The whole is always more than the sum of its parts; therefore, knowing how everything fits together is the key to understanding the stock market.

One of the most critical lessons from our previous articles is the role of inflation concerning stock market trends. This understanding is a cornerstone of successful investing.

The higher the rate of inflation, the worse stocks tend to perform. The lower it swings, the bigger the profits from stocks. As a result, for any stock market timing system to work, it has to be closely related to inflation.

We have pointed out five essential building blocks for predicting the relationship between stocks, economic growth, and inflation:

• Commodity prices
• Unemployment insurance claims
• Interest rates (real rates and the short-term/long-term interest rate spread) 
• Real P/Es, and the money supply (M1 and M2 growth)

Each building block is closely intertwined with growth and inflation. As a result, each verifies the others. Therefore, we can understand why they work, as well as how well they work.

Moreover, each indicator does a fine job of forecasting the market independently. Even if you follow only one of the indicators, year over year, you should reap marginal profits at a minimum. However, as we have pointed out in each previous article, only some indicators have a near-perfect track record for forecasting market moves.

Understanding how all five major stock market indicators fit together to form the ‘big picture’ can significantly enhance your investment strategy. By contextualizing each indicator with the others, you can make more informed decisions and potentially increase your profits. The ‘five indicators’ system can calculate how much the stock market will gain over the next twelve months, helping you plan your investments more effectively.

The easiest time to forecast the market is when all five key indicators point in the same direction, i.e., are either bullish or bearish. Then, your success is practically guaranteed. 

For instance, in early 1991, on the eve of the Persian Gulf War, all five indicators were very bullish. Commodity prices and interest rates were dropping. Unemployment insurance claims were rising, real P/Es were low, and the money supply was growing moderately. The market scored more than 30% in the next 12 months, validating the accuracy of our ‘five indicators’ system.

Let’s consider another example. In August 1987, all five of our key indicators were in the negative column. Commodity prices and interest rates were ticking up. The money supply was rapidly contracting. Real P/Es were high and rising. Unemployment insurance claims were dropping like a stone. The Dow plummeted more than 1,000 points over the next four months, confirming the accuracy of our ‘five indicators’ system even in volatile market conditions.

However, it’s important to note that the market rarely provides such clear signals. More often than not, some indicators flash bullish signals, while others warn of a stalking bear market, making it challenging to interpret the signals and make accurate predictions.

So, how do you know which indicator is the most important to follow when two or more conflict?

As we’ve presented, commodity prices are the most reliable individual stock market indicator out of the five. Why? Because they’re the rawest expression of inflation. However, even a good showing by commodity prices does not guarantee a bull market any more than a poor showing forebodes a bear market.

The real key for investors is to gain a firm grasp on how all the indicators fit together. Reaching that conclusion requires comparing all the indicators simultaneously through an equation, which is the basis of the ‘five indicators’ system.

Coming up with a single equation is challenging, even for the experts. Forecasting the market’s percentage gain over the next twelve months involves dozens of statistical calculations. The forecast is rarely correct down to the percentage point, but it does give a sure-fire big picture of what stocks will do over the next twelve months.

There’s no smoke in mirrors with the ‘five indicator’ system. Fitting the puzzle together to form the big picture takes time and common sense. Plus, you don’t need a finance degree to use it!

First, find out how much of the variation in stocks was explained by each of the five indicators independently of the others. Then, according to the data, did the other indicators fluctuate or remain the same?

For example, we discovered how much variation was explained only by factoring changes in unemployment insurance claims and not by the other four indicators, and so on. Then, weigh each indicator based on the results.

Furthermore, changes in commodity prices forecast the stock market swings better than other indicators. However, we found through regression analyses that we had to determine what commodity prices explained about stock market fluctuations that no other indicator did! And then, we weighted this information accordingly.

Historically, rising unemployment insurance claims are good for stocks. Falling and rising claims increase them. Moreover, rising commodity prices decrease projections, while falling commodity prices increase them. When commodity prices and unemployment claims send conflicting signals, commodity prices carry more weight. However, if the unemployment claims signal is more substantial, the projection will tilt in its direction.

For example, if commodity prices fall 10% (bullish signal) and unemployment claims fall 10% (bearish signal), the projection for stocks will still be good. But if commodity prices fall just 1% and unemployment claims fall 30%, stocks’ projected twelve-month performance will be just 3.44%. In other words, cash would still be your best bet.

We’ve done the same thing for the other three key indicators: real P/Es, money supply, and the interest rate. We only use the real interest rate (long-term AAA bond yields minus CPPI inflation) to simplify the interest rate indicators.

We use one indicator based on monthly M1 rather than M2 money supply growth. Why? M1 is typically a better indicator for the stock market than M2 because of its narrower focus.

To calculate the money supply indicator, we take the “absolute value” of the difference between the average monthly M1 money supply growth for the past twelve months and the forty-year average monthly change in M1 money supply growth. Absolute value means that no matter which of the two variables is more significant, we still treat the result as a positive number.

To calculate this variable, subtract the 40-year average of monthly M1 growth from the current monthly growth rate. For example, if the 40-year average of monthly growth is 0.2% and the current average is 0.3%, the value of this variable would be 0.1%.

Now for the tricky part. Suppose the average monthly change in M1 over the past twelve months was 0.2%, and the 40-year average rate was 0.3%. The equation’s result would still be 0.1%. That’s because we’re looking for the absolute value of the difference between current monthly M1 growth and the 40-year average of monthly M1 growth.

Remember, money growth is like a river. Too much or too little flow harms the economy and the stock market. Only a steady flow can guarantee success.

The faster M1 grows, the better it is for stocks up to a certain point. For example, suppose M1 was growing at a 5% monthly rate, as opposed to a monthly average rate of just 0.2%. That would be too fast for healthy economic growth. And our indicator would tip us off.

Next, note that the “big picture’s” weightings have changed. Particularly, commodity prices in our final outlook have a lesser weighting than their weighting independently considered. The lesser weighting may seem complicated, but it’s a function of the two basic rules of statistics.

Don’t forget that commodity prices best explain market swings by themselves or when all other indicators are constant. However, other indicators reflect many of the same things they do. These statistical ‘overlaps’ are weeded out when we view all indicators together. Additionally, commodity prices are more volatile than other indicators, such as real P/Es. Their smaller weighting takes this into account by making volatility less critical. The result is that the commodity prices’ relative weighting in the equation is much lower than if they were all considered by themselves.

Real P/Es, on the other hand, carry the equation’s most significant weighting. Why? Because they’re the only indicator that measures how the market values stocks. On their own, they’re probably a less effective forecaster than commodity prices. However, in the big picture, they have far less statistical overlap with the other indicators than commodity prices. And they’re less volatile. That’s why they draw a heavier weight.

Finally, add all of the weighted indicators together. The result is a ‘big picture’ that’s a pretty good projection of how much the market will go up or down in the next twelve months.

We hope you enjoyed this article! Stay tuned for more articles featuring educational content investors can use to help evolve their investment strategy.

Disclaimer: We aim to provide educational content on Substack and our company website’s News page. Any information provided must not be construed as investment advice. All investors should make investment decisions based on their investment objectives while independently performing their research.

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