George Bernard Shaw once quipped, "If all economists were laid end to end, they would still not reach a conclusion." 

There’s truth to Shaw’s comment—economic forecasting is tricky and imprecise. Everyone’s crystal ball is hazy, including mine.

But that does not mean all economic indicators are created equal (or rather, are equally unreliable). Some indicators are historically and statistically sound: a recession has never occurred when the Conference Board Leading Economic Index is high and rising, and an inverted yield curve has successfully predicted the last six recessions.

Today, another strong indicator is sending a clear signal, but few people are talking about it. A closer look could offer investing insights to help guide you into the New Year.

Citigroup’s Economic Surprise Index is Flashing Red

Citi’s Economic Surprise Index shows how economic data are progressing relative to the consensus forecasts of economists. Positive readings for the Index suggest economic releases have, on balance, been beating expectations. Negative readings suggest the opposite.

Why keep a close eye on this data series? There are several features I find worthy of attention:

• Surprises are what move markets
• The Index has a clear mean reverting tendency, which has paved the way for predictable outcomes in the past
• “Predictable outcomes” in the index can help investors anticipate asset flows—and that’s what the investing game is all about

Below is a graph of where the index currently stands:

The dotted lines indicate when the Surprise Index eclipses +/-50, which means an abundant amount of positive or negative surprises, respectively. Mean reversions are common once those outer bands are breached. With the current reading over 50, the expectation would be for economic data to weaken from here, relative to expectations.

Adding to the conviction of the call is the recent magenta 13 appearing on the graph. That’s derived from a technical indicator called TD Combo, which forecasts when a series is ripe for trend exhaustion (i.e. a reversal). Hedge fund traders apply it to a range of security types, including stocks, currencies, and in some cases—even economic data series. Since 2003, there have been five occasions when a 13 appeared with the series above 50, and each time saw a meaningful reversal.  

Fundamental clues may also point to weaker data ahead. Remember those hurricanes a few months ago? Well, they made September and October data messy. Bank of America notes that in September, building materials, gasoline, and deliveries of goods and supplies to affected areas drove much of the upside surprise in consumption. In October, data showed strength in furniture stores and discretionary goods, which also point to upticks in disaster relief spending. This temporary boost could fade quickly.

Alongside the positive surprises in spending, we’ve seen foreclosure and mortgage past-due rates surge (particularly in Texas and Florida), and disposable incomes fall. If the Fed hikes rates in December, and tax relief doesn’t take effect until 2019, we could see consumer sentiment start to top out.

If a Reversal in the Economic Surprise Index is Forecast, What are the Investment Implications?

If we’ve established a distinct possibility that the Economic Surprise Index could rollover soon, the next step is to establish what asset classes are affected most. In other words, show me the correlation!

Look no further than bond yields. Yardeni Research shows a strong correlation between 10-year US Treasuries and the Economic Surprise Index. In the past, when the Surprise Index snaps from positive to negative, bond yields have sunk, with the opposite effect also holding true.

If we reasonably expect the Surprise Index to turn negative, we can also expect bond yields to fall (meaning bond prices should rise). Takeaway: if you have a balanced asset allocation including bonds, now may be a valuable time to tactically rebalance by pushing up your allocation there. 

Another observation: when the economy is in “growth accelerating” mode, like we’ve seen the last few quarters—equity categories tilted to high beta and growth tend to outperform. That’s exactly what’s transpired in 2017. According to Hedgeye Research, high beta companies are up 18.3% year-to-date, while S&P 500 companies in the top 25% (quartile) of sales growth are up +23.5%. The S&P 500 is +17.3% over the same stretch.

There’s a whiff of rotation in the air. On Wednesday, the mighty FANG stocks erased $60 billion in combined market value by the time the closing bell rang—their worst day on record. Maybe tax reform progress is prompting money to move toward groups poised to benefit the most from lower corporate taxes (tech isn’t one of them). Or, maybe the rubber band has simply stretched too far on the momentum factor’s outperformance. Since the beginning of the year, momentum stocks like the FANGs have steamrolled other traditional factor groups (i.e. value, quality, low volatility, etc.).  That won’t continue forever.

As money managers begin to think about where the best opportunities will be in the year ahead, some will sit on this year’s biggest winners until year-end purely for tax reasons. However, with the Economic Surprise Index primed for a reversal, conditions are also ripe for new narratives to form.

If you’re inclined to trim some momentum from your portfolio, you’re probably looking at high beta/high growth positions that have outperformed while economic data has accelerated. Now that things may go the other way, it’s an excellent time to consider rotating into value opportunities in non-cyclical/lower beta equity categories which underperformed this year.

Also published on RealClearMarkets. Reprinted with permission. 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.