The stock market is a neurotic dog

A friend of mine has an annoying yappy dog.

This dog has anxiety or something, because it flinches any time a stranger comes near it.

And it has a hair-trigger bark. Any noise outside the house gets a ten second yapping, minimum.

My friend loves the dog obviously. He thinks it keeps away burglars.

The issue, though, is that the neurotic dog thinks it detects a late-night burglar around once a month, and barks the house down. Of course there’s never really a burglar.

Anyway, my point is this: the stock market is like a neurotic yappy dog. An over-sensitive alarm system.

Yes, the stock market does spot recessions early. The first sign of a major recession is always a stock market crash. It never misses them.

But like the neurotic dog, it sees recessions where they don’t really exist. It’s perfectly normal for the stock market to drop 10% in a week, causing everyone to panic, after which… nothing happens.

The ultimate example of this is the “Black Monday” crash of 1987, the worst stock market event since 1929. The Dow crashed 22% in a day.

What caused it? Who knows. But over the next month, as traders gingerly stepped out of their underground bunkers, the world continued as normal. Soon afterwards the economy was booming. The Dow recovered all its losses fairly quickly.

Obviously we’re in a global stock market correction of our own. The MSCI world index fell 18% from September to Christmas (though it has bounced back somewhat since then).

So what are we to make of that? Which market crashes signify a recession, and which ones are false alarms?

Corroberation

My friend, the dog owner, has one of those automatic lights outside. I’m guessing if he’s ever woken up in the middle of the night by a barking dog, and the automatic light is on outside, it’s time to call the cops.

That’s what we need: another reliable indicator we can use to corroborate the stock market. If multiple indicators are flashing at once, we can take the stock market more seriously.

What we’re looking for is a signal that tells us about the underlying health of the economy. It should be forward looking, picking up important information before the information works its way through the system, and shows up in formal statistics.

That’s why I like the Leading Economic Index (LEI). It’s basically a number that combines ten of the most important leading economic indicators.

The LEI includes: consumer good manufacturers new orders, capital goods new orders, new housing units, claims for unemployment, weekly hours for manufacturing, building permits, consumer expectations for business, and credit spreads.

Here’s how the index has performed since 1960. The black line is the LEI for the United States. The shaded grey areas are recessions.


Source: The Conference Board

As you can see, the LEI always turns before recession hits. It’s a reliable early warning signal. And unlike the stock market, it’s not prone to false alarms. There’s only one example, from the late 1960s, of an LEI downturn that failed to predict a recession.

So that’s America. Now let’s take a look at the Leading Economic Index for the UK.

The blue line is the one to keep an eye on. As you can see, it’s fallen sharply since Brexit. The LEI is strongly focused on leading indicators like confidence levels, orders and the like.

Those are precisely the type of thing that’s been hit by Brexit, because business people and consumers don’t know what’s going to happen in two years’ time.

So in a sense, the LEI for the UK isn’t giving a fair like-for-like reading at the moment. These are not normal times for purchasing managers and business people.

But on the face of it, the LEI clearly seems to be forecasting a recession.

If Brexit goes badly — and all that investment is cancelled instead of just delayed — a recession is probably what Britain will get.

If May gets her deal through, and we return to some kind of normality, you’d expect all those leading indicators to improve, as deferred investments get made.

The answer

So my genius insight is that if Brexit goes smoothly, investment in Britain will probably pick up. But if it doesn’t it probably wont.

And that’s the kind of razor sharp insight you come here for.

I’ll go one better.

As we saw earlier, according to the LEI the US economy is in good nick. It’s where about 40% of the world’s stock wealth is to be found. It’s cheap and easy for UK investors to trade stocks. And stocks there are going cheap, after last month’s pullback.

So that’s the takeaway: the stock market pullback in the States looks to have been a false alarm. Valuations had gotten stretched. Now they’re back to more normal levels.

But over here, things are more dicey.

My investment newsletter, Technology Profits Confidential, has been alert to this problem for a couple of years now. It’s shown UK investors how to back the most exciting technology companies, wherever they’re found.

Click here to read my latest post-Brexit investment.

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