Trader’s Narrative

Back in April, when this rally was young, we looked at something called the Anxious Index - a sub-index of the The Survey of Professional Forecasters which has had an uncanny ability to not only find the start of recessions but also to foretell their end.

Its most recent data (3rd Quarter of 2009) shows that it has collapsed from 74.78% to under 24%. This means that if the great recession isn’t over, it soon will be. At least according to the entrails of this specific econometric indicator. While we’re on the topic of econometric data, let’s take a look at another index hosted by the Philadelphia Fed.

Its full name is [deep breath] the Aruoba-Diebold-Scotti Business Conditions Index. The ADS index was the brain child of 3 economists - hence the tongue twister of a name - and it aims to measure economic activity. But unlike most metrics which are either lagging or leading indicator, it aims to track economic activity in real time. You can get detailed information about it here.

Here is a long term chart showing all the data for the ADS index from when it began being aggregated in March 1960 to now:

We just went through the deepest correction since the mid 1970’s. Looking at the chart, I also noticed that very rarely we see spikes when economic activity screeches to a halt, before rebounding sharply back to normal. The average value of the ADS is zero. Any number below it represents a contracting economy, and positive numbers indicate a falling unemployment and positive growth. So I became curious. What if we isolated just the 6 or so lowest readings and compare how the S&P 500 behaved during those periods. You can see the charts below.

December 1960
The first instance was in May 31st 1960 when the ADS hit -2.30 and then even lower in December 1960 at -2.70. A year long rally followed with the S&P 500 index trading 28% higher:

However, by July 1962 the S&P 500 was back to 54, undoing all those gains (not shown on graph).

October 1970
The second example occurred at the end of October 1970 when the ADS fell to -2.93. The S&P 500 entered a bull phase until peaking in early 1973 at around 120 (not shown on graph):

December 1974
The deepest economic contraction happened in December 1974 when the ADS fell to -4.57. That coincides with the double bottom formation in the S&P 500 which was the bear market bottom and has never since been revisited:

May 1980
The next occurrence was in the middle of 1980 when the ADS fell to -3.51. The stock market bottomed a few months before it and by the end of the year had climbed 36%:

January 1982
Within a short time, the ADS spiked lower as the S&P 500 rally of 1980 unraveled. This was the shallowest decline in the ADS, as it fell to just -2.52. However, the stock market didn’t find a floor until months later in August:

A noteworthy difference during this instance is the inability of the ADS to clamber higher as it had before. It barely manages to climb above zero before falling into the negative again signaling a contracting economy.

Before looking at the last period covering the two spikes in late 2008 and early 2009, consider that the Philadelphia Fed acknowledges the raw data but suggests an adjustment which would eliminate the first spike in late 2008:

Their reasoning is that the contraction in September 2008 was caused by a rare confluence of 3 events: Hurricanes Gustav & Ike as well as the Boeing machinists strike (the first back to back strike in Boeing’s history).

January 2009
The most recent spike low is the worst economic contraction since the mid 1970’s. While the ADS bottomed in January, the S&P 500 didn’t until March:

Notice that the ADS hasn’t yet managed to reach deeply into positive territory. It is heading up, which means that things are not getting worse. But while it remains at or below zero, we can’t say that the economy is expanding.

Conclusions
This quick and dirty, back-of-the-envelope analysis would seem to suggest that when the ADS is able to climb decisively above zero after having spiked lower, the stock market is on firm footing. However, the ADS does truly seem to be a real time index as it neither lags nor leads the stock market. Most of the time, it seems to follow a messy path along the same direction as the stock market - at least out of severe economic contractions.