A recent post suggested reducing equity exposure on the grounds that monetary and leading indicator evidence has turned mixed, having been clearly positive in late 2012. This ambiguity is illustrated by two formal equity versus cash investment rules.

The first rule, discussed in several previous posts (e.g. here), invests 100% in global equities if G7 annual real narrow money growth is above industrial output expansion but holds 100% US dollar cash otherwise*.

The second rule is based on a G7 “double-lead” indicator derived here from OECD country leading index data. The rule invests 100% in equities unless the leading indicator suggests below-average economic growth.

The first chart compares the cumulative return relative to cash of the two rules with a buy-and-hold strategy. The “excess money” rule would have delivered an excess return averaging 3.6% per annum since 1970 relative to buy-and-hold. The leading indicator rule would have delivered 5.2% pa.

These returns are hypothetical because they are based on currently-available data. This is less of a problem for the excess money rule – annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals. By contrast, the leading indicator series incorporates changes over the years in the construction and constituents of the OECD’s country leading indices. Data revisions to these indices, moreover, are sometimes significant. The historical return of the leading indicator rule, therefore, is unlikely to have been achievable in practice.

The two rules are now giving an opposite signal for the first time since August 2012. G7 real money growth remains above industrial output expansion on both an annual and six-month basis, although the surplus has fallen since late 2012. Accordingly, the excess money rule is still invested in equities.

By contrast, the G7 double-lead indicator fell marginally below its long-term average in March, causing the associated investment strategy to shift into cash – second chart.

Still-solid global real money growth raises the possibility that the weakness of the double-lead indicator will prove to be a false signal that is either revised away or reversed over coming months. Greater caution, however, may be warranted until the signals from the two approaches become realigned – either positively or negatively.

*A six-month lag is applied before buying equities after a positive cross-over.