Securinvest Financial Planners

When the stock market has rebounded as strongly as it has since March, an obvious question arises—have shares moved too far, too fast?

It’s a simple question but a very complicated one to answer. Firstly, because share prices and the economy (whilst related), do not move in synch with each other— the market makes a judgement today about what the economy will be doing tomorrow. Secondly, measuring what’s actually going on in the economy is not as easy as it looks. The indicators that economists use are a mix of forward-looking and backward-looking measures, they lead and lag. At times like these, when the economy is apparently on the cusp of recovery, the messages can be confusingly mixed.

So what should investors be looking at? Fidelity International have identified nine indicators that they believe should turn positive for there to be a lasting recovery, three from each of the three streams of the economy which need to show signs of improvement for the recovery to really take hold.

1. Industrial Recovery

Indicator 1: Shipping Rates — As most goods are shipped to their end destination, the Baltic Exchange Dry Index measures the cost of shipping various dry cargoes like coal, iron and grain around the world. As these raw materials are vital for the production of finished goods such as steel, electricity and food, the cost of transporting them is a leading indicator of future economic growth.

Indicator 2: Raw Material Prices — Copper and oil are two of the largest raw material inputs in industrial production. With 65% of all copper ending up in electrical appliances and a further 25% used in buildings for plumbing, roofing and cladding, the price of copper is an underlying indicator of industrial activity in many parts of the economy. Meanwhile, rising oil demand indicates that new infrastructure is being built, factories are being powered up and goods are on the move.

Indicator 3: Manufacturing Sentiment — The Purchasing Managers Index tracks manufacturing sentiment and is a forward looking indicator of what is really happening in the private sector economy. It tracks changes to variables such as output, new orders, stock levels, employment and prices. When it is above 50, the manufacturing sector is expanding: when it is below 50, manufacturing is in decline. The current PMI for Australia increased from 51.7 in August to 52 in September, its highest level since December 2007.

2. Financial Recovery

Indicator 1: Equity Volatility — The Chicago Board Options Exchange Volatility Index (VIX) measures the implied volatility in the developed markets, a high value corresponds to increased volatility, just as a trend downwards indicates confidence is returning to the market. In November 2008, volatility reached levels not seen since the Great Depression.

Indicator 2: Corporate Borrowing - The spread on high yield corporate bonds indicates how much risk there is that businesses will fail and default on their debt. This has a direct impact on the cost of borrowing for higher-risk companies and the risk-free rate at which Governments can borrow. This spread has narrowed dramatically since March and as a result, high-yield corporate bonds have been one of the best-performing assets of the rally.

Indicator 3: Bank Lending – The willingness for banks to lend to each other provides a great indication as to how they view their competitors and there ability to survive. As the GFC started to unfold, Governments around the world stepped in to either financially support banks or provide some form of guarantee. This was reflected in the difference between the London InterBank Offered Rate (LIBOR) and base interest rates. As this spread is now starting to normalise, we can take confidence that the banks believe they can survive.

3. Consumer Recovery

Indicator 1: Retail Sales - The most obvious measure of consumers’ willingness to spend is retail sales. This is the last link in the chain. When consumers feel safer in their job and in their home, they are likely to start spending again

Indicator 2: House Prices – Depending on which country and state you may reside, considerable wealth has been destroyed through the collapse of the housing market. Locally, there still remains some volatility in certain areas and with the upcoming reduction in first home buyer’s grant, house prices must at least stabilise if consumers are to regain their confidence.

Indicator 3: Unemployment - Unemployment in its simplest measure, the absolute number of people out of a job, is a lagging indicator. Instead, we want to look at the rate of change in unemployment. If fewer people are being laid off, that may suggest the economy is stabilising.

Where we are today?

Fortunately, the central pillar to recovery – the financial sector – looks to be in much better health than it previously was, with all indicators showing a positive trend. Banks are lending more willingly, there is less fear that businesses will default and we are seeing fewer wild swings in equity markets.

Within the industrial sector, the increase in the Purchases Manufacturing Index (PMI) is encouraging as manufacturing managers have become increasingly optimistic about future prospects in recent months. However, while an inventory rebuild is underway, the recent levelling off in raw materials prices and shipping rates suggests the expected strength of demand is yet to be confirmed.

Much of that uncertainty around end demand is because consumers still have the steepest hill to climb. In the US, improvement in retail sales and the US housing market are in contrast to unemployment that continues to rise. It would be useful to see unemployment rates stabilise to confirm a sustained recovery.