Economic Indicator System Says Stocks Are Low Risk

Charles Dow recognized the link between the stock market and the economy in the 1880s. He developed the Dow Jones Railroad Average as a way to measure the stock market and the broad economy. At that time, railroads were probably the most important economic sector. As industrial stocks became more important, Dow created the Dow Jones Industrial Average in 1896.

Dow’s indexes were based on the idea that industrial companies produced goods, and railroads delivered the raw materials and finished products. A bull market in stocks would require both sectors to be strong. The two indexes were combined into a trading system known as the Dow Theory that some investors still use today.

Although economic trends and long-term stock market moves tend to be related, it can be a challenge for traders to uncover that relationship.

Paul Samuelson, the first American to win the Nobel Prize in Economics, famously noted, “The stock market has called nine of the last five recessions.”

#-ad_banner-#Samuelson knew much more about economics than I do, but I think we measure success in different ways.

I want the economy to signal when stock prices are risky, and I understand the warnings will be wrong sometimes.

I am just looking for a trading edge and don’t expect a perfect forecast.

The model that I developed easily beats the results of a buy and hold investment, gaining 10.6% over the past 21 years while the S&P 500 has gained 6.5%. I use 21 years because that includes all of the available economic data.

In my mind, an important test of a system is how well it performed in the 2008-2009 bear market when the S&P 500 fell more than 55%. My economic indicator system lost 8% in that market and was back in the market at the end of April 2009, within weeks of the bottom.

This system combines data from seven different economic indicators and uses a linear regression to weight each indicator — not really the type of trading system that most individual investors can follow on their own. It requires a great deal of time and effort to maintain.

Fortunately, there are other models that offer high accuracy with only one or two pieces of economic data.

If I could only follow one economic indicator, it would probably be the new orders for manufactured durable goods, a data series updated monthly by the Census Bureau.

You could build a very simple trading system with this indicator. A simple 12-month rate of change (ROC) should be applied to the new orders data. If the ROC is positive, you would own SPDR S&P 500 (NYSE: SPY). When ROC turns negative, you would move to cash.

This indicator is usually released in the last week of the month. Taking time to calculate the ROC once a month would have helped you to beat the return of a buy and hold investment.

Historical data on new orders is available since 1992. Since then, an investment in SPY or another index fund prior to the time when the ETF started trading, would have provided a return of 7.3%, slightly more than the 6.5% gain of the index.

Right now, both of these systems are bullish. Stay invested in stocks until the 12-month ROC of new orders turns negative. Until economic conditions change, there is no reason to suspect that the bull market in stocks has ended.