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Positive indicators and mean reversion [ClearOnMoney]
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Commentary

Positive indicators and mean reversion

25 Mar 2011 by Jim Fickett.

Though we all tend to interpret indicator values simply as “good” or “bad”, it is best to go beyond this to a quantitative analysis when possible. Extremely high ISM manufacturing index values are actually a bad sign for the stock market. And rising stock prices are a short-term indicator for expansion, but a medium-term indicator for recession.

On Monday John Hussman warned that recent very high values of the ISM manufacturing index are not necessarily a positive sign for the stock market:

It's important to recognize that various indicators used by investors often have implications contrary to what is commonly assumed. For example, the strong ISM Purchasing Managers Index reading above 60 is widely seen as a favorable indication for stocks, yet historically, readings above about 59 have been followed by negative average returns for the S&P 500 over the short- and intermediate-term, and flat returns over a 12-month horizon. Weaker PMI readings are actually preferable, so long as they don't occur within a syndrome of pre-recession signals (rising credit spreads, flattening yield curve, weak employment growth and tepid stock returns).

To some extent this is just observing that most indicators mean-revert. I noted earlier that readings above 60 on the PMI are quite rare. That means the indicator will likely decline soon, which could dampen investor sentiment. To the basic mean reversion story Hussman adds important quantitative information, particularly on timelines.

There is a somewhat related story with business cycle indicators. Last summer I wrote about an academic paper, Evaluating the Classification of Economic Activity into Recessions and Expansions, by Travis J. Berge and Òscar Jordà at UC Davis. Berge and Jordà discuss both coincident (which I wrote about) and leading (which I intended to come back to – oops) indicators.

A very interesting point they make about leading indicators is that one must be very specific about the time frame. For example a steep yield curve (measured by the 10-year Treasury yield minus the Federal Funds Rate) is positively correlated with the business cycle 4 to 24 months in the future, but is actually negatively correlated 0 to 2 months in the future. By way of contrast, rising stock prices are an indication of expansion in the short term (about 0 to 6 months), but actually suggest economic contraction at times further out.

There are two lessons to be learned from this. One is that in contrast with much news and analysis, where new information is normally just “good” or “bad”, it pays to understand timelines and quantitative relationships whenever possible. Three cheers for Hussman, then!

The other lesson, obvious but always in need of repetition, is that good times do not go on forever. I admit that I grew pessimistic about the stock market rally far too soon, so I'll not guess on any timeline for it to end. But end it will, and with Hussman's analysis indicating a strong possibility of correction, and oil remaining quite high, it is a good time to err on the side of caution.