Using economic indicators to time the market

If you pay attention to the financial market news you may have noticed a lot of attention being focused on the slowing US/Global economy and the implications it has for financial markets. Just do a search on ‘slowing global PMI’ and watch the hours waste away. Basically, the US/Global economy is slowing which means recession is right around the corner which means financial markets will tank. That seems to be the predominant bear case now, or one of the many. There is some merit to this argument. The worst market downturns occur during recessions. The trick is that you need to know that before the recessions actually happen. In this post, I’ll point you to some research in this area then focus on just one indicator that does a decent job of forecasting recessions and how it can potentially be used as a market timing indicator on its own.

To try and predict recessions there are all kinds of metric and techniques used (ECRI, Conference board indicators, etc). You can spend many many hours looking at all of these and their histories. Believe me. Me and an investor friend have spent tons of hours looking at and studying these. And the history of indicators predicting recessions is mixed to say the least. But I won’t bore you with that here. Instead, if you’re interested, you should read this by Philosophical Economics (which I’ll call PhiloEcon) and some of the linked posts in that piece. There is some incredible work and insight in the post (pretty much anything he/she writes is worth your time). Turns out that historically, the change in the trend in unemployment rate has been a pretty good indicator of recessions. It has also been decent at signaling when the economy has come out of a recession. Below is the key chart.

Not bad. When the unemployment rate crosses above the 12 month moving average to the upside a recession is likely coming, when it crosses below the 12 month moving average the economy is out of the recession. Can this be used to time the stock market? And does it work better than other market timing indicator such as the popular 200 day simple moving average of prices? Basically, yes. You can read through the post and see how using the unemployment rate improves returns and risk over buy and hold and a trend following system. As usual, I wanted to run some numbers myself. Let’s take a look at that.

I first wanted to see how the unemployment rate indicator (UI from now on) performed on its own versus buy and hold and other trend indicators, specifically the 200 day SMA and 12 month absolute returns. I also wanted to use real investable products, including fees. I looked at returns going back to the beginning of 1999 through April 26, 2016 for the S&P500 ETF (SPY), which fortunately started in 1993. This time period encompasses two of the biggest market downturns in history. I compared buy and holding the SPY versus using the 200 day SMA, 12 month total return, and the UI to exit and enter the market. When the timing systems are out of the market they are not invested, i.e. 0% cash return. Below are the results.

Very impressive. This simple indicator delivered returns 3.4% per year greater than buy and hold and more than doubled risk adjusted returns. It also beat both other timing systems by a long shot. In addition the simple UI system produced fewer false positives and traded a lot less. Definitely worthy of consideration. You can probably see where I’ll be going next with this. In some following posts I’ll look at adding a risk free asset to the mix during times of risk-off, combining the UI with other indicators (which is what PhiloEcon has done in the GTT system), and adding some global risk assets to the mix. To give you a preview they are all better than what I’ve shown here.

Finally, before I end this post, what is the unemployment indicator saying right now. Does it support the bear case I noted in the opening paragraph. No it doesn’t. The current unemployment rate is 5.0% where the 12 month moving average stands at 5.2%. If the unemployment rate increases by 0.1% each of the next two months (April and May – remember the reported unemployment rate is for the previous month) then the rate would cross above the 12 month moving average. We won’t find out until the May unemployment rate  is reported at the beginning of June. And we’ll know this week what the April rate is. This seems unlikely but you never know. The FOMC’s own projections don’t support a change but they are notoriously poor forecasters. Others think that more realistically the end of the year would be the time frame we could possibly see a trigger. But there is no need to forecast to use the UI system. For now, if you were using this system it would be risk on still.

In summary, historically the change of trend in the unemployment rate has been a good signal to time the market. Better than the two most popular trend indicators around.