You don’t drive using just your rearview mirror. There’s a good reason for that.
Safe driving requires avoiding hazards ahead of you. This is obvious.
Yet many investors rely almost solely on rearview mirrors. Some don’t realize they’re doing that.
Let’s look at an example to clear that up.
On the first Friday of the month, investors anxiously await the unemployment report.
At 8:30 a.m. Eastern time, the report comes out. Analysts on CNBC read the numbers as quickly as possible.
They tell us this is big news for stocks. And futures on stock market indexes move quickly.
Within minutes, futures traders gain or lose billions of dollars.
But unemployment is a lagging indicator. A regression analysis finds no tradable relationship between the data and the S&P 500 Index.
This makes sense. Think of how businesses hire during a business cycle.
Why Many Indicators Lag
When a recession ends, managers are cautious.
They see more orders but wonder if the gains will last. Instead of hiring, they increase workers’ hours.
After a time, they finally believe the economy is expanding. Then they hire.
This pattern plays out in thousands of businesses.
You can already see that hiring lags the economy. Economists see the same pattern unfold as the expansion ends.
Hiring continues to increase as the recession begins. After the recession starts, we see companies lay off workers.
Statistical analysis and logic indicate there’s no link between the data and trends in stocks.
On a technical note, economic reports are revised. So it’s important to use “as reported” data in this type of analysis.
Even though unemployment reports look at the past, traders care about the data. The stock market is three times more volatile than average on unemployment report days.
The problem of lags affects almost all economic data. Very few data series look ahead.
A Few Forward-Looking Indicators
Investors want economic indicators to forecast the stock market. There are a few that do that.
These indicators include new orders for durable goods. I recently highlighted this indicator. When new orders are lower than they were six months ago, the stock market often declines.
The Manufacturers’ New Orders: Durable Goods 1-month line chart below shows the indicator is near a sell signal. The chart includes the history of the past 20 years.
Another leading indicator is the ISM Manufacturing Index. This is in the Institute of Supply Management Report on Business.
Every month, the ISM surveys factory purchasing managers. Purchasing managers are on the front line of the economy. They buy the raw materials to fill new orders.
If they buy too little, factories miss delivery deadlines and lose sales. If they buy too much, they waste money with excess inventory. Profits depend on purchasing managers knowing the state of the economy.
Other leading indicators include the weekly report on new claims for unemployment insurance and data on home sales.
It’s Not Just Economic Data
Fundamental data also lags price trends. At least most of it lags.
A company’s sales or earnings tell us what happened. They don’t tell us what will happen.
Ratios based on earnings or sales are highly correlated with past returns. But those ratios don’t forecast returns for the next 12 months. The future is more important than the past to investors.
When looking ahead, there are a few good data points. One is a company’s change in cash flow from operations (CFO).
This data has a high correlation with returns over the next 12 months. And there’s a logical explanation for that.
If CFO is growing, the company has cash to reinvest in the business. Management can reward shareholders with dividends or share buybacks. Or management can acquire other businesses.
Without positive CFO, management focuses on raising cash.
Cash flow indicators tend to forecast future returns. Other fundamental data looks backward and lags price trends.
Technical Indicators Can Also Lag
It probably won’t surprise you that many technical indicators also look backward.
Technical indicators use price data. Many manipulate closing prices. Many indicators measure the same data in slightly different ways.
For some investors, this isn’t a problem. They may want to follow trends. In that case, lagging technical indicators work well.
Lagging indicators include popular moving averages (MAs). They can help avoid large losses.
But it’s impossible to beat the market in the long run with lagging indicators.
I know that conflicts with what many analysts say. Unfortunately, that’s the truth.
There’s a simple reason some studies show MAs beating the market: selection bias.
If you change the start or stop point of the study, the results change dramatically.
In their defense, many analysts don’t understand selection bias. They believe they can use MAs to beat the market. But they’re still wrong.
In testing hundreds of technical indicators, only one group beats the market in the long run.
These are momentum indicators.
Common momentum indicators include relative strength or the rate of change.
How to Invest With Leading Indicators
Despite their weaknesses, indicators are useful for investors.
Of course, it’s best to avoid lagging indicators. It’s also best to combine indicators.
One useful strategy is to combine leading fundamental indicators with leading technical indicators. To do this, investors could consider growth in CFO and momentum.
The table below shows small-cap stocks with CFO growth of more than 100% and high momentum.
|Small Cap Stocks With CFO Growth > 100%
& High Momentum
|E. W. Scripps Co||SSP|
|NMI Holdings Inc||NMIH|
|Propetro Holding Corp||PUMP|
|The Ensign Group, Inc.||ENSG|
This approach can also include economic data. For example, only accept buy signals when new orders data is bullish.
This is a simple approach. But investing doesn’t need to be difficult.
Success simply requires using good data. Many investors fail to beat the market because they use popular ideas.
With a little thought, we can see popular indicators can’t work.
Let’s look at the price-to-earnings (P/E) ratio.
Many investors use P/E ratios. If they really worked, most investors would succeed.
The fact that something is popular is a great indication that it doesn’t work.
CFO is not popular. Neither is momentum or economic analysis. Yet dozens of academic studies show these ideas beat the market.
It requires a little more work to use unpopular ideas. But the results are worth the effort.
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader