A great chess master once said… “If you see a great move, look for a better one!” This wisdom is equally applicable to the strategic game of stock market forecasting. The quote resonates with the complex nature of investing, where the best move is not always the most obvious.

As the past 40 years have unfolded, we have identified two related variables that improve the overall performance of the Top 5 Stock Market Indicators “formula” in a big way:

• Unexpected Gains UG
• Unexplained Slack US

Investors can harness the power of the Top 5 Stock Market Indicators, a practical and tangible set of guidelines featured in our company website’s extensive INVESTING INTEL newsletter archive. These indicators are not just abstract concepts but fundamental data points that can equip you with the knowledge to make well-informed investment decisions, empowering you in your investment journey.

Strategic Planning

Unexpected gains, or UG, are a highly relevant data point in stock market forecasting. They measure the extent to which stocks have overperformed, showing how stocks have defied expectations based on the core Top 5 Stock Market Indicators. The concept behind UG is relatively straightforward, which should instill confidence in your understanding.

Unexplained slack, or US, is slightly more complicated, as it exclusively measures slack in the economy that’s not reflected in the other four monetary/economic variables:

• Commodity Prices
• Unemployment Insurance Claims
• M1 money supply growth
• Real Interest Rates

As we have explained in previous articles, our avid readers understand the concept of sustainable economic growth. The stock market performs best when the economy is growing steadily and sustainably. As long as there’s enough slack to allow growth to speed up without igniting inflation, the market will generally continue to move higher.

For instance, if the other four variables suggest that the economy is at its peak, but the unexplained slack indicates there’s still room for growth, it would signal investors to hold their positions. Once the slack tightens up, stock rallies tend to fizzle. In conjunction with the other four variables, unexplained slack tells us how much room the economy has to run before stock market investors should start considering their exit strategies.

Context Is Key

So, how do UG and US relate to picking stocks? Past market performance is never indicative of future gains or losses. Consequently, past performance doesn’t seem like a very relevant forecasting tool. However, it only becomes crucial when we keep all the other monetary/economic variables constant. In this context, past performance does prove to be an essential indicator for forecasting the stock market, but only in a statistical sense.

It’s important to note that relying solely on UG and US for stock market forecasting can lead to unforeseen consequences.

For example, suppose that all the conditions for a bull market are in place over two years: real interest rates are high, real P/Es are low, commodity prices and unemployment claims are dropping, and the money supply is rising at a moderate rate. On average, the market has done exceptionally well historically under such conditions; therefore, your “expected gains” should be relatively high for those two years. After all, these conditions suggest that a combination of high economic growth and relatively low inflation prevails. Hypothetically speaking, let’s say the performance of the stocks during those two years was far higher than our Top 5 Stock Market Indicators forecast. 

What does that mean? The stock market would have had a very high unexpected gain or UG in this example.

UG: No Smoke In Mirrors

Like the Top 5 Stock Market Indicators formula, UG also makes theoretical sense. False indicators and phony market timing systems always give themselves away because of one fatal flaw: They have no verifiable relationships to back them up.

How do we know that UG has a real relationship with the market and that it’s not just a meaningless coincidence?

UG is simplistically related to stocks. When unexpected gains are high, it’s a sign that stocks have gotten ahead of themselves. That’s why a high UG tends to affect the market negatively.

Remember the economic train? When the engine runs cool (earnings are growing slowly, and stock prices are down), stocks have the most room to run. But on the flip side, when the economy is running hot (earnings and stock prices are rising), the market typically peaks and hits the skids.

When UG is high, it’s a clear sign the economic train is starting to run too fast. Under such conditions, the Fed is almost certain to slam on the monetary “brakes” to fight inflation, usually by raising interest rates. And folks, that’s bad news for stocks. On the other hand, when UG is low or negative, the economic train is only beginning to pull out of the station. Stocks tend to soar under such conditions.

What About Unexplained Slack?

Unexplained slack, or US, is an indicator that’s become especially important in this century’s unique economic environment, characterized by unprecedented conditions.

The first component of unexplained slack is the twelve-month rate of change in long-term bond yields. Unfortunately, there’s no reliable correlation between stock prices and long-term bond yields. However, economic growth and bond yields have a strong and verifiable relationship. When there’s a lot of slack in the economy, there’s no inflation, and bond yields tend to fall. When slack tightens, bond yields rise in anticipation of faster inflation, indicating the economic landscape.

The second component of unexplained slack, or US, is the relative money supply growth rates. When the Fed starts pumping out money, it’s essential to understand how much is getting through to the real economy, thereby generating growth, tightening up slack, and ultimately putting an upside cap on stock prices. The two money supply measures for comparison are the six-month rate of change in M2 and the twelve-month rate of change in the narrower M1.

As explained in a previous article, Investing In Stocks: The Rule of Three, M1 and M2 money supply measures mirror each other over time. The way they measure economic slack together is timing. Statistically, M1 is the rawest measure of the money supply, comprised of only the most spendable or liquid types of money, such as checking accounts and currency in circulation. M2, on the other hand, includes less liquid forms of money, such as savings accounts and bank certificates of deposit. Generally, greater inclusion makes M2 a better indicator of what’s happening in the real economy, whereas M1’s relative narrowness makes it superior in gauging the Fed’s latest moves. In most cases, the difference between M1 and M2 growth will be slim and not too revealing of economic slack.

Wrap Up…

As with unexpected gains, unexplained slack makes logical sense. It’s not a “smoke in mirrors” indicator. The stock market runs best on an empty tank when prospects for faster economic growth without inflation are best. Under those conditions, there’s a lot of economic slack. Conversely, the market runs worst on a full tank when the economy is already running rapidly; further bursts of speed will likely ignite inflation.

And don’t forget, when you see a great stock market move, look for a better one!