Why This Indicator Is Pointing to a Strong Market in 2014

It's a new year, and Foolish investors' thoughts will naturally turn to the outlook for the S&P 500 (SNPINDEX: ^GSPC  ) and Dow Jones Industrial Average in 2014. One useful predictor of future market conditions is U.S. household net worth, because history suggests that so long as it's growing, then investors should feel optimistic about equity markets. However, when it stagnates, it's time to consider some downside protection.

The roaring 1980s
When it comes to U.S. household net worth, the warning indicator is two consecutive quarters in which the metric grows less than 1%. My earlier article goes through the basics of household net worth and outlines the evidence of its usefulness from 1960 to 1980. The graph below shows the relation between household net worth (numbers on the left-hand side) and the level of the S&P 500 (on the right-hand side).

Source: Federal Reserve, Yahoo! Finance, author's analysis.

The 1980s were notable because not once did net household worth growth less than 1% for two consecutive quarters. While this may seem unremarkable, take a close look at what happens at the end of 1987. The market experienced the famous Black Monday crash, when the Dow Jones fell more than 22% in one day in October. However, U.S. household assets weren't significantly affected, and the fact that there was no warning sign would have encouraged investors to stay in the market despite the trauma of Black Monday.

The 1990s
This graph picks up where the last one left off, marking three instances in the '90s when household net worth grew less than 1% for two consecutive quarters. These instances are marked along the blue line representing household net worth; the numbers above each instance indicate how many quarters each lasted.

Source: Federal Reserve, Yahoo! Finance, author's analysis.

The decade was a favorable environment for long investors, and although there were a few warning indicators, they weren't particularly strong, and investors' fortunes wouldn't have been significantly altered if they followed them. The important thing is to avoid significant downside.

From 2000 to 2013
This is where it gets really interesting:

Source: Federal Reserve, Yahoo! Finance, author's analysis.

While there were only a couple of minor warnings from 2000 to 2003, the market dropped significantly in that period. Clearly, market valuations matter, too, and merely following household net worth isn't enough. Meanwhile, the indicator in Q4 2007 presaged six quarters of negative growth in net household worth and would have proved a useful signal to avoid the worst of the 2008-2009 crash.

Right now, however, the current situation looks favorable, as household net worth has risen nicely over the past couple of years.

Is this indicator valid?
In conclusion, the evidence is that following movements in US household wealth is a useful way to gauge the future direction of the market. However, the 2000-2003 period demonstrates that the indicator can't be looked at in isolation. Investors will need to feel comfortable with market valuations, as well as the underlying trends in the economy.

Foolish investors will also need to consider that each recession appears to be getting more and more severe, so this kind of warning system is well worth following, because if the trend continues, then the next recession could be quite nasty.

In addition, there have been plenty of periods where the indicator didn't signal a protracted decline. However, in these cases investors would not have missed out on much upside, either. It's not a perfect science, but it's a useful metric for investors to follow, and right now, it's indicating further gains for the markets in 2014.

Which Stock Will Shine Brightest in 2014?
There's a huge difference between a good stock, and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2782859, ~/Articles/ArticleHandler.aspx, 8/31/2015 4:08:38 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Lee Samaha

Investing commentary to help retail investors outperform professionals. I research and write post-earnings analysis of leading companies. Follow me on Twitter or Google+ to receive quick and thorough earnings analysis of your favorite stocks.

Today's Market

updated Moments ago Sponsored by:
DOW 16,560.93 -82.08 -0.49%
S&P 500 1,973.62 -15.25 -0.77%
NASD 4,784.88 -43.45 -0.90%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

8/31/2015 3:58 PM
^GSPC $1973.16 Down -15.71 -0.79%
S&P 500 INDEX CAPS Rating: No stars