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April 9, 2009 – Update: ECRI’s Weekly Leading Index and the Stock Market

April 9, 2009 – Update: ECRI’s Weekly Leading Index and the Stock Market

http://cxoadvisory.com/blog/internal/blog4-09-09/

Financial market experts sometimes cite the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) as an important economic indicator, implying that it is somehow predictive of future stock market performance. According to ECRI, WLI “has an average lead of 10 months at business cycle peaks and three months at business cycle troughs…” with the most recent value summarizing any shift in overall outlook as a result of “data through the previous week.” Does this indicator usefully foretell the future of equities? Using WLI readings for 3/2/01 to 3/27/09 (423 weeks) and contemporaneous weekly S&P 500 index data, we find that:

Not being ECRI subscribers, we collect WLI data from various public web sources, such as DismalScientist. Note that ECRI releases a preliminary (revised) WLI with a one-week (two-week) lag.

The following chart depicts the behaviors of the S&P 500 index and WLI over the entire sample period. The shapes are generally similar, but the degree to which WLI leads or lags the stock market is not obvious. Because stock market behavior is an input to the WLI, two series should display some similarity.

Does the alternative visualization of a scatter plot reveal more about the relationship between WLI and stocks?

The following scatter plot relates the S&P 500 index to WLI over the entire sample period, with an exponential best-fit curve. The data indicates that the two series generally move up and down together. However, clustering of data suggests that the relationship sometimes changes (switches regimes).

Where might the regimes be within the sample period?

The next scatter plot breaks the stocks-WLI relationship into three regimes: (1) the declining stock market of 3/01-6/02; (2) the advancing stock market of 7/02-10/07; and, (3) the declining stock market of 11/07-3/09. There is a positive relationship between the stock market and WLI during both bull and bear regimes, but the bull regime appears to be more conservative (lower stock price for a given level of leading indicators). Possible explanations are:

  • When the stock market is advancing (declining), inputs to WLI tend to be optimistic (pessimistic).
  • Investors accept a lower (higher) level of risk to the economy when the stock market is advancing (declining) stock market in anticipation of reversal.

The number of data points on this plot and the prior one likely overstates reliability of any inferences, because some inputs to WLI probably do not vary weekly.

For a more sensitive view of the relationship between WLI and stocks, we compare weekly changes.

The next scatter plot relates weekly change in the S&P 500 index during the week before WLI release to change in WLI across the entire sample period. The Pearson correlation between these two series is 0.30, and the R-squared statistic is 0.09, confirming that WLI and stocks tend to move in the same direction and suggesting that weekly changes in WLI explain 9% of the variation in contemporaneous stock market behavior.

But does WLI lead the stock market, or vice versa?

The final chart shows the Pearson correlations for various WLI-stocks lead-lag relationships. As noted above, the coincident correlation (0 weeks lead-lag) between weekly changes in WLI and weekly changes in the S&P 500 index is 0.30. Offsetting the two series such that the weekly change in WLI leads the weekly change in the stock index by 1-13 weeks produces a series of correlations near zero. Offsetting such that weekly change in the stock index leads the weekly change in WLI by 1-13 weeks produces some small positive correlations, but all weaker than the coincident correlation. The argument that stocks lead WLI is stronger than the argument that WLI predicts stock market behavior, especially since ECRI releases WLI preliminary/revised readings with one-week/two-week lags.

To test whether WLI exhibits any cumulative and exploitable predictive power for stocks, we relate weekly change in WLI (as revised) to the change in the S&P 500 index from initial release to four weeks later, from initial release to 13 weeks later and from initial release to 26 weeks later. The Pearson correlations for these three relationships are 0.05, 0.06 and 0.06, respectively, all close to zero. In contrast, the correlation between the weekly change in WLI and the change in the S&P 500 index during the four weeks prior to WLI release is 0.33, again suggesting that WLI lags rather than leads the stock market.

In summary, ECRI WLI movements probably coincide with or slightly trail stock market behavior, offering no significant trading intelligence over the short or intermediate terms.

For related research, see Blog Synthesis: The Economy and the Stock Market.

October 10, 2009 - Posted by | Indicator setup

3 Comments »

  1. Owen – Great article! Thanks.

    I am surprised you find this blog. We started this blog with the original intention for private reference only… Anyway, we definitely welcome your feedback and wisdom.

    Comment by vicktorquant | October 13, 2009 | Reply

  2. A Look at ECRI’s Recession Predicting Track Record

    http://globaleconomicanalysis.blogspot.com/2009/10/look-at-ecris-recession-predicting.html

    Comment by vicktorquant | October 14, 2009 | Reply


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