Traders are familiar with the Dow Jones Industrial Average, the Dow. It might be the most widely followed stock market index in the world. The index was developed by Charles Dow in the late 1800s and has been maintained ever since.

Even though it’s almost 120 years old, the Dow is not the world’s oldest stock market average. That honor belongs to the Dow Jones Transportation Average, or the Transports. That average was also developed by Charles Dow and was his first attempt to tie the stock market and the economy together.

Stocks generally go up when earnings are rising. This usually coincides with an expanding economy. Bear markets tend to occur during periods when earnings are falling and the economy is contracting. In this simple view, the link between the economy, earnings and stock prices is clear.

The chart below highlights this relationship. The chart below shows the Wilshire 5000 Total Market index. This index was selected because the Federal reserve provides data on the index backs to 1950. The Fed has later starting dates for more popular indexes due to licensing restrictions.

We want to use a chart generated by the Federal Reserve’s data system to include periods of recessions on the chart. The Fed data base highlights recessions with vertical grey bars on their charts. This makes it easy to spot the relationship of the data to the economic cycle.

Source: Federal Reserve

The chart above shows the 52-week rate of change (ROC) in the price of the Wilshire index. We can see that stock prices did decline during every recession, and the annual ROC actually turns negative during recessions.

The ROC has not fallen below zero for a significant amount of time while the economy was growing since 1990. This relationship is interesting, but does not directly lead to a trading strategy because we never know we are in an official recession until months after it starts.

Using Economic Data to Build a Trading Strategy

While there is a clear link between the economy and the stock market, many traders ignore the state of the economy when developing. This is unfortunate because there is so much economic data that a trader could gain an edge simply by observing the trend in the data.

Observing trends in the data provides information about two important trends.

First, a trader can gain insights into sentiment. Many stories about economic data include a phrase similar to “the report was better than expected” or “the report was weaker than expected.” Notice that these phrases have nothing to do with the data. They reflect expectations.

Expectations are based on sentiment. If analysts are bearish, they are likely to be affected by their bias. They will therefore lower their expectations for the economy. This should be bullish for the stock market.

For example, we can consider the employment which is released on the first Friday of the month except when a holiday delays the report. If analysts are bearish, they will expect few jobs to be created and unemployment to be rising.

If analysts are bullish, their bias could lead them to expect a strong economy. This would result in estimates of robust growth in the number of jobs and declines in measurements of unemployment.

When a report is stronger than expected, it is likely that traders will be forced to chase stocks in order to align their portfolios with the data. Because they had expected weak data, they are likely underweight stocks in their portfolio. The report acts as a catalyst to buy in this example.

This illustrates a subjective approach to using economic data. This approach can be useful but it is also possible to use more objective techniques. The next chart shows how economic data can be used to develop a trading strategy.

This chart shows the 52-week ROC for new orders of durable goods (the blue line) and the 52-week ROC for the Wilshire index (the gold line). The Wilshire index is used because that’s what available in the Fed’s system. This index is highly correlated with the S&P 500 and Dow and those indexes could be used in the test. The results would be similar.

Source: Federal Reserve

Durable goods are items that are designed to last, like refrigerators in your home or equipment that is used in factories. New orders for durable goods indicates that factories will be working in the future to meet those orders and an increase in new orders now should signal an increase in economic activity later.

Because it reflects future activity, new orders is a forward looking indicator. The stock market is also forward looking since traders are buying when they expect future earnings to be growing and selling when they believe earnings will be lower or growth will, at least, be slower.

In the chart, the visual relationship between the economic data and the stock market data is strong and back testing confirms that there is a great deal of value for traders in the durable goods data.

Quantitative Testing Demonstrates the Importance of Economic Data

Data on new orders for durable goods goes back to February 1992. That means we can test how well this indicator aligns with stock market moves for the past 25 years, a period that included two devastating bear markets and three strong bull markets.

The test can be designed with simple rules that any trader can follow even without sophisticated testing software or access to subscription data services.

For the test, we will hold stocks only when the ROC of durable goods is positive. We will move to cash when the 52-week ROC is negative. This simple strategy would have doubled the gains of a buy and hold investor and it would have avoided all market losses greater than 15%.

This trading system could be applied with SPDR S&P 500 ETF (NYSE: SPY) or other ETFs that track broad stock market indexes.

Now, traders often combine several technical indicators to form a trading strategy and traders that use economic analysis can also combine several indicators. The advantage of this would be to avoid short whipsaw trades and to minimize the risk of false signals.

In testing economic data, new orders for durable goods is among the indicators that are most highly correlated with changes in the stock market.

One of the most complex indicators combines 85 different data series into a single indicator. This is the Chicago Fed National Activity Index, an indicator that has historically been among the most highly correlated with the stock market. This indicator, however, is volatile and trades frequently.

Source: Federal Reserve

The chart above applied the same rules we used with new orders for durable goods. It is bullish when the 52-week ROC is above zero and bearish when the ROC is below zero. This indicator is bearish right now.

Other indicators that work well include the Institute of Supply Management manufacturing index. This indicator is bullish.

Those three indicators can form the basis of a model. Right now, with two of the indicators bullish and one bearish, the model is bullish but cautious.

Based on the economic data, it is a good idea for now to use tight stops on long positions. It is also a good time to begin adding short positions to your trading portfolio. Unless the economy regains some strength in the next few months, we are very likely in the final days of a bull market.

Traders should use several indicators in their buy and sell decisions and economic indicators should only be one of the inputs. Simple economic indicators can help identify whether we are in a bull or bear market and they should be followed by almost all traders.

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