Question

Francisco Martin and Emma Liu are analysts at the same firm. Martin uses the cyclical indicator approach to formulate his equity market outlook, whereas Liu uses micro evaluation analysis to develop her equity market outlook. Martin and Liu have conflicting views on the current outlook for the U.S. equity market.

Martin prepares Exhibit 1, a table of recent values of deleted U.S. cyclical indicators. He makes the following observation: " Several leading indicators suggest further deterioration in economic conditions. Based on the cyclical indicator approach, these developments are clearly unfavorable for the U.S. equity market. "

Indicator	Value as of 31 December 2009	Value as of 31 March 2010
Average duration of unemployment(weeks)	18.1	18.2
Average prime rate	5.0%	5.0%
Average weekly hours of manufacturing workers	40.3	39.2
Index of consumer expectations	59.8	49.2
Labor cost per unit of output, manufacturing	124.1	125.3
Index of new private housing starts authorized by local building permits	2429	2120
Manufacturing and trade sales(in U.S. dollar billions)	989	920
Ratio of consumer installment credit outstanding to personal income	0.175	0.186
Consumer price index(inflation rate) for services	217.7	216.8
Interest rate spread, 10-year Treasury bonds less federal funds rate	2.22%	2.45%

Identify two leading cyclical indicators in Exhibit 1 that support Martin’s observation regarding the U.S. equity market. Explain how the change in value of each of these indicators support Martin's observation.

Describe two general limitations of Martin's approach to formulating an equity market outlook.

Answer 1

Identify two leading cyclical indicators in Exhibit 1 that support Martin’s observation regarding the U.S. equity market.

Two leading indicators:

• Index of new private housing starts authorized by local building permits
• Manufacturing and trade sales(in U.S. dollar billions)

Explain how the change in value of each of these indicators support Martin's observation.

• Index of new private housing starts authorized by local building permits has seen a sharp decline in just one quarter. There is more than 10% decline q-o-q. The decline in this index indicates deterioration in economic condition. In an extreme condition, this can also be seen as an onset of a reession.
• Manufacturing and trade sales(in U.S. dollar billions) have seen a similar decline albeit slightly lower. The decline is close to 9%. Such a sharp q-o-q decline in manufacturing and trade sales does indicate downturn and deterioration in economic scenario. This is also an indicator of decline in consumption.

Describe two general limitations of Martin's approach to formulating an equity market outlook.

• The cyclical indicator usually lag the actual situation by a qquarter or even more. An economic downturn may take about 3 - 6 months to get reflected in the indicators. Hence, an equity market outlook based on such lagging indicators will always be a limited and reactive outlook.
• Most of the time, just a couple of indicators will show a sharp decline or increase and not all of them. It's really difficult to gauge which indicators are more important than the others. There is no weightage system. All the indicators are treated at par in this method.