READER QUIZ: WHICH IS WHICH?
2 September 2010 by Cullen Roche
20 Comments
In our continuing effort to decipher the ECRI’s Weekly Leading Index we decided to explore what, in our opinion, looks more like a coincident indicator than a leading indicator. This has become vitally important in recent months as this index has become the “go to” index for many investors making their investment decisions and pleading their bearish case.
We looked at the S&P 500 vs the ECRI Weekly Leading Index going back to 1968 and found an uncanny correlation. Attached below is an unlabeled chart of both. Can you tell which is which? Feel free to make your guess in the comment section:
The top chart is obviously the equity markets, but the correlation is insanely close. If you had shown me the bottom one by itself I would have told you it was the S&P 500 for sure.
TOP: S&P 500
BOTTOM: ECRI WLI
The bottom one makes a significantly higher high in 2007 over the 2000 peak, therefore it cannot be the S&P 500, although it looks a lot like the DJIA.
is the equity index part of the ECRI WLI equation?
Uh, it looks to me like the ECRI is almost entirely made up of the S&P 500.
Yes, 1 of 6 components of the WLI is stock prices.
“The WLI is based on six components: money supply, JoC-ECRI Industrial Materials Price Index, housing activity, bond market measures, stock prices, and job market measures.”
Top is definitely the S&P 500.
Bottom chart — ECRI
TPC, could you also post the chart but with much shorter time frame, let’s say from 2007 to present? That way the timescale will be more clear and we can see how much lead time ECRI has on the SP500. It seems the latest dip in ECRI has not been fully reflected in SP500 yet.
Sloppy, but this should give you an idea. Correlation looks to be near 1:1 if you ask me. Hope this helps.
Ignore the date on the S&P chart. I must have slid the dial over a bit. It is up to date so you know….
Another indicator bites the dust.
Well, not quite bites the dust, but you have to recognize that it’s very highly correlated to the equity markets so using it as an indicator is not unlike following a trend followers approach….
I believe ECRI claims to be a leading indicator of the economy, not the market. Your charts show pretty nicely that the reputation of the market as a leading indicator is as well deserved as ECRI. You might describe the ECRI as a leading indicator of the economy and coincident indicator of the market. Have you tried overlaying GDP with a lag? It might be interesting to see how well these indicators have predicted the economy and under what circumstances they vary from it.
If they sell the index as a leading economic indicator they should probably stop telling people that you can use it to trade the stock market because it’s 100% clear that it is not a leading indicator of the equity market.
+1 Alan
Of course it’s a leading economic indicator. But who gives a shit? Mish has already proven that the index is basically useless.
http://globaleconomicanalysis.blogspot.com/2009/10/look-at-ecris-recession-predicting.html
Krugman piled on:
http://www.businesscycle.com/news/press/1591/
They’ve responded to Mish accusing defamation and whatnot. So then they published a study showing that their index would help you make money in the stock market.
http://www.thestreet.com/story/10608336/1/solid-indicators-are-investors-best-friend.html
Mish recently published more on this:
http://globaleconomicanalysis.blogspot.com/2010/08/ecris-lakshman-achuthan-still-blowing.html
I think it’s clear from TPC’s charts that this thing will not help you make money no matter what. It’s a coincident indicator to the market and therefore no better than reading moving averages or something equally stupid.
One thing is for sure – I’ll bet they’ve made a ton of money from selling subscriptions to the index.
Looks like your core point is valid: ECRI is accurate and leads the economy, but it is coincident to the stock market. Enough market participants follow ECRI and other economy-leading indicators that you can’t make much money trading the ECRI.
Beware autocorrelation. Most of the factors in the ECRI also drive stock prices, that’s the problem with most of these leading indicators. However, the big decline in May & June is suspect. US Stocks were affected mainly by external factors during this period, so it makes one wonder what the weightings are.
