Leading Indicator: Current Rally in Equities Has Three Months Left In It

In trading equities, it is commonly said, perception is reality. That perception is often viewed through the lens of what the market consensus is expecting will happen in the near future. Investors generally see themselves as bullish if they believe the intrinsic value of a security is higher than the "experts" do, and bearish if the opposite dynamic is at play.

All of which gets ever more muddled by the fact that the 'experts' are as likely as anyone else to change their minds.

Exhibit 1: The Citigroup Economic Surprise Index (CESIYUSD) is a closely watched weighted index that compares economists' expectations for key indicators just prior to these being made public. It also measures the deviation between forecasts and actual results.

When the CESI is in the positive territory, it means that the released data is better than economists had expected. In other words, the researchers are not as optimistic on the economy as data suggests they should be. When CESI is negative, it means that the reported indicators have been worse than expectations.

The surprise index hit a nine-month high of 77.2 Monday after running continuously upward in positive territory since mid-October. A reading above positive 50 means the realities are beating expectations by what the index publishers call a "wide margin." A reading below negative 50 indicates a significant miss.

Strong Correlation between Stock Prices and the Surprise Index

The last time the surprise index gained a continuous upward momentum was during the period from December 2010 to March 2011, when economic data was soundly beating expectations on a consistent basis. Stocks were soaring higher as a result of the positive sentiment.

The index peak came on March 7 at 93.2, its highest point in five years of available data. It then turned around and plunged all the way into the deep negative territory, hitting a bottom reading of negative 112.7 in the summer, meaning economic data was much worse than expectations. Needless to say, the past summer proved a nightmare for many investors. The S&P 500 lost about 10 percent in value between late July and early August, in just a little over ten days.

Even though the surprise index moves higher whenever the gaps between realities and expectations grow wider, it cannot trend upward forever. After missing enough times, economists will inevitably begin to question their outlook on the economy and adjust their models to reflect a more bullish view of the market. Eventually, they will reach a stage where their expectations get ahead of the economic reality. And this is when numbers start to surprise investors again, this time as negative misses.

Then the cycle repeats itself. Economists lower their forecast, positive surprises increases...economists start to get comfortable with the idea that the recovery is chugging along nicely... the surprise gap narrows and negative surprises emerge.

In October, the index started its journey back into the positive territory. And, like clockwork, the stock market began moving higher.

This new round of rally indicates that right now, economists have not ratcheted up their optimism enough to match the data coming in. Analysis of previous cycles suggests that it usually takes about three months for the index to move from a peak to a valley. Assuming today's reading has reached the peak of this round, the stock market will continue to trade higher until the surprise index reaches below a reading of zero, which is unlikely to happen until at least March of 2012.

Policy Uncertainty Weighs On the Bullish Run

After the Friday payrolls came out, some started wondering whether they are getting set up for another situation where the numbers improve, people start talking of a much better growth story and in the end, it doesn't pan out.

Although the trend seems bullish, the "discretionary impulse of government policy can become a hindrance on the economy," Cary Leahey, economist at Decision Economics Inc. told the International Business Times. "And the main reason for that would be the expiration of the $110 billion to $120 billion employee payroll tax credit."

If the payroll tax cut is not extended, it will affect leading indicators such as consumer spending, and the economy would likely lose momentum in January, Leahey added.

Then there's Europe.

"Any positive news of collaboration coming out of Europe creates a decline in the risk premium and big upward movement in stocks, and anything in the other direction does the opposite," James Kee, president and chief economist at South Texas Money Management Ltd. told the IBTimes. "That's what's going to be driving the market in the next couple of quarters."

That means if we look at the market as discounted cash flows -- determining future cash flows' worth in today's dollars - any information of material importance can cause discount rate movements, in other words, increases or decreases in equity risk. And risk premium reflects the extra return investors demand because they want to be compensated for the risk in the even that the cash flow might not materialize after all.

Is The Risk-On Trade Back In Play?

Traditional asset allocation on Wall Street, the so-called model portfolio, is to put 55 percent in stocks, 35 percent in bonds and 10 percent in cash.

Leahey thinks investments in riskier assets can be profitable from time to time, as it was last week, but cautions anyone who plans on keeping that trade for the next one to eight weeks.

"I would say it is so obscure that if you had a mild overweight on risky assets, keep it. But if you were up at 75 percent, I would probably want to cut it back," he said.

Leahey also suggested not to put too much weight on the decisions of a trader-driven market.

"Imagine the most obnoxious and sharpest guy on your high school football team, that's the guy trading stocks and bonds on Wall Street," Leahey said.

"If the economy is in recovery, and companies are generating earnings, you don't want to sell the market this early into expansion. But if you are out on your skis, pull back and wait."