THE CITIGROUP ECONOMIC SURPRISE INDEX SENDS A WARNING

It’s often useful to compare market expectations to reality.  After all, a market is not built solely on fundamental realities, but how broadly those realities are expected by investors.  When expectations are high there is the likelihood for disappointment.  When expectations are low there is a potential for upside surprise.  This has been most apparent in my Expectation Ratio which has been consistent with a dramatically improving earnings environment since mid 2009.

More recently, we’ve seen an increasing level of bullishness in sentiment surveys and analyst’s expectations.  CitiGroup tracks an economic surprise index that shows how recent economic reports have been trending versus expectations.  Throughout the last 5 years this index has tended to show a high correlation with near-term market peaks.

I calculated 1 and 2 month market returns from the initial reading of 55 – an arbitrary, but high historical data point in the series.  Going back 5 years the total returns on a one and two month basis are as follows:

1 month:  – 3.98%

2 months: -4.28%

The above data points are heavily skewed by the market crash of 2008, however, the risk/reward proves to be little improved when removing the crash data.  Markets still tend to trade lower to sideways:

1 month: -1.8%

2 months: 0.28%

Given the very high levels of bullishness and analyst expectations of economic data, we could finally be due for an equity market correction.  That’s assuming that the Bernanke Put isn’t so firmly entrenched that it overrides any and all historically reliable data….

Source: Bloomberg

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. One of my favorite traders to listen to on a daily basis is phil grande, he says he helped start the oil trading pits. He says that it is easy to beat expectations when you put the bar so low on the ground that even a baby can step over it! LOL! An analogy he used last week was about a kid who wants a new bicycle, and he keeps getting f’s on his report card, then one day he makes a D and his parents are so happy they buy him anything he wants. That is like our wall street system with thier anaylysts and earnings expectations, the bar has been set on the ground, and CNBC flips out on even the most small beating of expectations. I think his point is we should expect more than what we are being given and not settle for a bar that is on the ground.

  2. This is helpful. Interesting the index always seems to roll over in the mid 50s. In the end, I am afraid it might fall into the bucket of all other helpful analysis I’ve seen and done myself – not that useful when the Fed is guiding the markets higher.

  3. It’s starting. Zacks daily commentary is also starting to sound less bullish. The stress cracks are beginning to show, as the most bullish remove the shades. Time to start blaming everything that we’ve been ignoring. The market has so overshot, that a 10% correction may still seem pricey. So, how big will it be?

  4. One could surmize that 80% of the eventual correction ocurrs within one month of it’s start. Therefore, 45-60 day options would be the most efficient to capture this bulk? John B

  5. Well this is a tough one. These indexes have defied a lot of very smart traders for a long time now (notice I didn’t say market analysts because they aren’t putting their money where their pocket books are)…..believe it or not myself included. I suspect we are nearling a top but I would not put a position on it just yet. I caught the last two big down turns only to see the position turn back up after taking profits and stop me out at brek even. Conversly my buy strategy with the S&P 500 has turned a very hefty profit. Based on fudamentals you can’t possibly believe that the DOW or S&P should be where they are…..but I learned many years ago that my indicators know more than me and they have not signaled yet. It is simply the forces of the FED put, low volume HFT morons sitting in the wings and the fact that “bad = good” and “terrible = not as bad as thought”. No fundamental trader can possibly use any traditional or historical sentiment right now as it simply doesn’t apply.

  6. I think this market is a case of game theory. Where are investors going to put their money? If you sell stocks you get cash. We all know cash is being printed and worthless. Cant buy gold. Market is too small, might be a bubble, plus its up way too much. A home (probably the best option)? Naw cant do that just got burnt on one, ala Mark Twains cat. Tax free muni bonds? Nope some analyst told me there is going to be huge defaults. Corporate bonds? They had a good run, but rates will be going up soon. Emerging markets? Isnt that a bubble? Didnt they peak late last year? Isnt the easy money made? Commodities? Nope, have you seen the charts? They are all parabolic…plus my farmer cousin says hes planting twice as much this year. Since Im the average broker or investor and I cant buy uncorrelated assets like toll bridges and vast tracks of farm land. I guess I have to buy the tried and tested asset of US stocks. If you remember that means you are buying a share of a US business.

