Why are stocks up 20%+ in a month? Because, for the past month, economic data has been better than expected (until this morning).
In the chart below, Bill Hester of the Hussman Funds shows how closely stock-market movements track positive and negative surprises. In Q4 of last year, the economy’s free-fall shocked forecasters who were looking for a modest decline and quick recovery (the descending blue line represents negative surprises). By March, however, forecasters had caught up with the runaway train, and their predictions called for ongoing disaster–and the economy suddenly surprised on the upside (ascending blue line).
Bill’s chart is another reminder that, in the short term, stocks do not follow the economy–they follow the direction of surprises about the economy.
Bill’s second important point is that recoveries rarely proceed in a straight line. Analysts don’t suddenly stop underestimating the economic collapse and then start underestimating the economic recovery. They keep adjusting their estimates up and down, erring on both sides, as the economy gradually begins to recover.
So don’t assume that, because we’ve had a few weeks of better-than-expected news, the news is going to stay better-than-expected indefinitely.
The rebound in the stock market has been at least partially fuelled by economic data that consistently came in better than expected last month. Some part of this rally is likely relying on the continuation of these “positive” surprises.
To track the trends in economic performance, we keep an ongoing tally of how data is announced relative to expectations – a method of analysis originally inspired by Bridgewater Advisors . Economic data that surpasses expectations gets added to a 3-month running total. Data that comes in weaker than expected gets subtracted. A rising line means that economic data is generally coming in above expectations, while a falling line means that the data has disappointed. A descending line could be the result of an economy that is not expanding as quickly as economists predict or – like in 2008 – it could be the result of an economy that is contracting at a faster rate than expected…
The red line in the graph above tracks the S&P 500 Index and it shows that stocks have recently closely tracked the trend in data surprises. The market fell along with the deteriorating surprise line last year, rallied slightly prior to improved news in December, and then rolled over again as the news weakened versus expectations in late January. In March the market rebounded along with a more pronounced persistence in favourable economic news versus expectations.
The data released in March was better (or less negative) than expected on a number of fronts. The slowdown in spending eased, there was temporary relief in the new and existing homes sales data, and sentiment measures mostly halted their steep decent of recent months…
There are a couple of reasons why the trend in the rate of data surprises could change. The first is that trends in economic surprises are very prone to reversals.
Another reason why the economic news may begin to disappoint at some point is that recoveries rarely proceed smoothly. The trends in month-to-month and quarter-to-quarter data tend to lurch forward and backward as the economy regains its footing (and at times, like in 1982, the economy can fall right back into recession).
One recent example of this was in 2002, which is shown in the graph below. The trends in economic data versus expectations were persistently better than expected from late 2001 as the economy emerged from recession that year through late spring of 2002. The S&P 500 surged by more than 20% from its 2001 low as the economy began to regain its footing and offer up positive data surprises. But by the summer of 2002 the rebound proved not robust enough when compared with economist’s expectations, and the surprise line rolled over. With stocks not yet at valuation levels that were attractive to investors, the S&P plunged along with the data surprise line.
It’s important to note that this was during a period where the economy was, in hindsight, no longer in recession, and where there were many measures that showed the economy was growing again. But the market was still tripped up at least partly because expectations had moved ahead of the economic recovery. The bear market remained unfinished, and stocks fell to new lows. This may turn out to be an important risk over the next couple of months. The economic data is certain to be uneven, which in turn may cause investors to begin to question whether an economic recovery is really at hand. Risks will likely be higher at points where the market is overbought.
Business Insider Emails & Alerts
Site highlights each day to your inbox.