Monday, May 23, 2005

Economic indicators and stock markets change their minds

What a difference a month makes. After worrying for much of April and early May that the global economy is headed for a downturn, recent data have pointed to a more benign outlook and stock markets have responded accordingly.

Early April saw US light sweet crude oil prices hitting a record of over US$58 a barrel, triggering fresh concerns of an oil-induced recession. This was followed by the report of unexpectedly weak growth in US retail sales in March, a fall in housing starts in March, higher inflation in March, a decline in the Conference Board's US leading index in March, a decline in consumer confidence index in April, a plunge in new orders for durable goods in March, and culminated with a first quarter GDP report dominated by the revelation of a downwardly revised growth rate of 3.1 percent, rising prices, rising inventories and slowing business investment.

Elsewhere, the data were as bad if not worse. Japan and Europe saw falls in industrial production in March, and leading indicators gave little confidence of improvements in economic outlook.

All these indicators had economists worried that what Federal Reserve chairman Alan Greenspan thought was a "soft patch" in the economy was turning into an outright downturn.

A survey of fund managers by Merrill Lynch in early May found that out of 339 managers questioned, 56 percent expected global growth to weaken slightly or a lot over the next 12 months, while only 23 percent expected a stronger world economy. And whereas in the previous month, fund managers in Asia had been relatively optimistic, they were now more negative.

Towards, the end of April, though, better news was already starting to seep through.

In the US, there was news that sales of new and existing homes and house prices rose in March. What was probably most significant in turning the tide in sentiment, however, was the very healthy increase in non-farm payroll reported for April. Retail sales also improved in April, inflation fears abated as price increases outside energy remained moderate in April and housing starts reversed the fall in March by turning up in April.

Meanwhile, in Japan, unemployment reportedly fell in March and unlike in the US, first quarter GDP turned out unexpectedly strong. And in Europe, inflation, especially core inflation, remained moderate in April.

Of course, the global economy is by no means out of the woods. The Conference Board's US leading index continued to fall in April while in Japan, the index of leading economic indicators was below 50 percent in March for a second month.

Nevertheless, the pessimism exhibited in April seems to have lifted somewhat, and this is probably best reflected in stock markets.

Around the middle of April, stock indices had made what at that time looked like decisive plunges below their 200-day moving averages -- for examples, see the charts below for the S&P 500, the Nasdaq and the Nikkei 225. This led many investors to make sell calls.



However, with the economic data becoming more benign going into May, the S&P 500 and the Nasdaq turned back up above their 200-day moving averages. Only the Nikkei 225 remains below its average.

Interestingly also, despite the weak economic data coming out of Europe in general and the UK in particular, the FTSE 100 has been resilient this year and never dropped below its 200-day moving average.

Historically, the 200-day moving average has had some usefulness in market timing. Buying stocks whenever the Dow Jones Industrial Average rises above its 200-day moving average and selling when it falls below would have enabled an investor to beat the market on a risk-adjusted basis, according to evidence provided in Prof Jeremy Siegel's book Stocks for the Long Run. Its main claim to fame, though -- as related by Siegel -- is that it would have enabled investors to get out of the market just before the 1987 crash.

However, followers who timed the S&P 500 and Nasdaq using the 200-day moving average would have been whiplashed by these markets over the April-May period. In fact, the charts above show that this would have happened quite frequently over the past year. Unfortunately, this is an unavoidable hazard with following this technique -- or at least with following this technique on its own. As Tomi Kilgore wrote in MarketWatch recently, "charts don't lie, but they can certainly change their minds".

So, too, for that matter, can fundamental economic indicators.