indicator won’t necessarily be helpful if a geopolitical event triggers a major market decline. But, the most common cause of bear markets in equities are recessions. For now, that doesn’t appear to be on the horizon.
1. Standardizing entails subtracting the raw data by its average and dividing by its standard deviation. The resulting number is then adjusted by how far it is from average and how far it is from its normal deviation. Standardizing allows one to combine unlike indicators and essentially balance their relative effect. In this case, the formula is Indicator = (standardized CRB + standardized Consumer Confidence) – standardized Initial Claims. We subtract the claims data because lower claims indicates a stronger economy. Subtracting that number thus allows the indicator to rise when economic data are improving and vice versa.
Past performance is no guarantee of future results. Information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Opinions expressed are current as of the date shown and are subject to change. This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security