Breadth in economic growth fell to 88% in January, putting it below the nine-month moving average. While such a break has not prevented equity prices from moving higher in the past, Dundee Securities strategist Martin Roberge warns that the most likely scenario is what he calls a “prolonged churning phase,” with the odds of a sizeable correction rising slightly.
In order to get a jump on turns in the equity market, Dundee built a diffusion index of the OECD leading economic indicator (LEI). The firm calculated that the 35-country index leads the OECD LEI and equity market turns by roughly two quarters.
From a 100% reading in October 2009, the OECD diffusion index dropped to 88% in January, below the nine-month moving average of 97%. Mexico, India, Brazil, Greece and Norway had decling LEI.
“This deterioration in economic breadth is meaningful as the expected return for equities drops markedly when our diffusion index drops below the 9-month average,” Mr. Roberge told clients, noting that the six-month forward return drops from 6.5% to 1.8%.
Market corrections of 10% or more typically occur when the OECD diffusion index has broken below the 9-month moving average, he added.
This break should serve as a reminder that investors should take profits on strength throughout the year. With the relative strength index on the S&P 500 and the S&P/TSX composite above 70, and both indexes again trading near 15x forward EPS, Mr. Roberge said such an opportunity has arrived.
“We recommend investors wait to redeploy fresh cash. Otherwise, profit-taking activities or rotation into industry laggards seem a more pragmatic strategy at this point. Thus, investors should not chase price break-outs, but should expect more market churning and work with higher probabilities of a sizeable market correction later this year.”