The Citi economic surprise indexes are among the most important and useful indicators developed by major research firms. The problem now is that the U.S. economic surprise index is heading lower in a hurry, signalling the distinct possibility of a slowdown and equity market weakness.
The surprise indexes are a great exemplar of second derivative growth or "change in the rate of change," one of the most important concepts in investing. The first derivative of growth describes the simple calculation we're all familiar with. A stock that has generated average profit growth of 8 per cent over five years, for instance, has earnings with a first derivative growth rate of eight.
Imagine that same stock reported earnings growth of near 12 per cent for a number of quarters in a row. The stock's profit growth is showing a change in second-derivative growth – the rate of change has moved from 8 per cent to 12 per cent.
As portfolio managers are well aware, movements in second derivative growth rates are the prime drivers of stock values. A company with a history of high earnings growth near 20 per cent per year, for instance, will not see much change in its stock value if it reports year-over-year profit growth of 21 per cent. But, a stock with a previous profit history of 5 per cent growth that reports a 7.5 per cent increase is likely to see its price increase dramatically as the value adjusts for the new, faster growth rate.
The Citi economic surprise indexes can uncover the second derivative of growth for national economies in the same way that beats and misses for corporate earnings highlight changes in the profit growth outlook for individual companies. The indexes move in accordance with economic data relative to consensus economist forecasts. If, for example, actual employment numbers come in well ahead of estimates, the surprise index moves higher.
The chart below shows the recent close (but not exact) relationship between the U.S. economic surprise index and the year-over-year change in the S&P 500. Most recently, the sharp drop in the surprise index – economic data have been weak relative to consensus forecasts – has roughly corresponded with weakness in U.S. equities.
Economists and analysts are adjusting to the waning of the reflation trade (or Trump trade, if you must) where economic growth and earnings were predicted to accelerate after the U.S. election. Aggregate earnings growth has been fine so far, but the surprise index underscores a series of weaker than expected economic data reports.
In addition, the resource stocks that were expected to be among the biggest beneficiaries from reflation are now reeling from declines in base metals prices. The S&P/GSCI industrial metals index has dropped 7.2 per cent since the beginning of March, 2017. Global bond yields, predicted to move higher as growth quickened, are moving sharply lower in another sign that investors are skeptical about the economic future.
The surprise indexes, not just the U.S. version but also the Canadian and global versions, are important to keep an eye on at all times, but they are vital in the current market environment. Without improvement or at least stabilization in the surprise indexes, there is a risk that already-expensive equity markets have much more room to fall.