The Economic Surprise Chart Tells All

You’ve probably noticed that stocks have done pretty well lately. Turns out that UK vote about leaving the European Union on June 23rd wasn’t the end of the world as we know it…

In fact, if you didn’t really take a good look at what’s been going on, you might think that Brexit vote was a huge upside catalyst. After dropping to 2,000 in two days after that vote, the S&P 500 has made one of the sharpest moves ever, rallying nearly 10% in three weeks. In fact, the S&P 500 just blew past its old all-time highs by 50 points!

It probably goes without saying that this latest rally has taken a lot of investors by surprise. And it’s easy to see why. The EU may be falling apart, EU banks are definitely a mess, global growth got another downside revision, the Middle East looks like it’s falling back into the Dark Ages, Brazil is on the verge of collapse (just in time for the Olympics!), Turkey is becoming a dictatorship, and nobody knows what those negative interest rate lunatics are doing in Japan… (Man, every time I write one of these laundry lists, I have to immediately go get a cocktail.) 

You know all this. None of these are a surprise, right? The fact is, investors have been living with a lot of bad news for years now — ever since the financial crisis. New data points that show weak manufacturing growth or little in the way of wage gains don’t surprise anyone these days.  

But here’s the thing: the current market rally we’ve been enjoying has everything to do with surprises…

An Upside Surprise

One of the most difficult concepts to grasp as an investor is the interplay between expectations and reality for earnings and economic data.

For instance, a weekly jobs report showing 200,000 jobs were added might look good on the surface. But if the market was expecting 260,000, well, there’s a disconnect, and stock prices might well drop.

Rallies and bull markets form when data is beating expectations. Corrections and bear markets happen when data consistently misses expectations.

With that in mind, here’s a chart that helps explain why stocks have gone on such a ridiculous run over the last few weeks.

Click Chart to Enlarge

This is the Citigroup Economic Surprise Index (CESI). It doesn’t show you the absolute reading on any economic indicators. It doesn’t tell you how many jobs were created or if GDP is above 2%.

Instead, it shows you if various economic indicators are beating expectations or not.

In many ways, a chart that shows you to what degree investors and economists are surprised by data is more important than simply showing the absolute levels of the data. After all, if you don’t have any context for data, then it’s more difficult to know what it means. 2% GDP growth would be bad if the previous reading was 3%. But if the previous GDP number was minus 3%, well, a positive 2% would be pretty good. 

Current stock prices are always a bet about where earnings will be in the future. If the economy is improving, then investors expect earnings to be better in the future.

If the economy is weakening, then you expect earnings to fall.

Now, if you remember, in the last 12 months, we’ve seen two pretty nasty corrections. Last August, there was vicious 11% drop in about five days. And 2016 started off with a nasty 12% correction that lasted into February.

If you check the chart above, you’ll see that economic data in general was coming in weaker than expected for pretty much all of 2015 and much of this year.

But just recently, the tide turned. And ironically, it was right about the time of the Brexit vote. That’s why the market turned higher in the face of what seemed like a pretty bearish catalyst.

The Data Improves

We can even go back and see the economic reports that did it. On June 14, retail sales came in better than expected. The next day, June 15, the Empire State Manufacturing Index blew expectations out of the water. And the day after that, June 16, the Philadelphia Fed’s regional survey of business activity also blew expectations out of the water.

Then, of course, there was the Brexit vote on June 23. That proved to be the red herring. Because on June 30, just a week later, the Chicago PMI manufacturing index surged into positive territory.

ISM Services came in strong on July 6, and then there was that blowout Non-Farm Payroll number on July 8.

And just yesterday, we got some surprisingly good housing data.

Will it last? I don’t know. But I do know that expectations matter, and I would guess that most investors don’t expect the U.S. economy to truly pick up any steam. Which tells me stocks can go higher, so long as the data — and earnings — is supportive.

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.