ECRI doesn’t take kindly to criticism. CXO took down their great study of ECRI’s use as a market indicator:
http://www.cxoadvisory.com/economic-indicators/ecris-weekly-leading-index-and-the-stock-market/
Can only be found here: http://webcache.googleusercontent.com/search?q=cache%3Ahttp%3A%2F%2Fwww.cxoadvisory.com%2Feconomic-indicators%2Fecris-weekly-leading-index-and-the-stock-market%2F&ie=utf-8&oe=utf-8&aq=t&rls=org.mozilla:en-US:official&client=firefox-a
Financial market experts sometimes cite the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) as an important economic indicator, implying that it is somehow predictive of future stock market performance. According to ECRI, WLI “has an average lead of 10 months at business cycle peaks and three months at business cycle troughs…” with the most recent value summarizing any shift in overall outlook as a result of “data through the previous week.” We collect WLI data from various public web sources, such as DismalScientist. Note that ECRI releases a preliminary (revised) WLI with a one-week (two-week) lag. Does this indicator usefully foretell the future of equities? Using WLI readings for 3/2/01 to 4/16/10 (478 weeks) and contemporaneous weekly S&P 500 Index data, we find that:
The following chart depicts the behaviors of the S&P 500 Index and WLI over the entire sample period. The shapes are generally similar, but the degree to which WLI leads or lags the stock market is not obvious. Because stock market behavior is an input to the WLI, the two series should display some similarity.
Does the alternative visualization of a scatter plot reveal more about the relationship between WLI and stocks?
The following scatter plot relates the S&P 500 Index to WLI over the entire sample period, with an exponential best-fit curve. The data indicate that the two series generally move up and down together. However, clustering of data suggests that the relationship sometimes changes (switches regimes).
Where might the regimes be within the sample period?
The next scatter plot breaks the stocks-WLI relationship into four regimes: (1) the declining stock market of 3/01-9/02; (2) the advancing stock market of 10/02-10/07; (3) the declining stock market of 11/07-2/09; and, (4) the advancing stock market of 3/09-4/10. There is a positive relationship between the stock market and WLI during both bull and bear regimes, but bull regimes appears to be more conservative (lower stock price for a given level of leading indicators). Possible explanations are:
* When the stock market is advancing (declining), inputs to WLI tend to be optimistic (pessimistic).
* Investors accept a lower (higher) level of risk to the economy when the stock market is advancing (declining) in anticipation of reversal.
The number of data points on this plot and the prior one likely overstates reliability of any inferences, because some inputs to WLI probably do not vary weekly.
For a more sensitive view of the relationship between WLI and stocks, we compare weekly changes.
The next scatter plot relates weekly change in the S&P 500 Index during the week before WLI release to change in WLI across the entire sample period. The Pearson correlation between these two series is 0.30, and the R-squared statistic is 0.09, confirming that WLI and stocks tend to move in the same direction and suggesting that weekly changes in WLI explain 9% of the variation in contemporaneous stock market behavior.
But does WLI lead the stock market, or vice versa?
The final chart shows the Pearson correlations for various WLI-stocks lead-lag relationships, ranging from stocks lead WLI by 13 weeks (-13) to WLI leads stocks by 13 weeks (13). As noted above, the coincident correlation (0 weeks lead-lag) between weekly changes in WLI and weekly changes in the S&P 500 Index is 0.30. There is some indication that stocks may lead WLI by a few weeks, but these indications are all weaker than the coincident correlation. There is no evidence that WLI leads stocks, especially given that ECRI releases WLI preliminary/revised readings with one-week/two-week lags.
To test whether WLI exhibits any cumulative and exploitable predictive power for stocks, we relate weekly change in WLI (as revised) to the change in the S&P 500 Index from initial release to four weeks later, from initial release to 13 weeks later and from initial release to 26 weeks later. The Pearson correlations for these three relationships are 0.06, 0.10 and 0.09, respectively. These relationships are all small but positive, possibly indicative of some momentum. In contrast, the correlation between the weekly change in WLI and the change in the S&P 500 Index during the four weeks prior to WLI release is 0.36, again suggesting that WLI lags rather than leads the stock market.
In summary, evidence from simple tests suggest that ECRI WLI movements coincide with or slightly trail stock market behavior, offering little trading intelligence over the short or intermediate terms.
The bottom one looks even more like the Dow than it does the S&P.