Throwing economic data at a stock market is rather like throwing a surprise party for a 100-year-old. A pleasant little surprise can really lift their spirits – but surprise them too much and you could kill them.
The string of unexpectedly strong U.S. economic indicators this autumn has undoubtedly been a key driver in the resurgence of stocks from their early-October lows. But history shows that once economic surprises get too far above economists’ expectations, it usually means a period of underperformance is on the way for equities, researchers at brokerage house Brockhouse Cooper said.
“There’s one thing more cyclical than economic data: Economic forecasts,” wrote global macro strategist Pierre Lapointe and financial economist Alex Bellefleur in a report this week. “Economists usually swing between being over- and under-confident.”
The shifts in momentum in the stock market this year closely tracked these swings in economists’ sentiment. Early in the year, in response to stronger-than-expected U.S. economic indicators, economists ramped up their forecasts; the result was a string of economic data that couldn’t live up to the newly optimistic expectations (as seen in the Citigroup Economic Surprise Index, which measures the degree to which the economic data deviate from economists’ consensus estimates).
“Lower-than-expected economic releases contributed to the summer's equity decline. But [they]also led economists to revise their expectations downward once again,” Mr. Lapointe and Mr. Bellefleur said.
Those lower expectations, in turn, have been surpassed by this fall’s economic data – sending the Surprise Index sharply upward again. Stocks have gone along with the ride: The S&P 500 is up 11 per cent from its early-October low while the S&P/TSX composite is up 7 per cent – gains achieved in the face of a deepening sovereign-debt crisis in Europe.
This porridge is too hot
But the current heights of the Surprise Index – just a tad below 50, meaning the economic data have exceeded consensus estimates by 0.5 standard deviation – do not bode well for stocks, they said.
“History tells us that when the Surprise Index is above 50, one should not expect economic data to boost equities further,” they wrote. At such lofty levels, “there is more chance of economic data surprising on the downside.”
The S&P 500’s six-month average returns have historically been their lowest when the Surprise Index tops 50 – presumably because the higher expectations get priced into the market as expectations catch up with (and even surpass) the economic data. Government bonds have proven to be a much better six-month bet when the upside surprises in the economy reach their current extremes, they said.