As everyone keeps trying to call the bottom of the market, it may be helpful to go over some of the more useful, yet likely least understood, leading indicators for the markets. These so called “leading indicators” may not have been traditionally considered good predictors for equity market performance, but each has been very good at telegraphing recent market performance, and will likely be important indicators to watch for any indication that the market is turning the corner.

The Yen-Euro Currency Cross Rate
As Japan held interest rates near zero for nearly two decades and the rest of the world increased rates as economies improved over the last few years, a kind of arbitrage trade developed known as the “Yen carry trade”. In this trade, investors would borrow Japanese Yen at low interest rates, and then invest those funds in the countries paying higher rates of interest. Executing this trade puts pressure on the value of the YEN as investors flood global markets with YEN in exchange for “higher yielding” currencies like the EUR. As a result the JPY/EUR cross rate (how many Yen it costs to buy 1 EUR) has steadily appreciated over the last few years – signaling a weaker YEN. Due to the nature of this carry trade (i.e., investing borrowed money) this cross rate has become a good barometer for the market’s collective appetite for taking risk. Recently, however, this cross rate has fallen off a cliff, as investors unwind this carry trade in order to take risk off the table – just part of what the media is calling the “global de-leveraging”.

Looking at the chart below showing both the JPY/EUR cross rate and the S&P 500 Index, you can see that in early August, the JPY/EUR cross rate begun to decline dramatically two months prior to the market’s plunge in late September/early October.

Keep an eye on this cross rate over the next little while. Any signs of prolonged strength may indicate that markets are stabilizing and are willing to take on risk again.

The Baltic Dry Index
Baltic Dry Index measures the demand for shipping capacity versus the supply of dry bulk carriers (i.e., large ocean freighters that ship raw materials) – essentially it measures the price of moving major raw materials by sea. Recently, it has been a good leading indicator for general economic activity. Logically it would make sense that as economic development slows, the demand for shipping raw materials would also slow, and the Baltic Dry Index would fall.

Over the past few years, the global economy has been driven largely by the development of emerging markets and by the US real-estate market. As a result, the Baltic Dry Index has soared through 2006/2007 and peaked in June 2008, after which it went on to lose over 70% of its value by the time October rolled around, well ahead of the sell-off in the equity markets (see chart below).

The Ratio of Coincident to Lagging Indicators
The Conference Board in the US is an economic and consumer-research organization responsible for publishing a variety of economic indicators, which have become widely adopted market benchmarks. The three most popular indicators are the Composite of Leading Indicators, Coincident Indicators, and Lagging Indicators. Each Indicator is published monthly and has a number of different components. I won’t get into the components of each index in this article, but as an example the Composite of Leading Indicators is composed of average weekly manufacturing hours worked, weekly jobless claims, building permits, and the S&P 500 Index, among others. Movements in the indices are intended to correspond to changes in the economic cycle – the Leading Index rising and falling ahead of the economy, the Coincident Index in line with the economy, and the Lagging Index following the economy.

Individually, only the Composite of Leading Indicators holds any real value for investors, and even then it’s not really considered to be a good predictor of future market performance given one of its components is the S&P 500 Index itself. A better indicator may be the ratio of coincident to lagging indicators. The ratio is just simply the Composite of Coincident Indicators divided by the Composite of Lagging Indicators. The ratio helps give you an idea of when changes in the direction of the economy may occur.

For this ratio, the trend is the key. The ratio will increase when the coincident indicators are increasing at a faster rate than the lagging indicators, suggesting that the economy is still expanding. Conversely, the ratio will fall when the coincident indicators fall faster or increase at a slower rate than the lagging indicators, suggesting that the economy is slowing.

The chart below shows that the ratio peaked back in January of 2005 and held pretty much steady between 1.00 and 0.98 over the next few years. However, in September 2007, the ratio began declining rapidly, suggesting that the economy may be slowing. This may seem obvious now, but remember, back in September of 2007 the investing public was just becoming aware that sub-prime mortgages were causing problems in the credit market… and very few people were calling for a recession.

This ratio will likely make a bottom long before a prolonged recovery in the equity markets.

The Ratio of Equity Prices to Long-Bond Prices
This ratio simply shows when equity market prices may have become too overvalued or too undervalued relative to bonds. There’s no rule of thumb as to what this ratio should be, so when determining if this ratio is out of whack, we just compare its current value to what the ratio has been in the past.

There’s also no market convention for which bond and equity prices we should be comparing. Personally, I like to compare the S&P 500 Index with the iShares Lehman 20+ year Treasury Bond Fund ETF (NYSE: TLT). The TLT ETF tracks the price and yield performance of the long-term US Treasury market and is widely followed.

From the chart below, we can see that the ratio peaked back in July 2007, as equity prices reached all-time highs vs. bond prices. Since then the ratio has fallen and is currently testing the lows made back in 2002, the beginning of the most recent bull market.

A turn-around in this ratio would suggest that investors are beginning to move money out of bonds and back into equities, causing equity prices to rise and bond prices to fall.

S&P/Case-Shiller United States Home Price Index
Finally, no analysis would be complete (in this environment, anyway) without looking at what is happening to US home prices. The S&P/Case-Shiller US Home Price Index is the broadest national measure of US home prices and is released on a quarterly basis. Given that many of our current economic issues have either been caused, or at least exacerbated, by the decline in housing prices, it’s important to keep an eye on this index when looking for insight into future long-term economic and market performance.

The chart below shows quarterly data for the S&P/Case-Shiller Home Index along with quarterly data for the S&P 500 Index. Not surprisingly, home prices peaked in June of 2006 and have been steadily declining ever since. One takeaway from this chart that may be surprising to some is just how much lower home prices may go… the latest correction may be just scratching the surface.