    Stocks will pull back and sharply, but money goes somewhere. If it doesnt, thats when we are really in trouble.

  7. This is a fantastic chart. We seem to be in new territory now where the FED and the High Velocity Trading Machines seem to be able to manipulate the market ever onward and upward.

    How relevant can fundamentals be when we have such a perfect ‘Vanilla Sky’ scenario.

    Until the call goes out ‘Tech Support’!!…

  8. BP –

    You could always short the market if you think it’s going down. At this point there is an inverse ETF for almost anything you can think of. As to commodities, yes they are high but trading them does not cost as much. Granted, you need a margin account to start, but if you are pulling out of stocks you ought to have the money for it.

    People will talk about risk and losing the farm in that ‘rigged’ market. I say show me a market not rigged and without risk at this point. By using some simple trailing stops you can pretty safely control your losses. The prices look high, to be sure, but with the leverage they offer a $1 move could get you $1000+ depending on the commodity.

    Something to consider.

  9. While USA is printing money, Stock and property will need more and more $ to pay for them. The illusion is that the more $ the stock represents is the more you are worth. While the printing presses continue the stocks will need more and more of those cheaper dollars to pay for them. That you are making money is an illusion. The rich get richer. Inflation.

    On the other side of the coin the poor who have to pay for services, food, utilities, fuel in cheaper and cheaper dollars will need more and more of them to buy the same things The poor get poorer and poorer. Deflation in the value of earned income. Printing more money will reward the rich, and punish the poor. And the share prices will continue up until America stops the printing presses. You have already been told the printing presses will go on until June. If they stop then you will have the top of the Stock market. Stingray.

  10. cullen, i am not buying your analysis, although i appreciate the effort.

    the economic surprise index seems to me to be more closely correlated with treasury yields, as opposed to equity performance.

    now, as a second derivative when yields go up, will the equity market go down as investors switch back and the opportunity cost of owning bonds increases. maybe eventually, but i think the bond market has a ways to go before that will happen.

    as for the actual chart above that i guess you prepared, as you admit, the small recent sample is heavily skewed by the 2008 crash. all of the other 5 points have positive returns if you go beyond your 1-2 month horizon.

    not to say we won’t have a correction soon, it’s just i don’t see it from this presentation.

  11. to my knowledge, no one associated with the publication of the econ surprise indicator says anything about the indicator’s relationship to equity values.

    someone had to make the analytical leap to relate one to another. i thought that someone was you judging by this post (and i thought making the relationship was mistaken). if i am wrong and the publisher of the indicator (or some analyst) does purport to establish some correlation or relationship between the two, i would be interested in knowing who that was.

  12. I can’t help but wonder sometimes if the market isn’t currently forming the right shoulder of a monstrous 2 decade long head and shoulder pattern. If so, that would tend to indicate that the current bubble (er, I mean rally or up trend) would have a bit further up to go before we see an equally monstrous “look out below” trend. But I’m no analyst and all of those silly charts sometimes get me confused, seeing patterns that couldn’t possibly be there. :-)

  13. i’m sure there is some correlation between equity prices and arod’s home run total…(both juiced?)

    cullen, this is just a small point, so no need to get testy; you quote as a source bloomberg. well i dont have a bloomie, so i just wanted to know whether bloomberg tracks this relationship, or tracks someone who tracks this relationship, as i haven’t heard of this before.

  14. I just thought it went without saying that a Citigroup economic index that measures estimates to expectations would be compared to markets….

  15. What good are historical, financial method and assumtions,
    when having changed from a free market to a government controled
    econemy. Really.

  16. I’m a bit skeptical, I mean Goldman sack’s was shorting the same investments they were promoting. Citi is no angel, However a correction is due. But at the same time when merger and aquisition are picking up the market usally rises. Anybody do charting, because I find Leland’s comment very interesting.