Good economic news isn’t always great news for investors

Good news keeps coming for the U.S. economy. For contrarian investors, this isn’t exactly great news.

Consumers say they feel better about the economy than they have in the past 17 years. Optimism among small-business owners has surged since the election. Jobs are plentiful and wage growth is strengthening. New data coming this week, including reports on existing home sales, new home sales and durable goods orders, should contribute to the positive trend.

Stocks have responded to the improving economy and President Donald Trump’s promises to cut regulations and reduce taxes. The S&P 500 is up 11% since Election Day and hovers near its record high. But in these heady times, it is important to remember when markets historically perform best: Not when the economy is booming, but rather when its performance is exceeding diminished expectations. A good way to measure this is the Citigroup Economic Surprise Index.

This rolling indicator measures economic data relative to forecasts. This means that, when reports such as employment, inflation and manufacturing are beating estimates, the index usually moves higher. When data fall short of expectations, Citi’s indicator typically moves lower. The index, which bounces above and below zero, has been on the upswing for months and rose to 58 last week, a fresh three-year high.

Maintaining that trajectory won’t be easy. That is because forecasters are getting more optimistic. For instance, economists surveyed in The Wall Street Journal’s latest monthly poll now expect economic growth of 2.4% this year and 2.5% in 2018. Both forecasts are up from 2.2% and 2% in pre-election surveys, respectively.

More often than not, forecasters incorrectly extrapolate recent trends for what will take place in the future. That is typically what prompts the surprise index to decline, with stocks often following suit.

Since 2003, stocks perform best in the three-month period leading up to when the Citi index hits a short-term peak. The S&P 500 often struggles when the surprise index trends lower from peak to trough, but then often rallies as the index turns higher again. Citi’s index had been in negative territory for much of an 18-month stretch through last summer. Stocks were stuck in a fairly narrow trading range over that time frame, but have risen almost 20% as the surprise index has rallied.

Since 2011, prior peaks for the Citi index have ranged between 72 and 93. If history is a guide, then this latest uptick might have more room to run—an additional tailwind for stocks in the short-run.

But the better the economy does, the more optimistic forecasters get. That means it gets tougher for data to keep beating expectations, which makes it harder for the Citi index to keep rallying.

Investors should watch this space. In this age where markets keep rallying without much opposition, this is one leading indicator worth keeping tabs on.

The Wall Street Journal

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