The MSCI World equity index closed yesterday at a new post-crisis high and is only 5.7% below the all-time peak reached in October 2007*. Recent solid performance is consistent with two investment rules followed here.
The first rule, discussed in numerous posts in recent years, switches between global equities and US dollar cash depending on whether the annual growth rate of the G7 real narrow money supply is above or below that of industrial output. The motivation is that “excess” money growth is usually associated with asset price inflation. This rule outperformed buying-and-holding equities by 3.6% per annum between 1969 and 2012. G7 real money growth is currently still above output expansion but the two series are converging, raising the possibility of another “turn defensive” signal within the next 12 months – see first chart.
The second rule, discussed in a post in May, switches between equities and cash depending on whether the G7 longer leading indicator followed here is above or below its long-run average. The indicator is derived from the OECD’s country leading indices and is designed to predict turning points in six-month industrial output growth. A cross of the indicator below the long-run average suggests sub-trend economic growth (or worse) – equities underperform cash on average during such episodes. This rule outperformed buying-and-holding equities by 5.3% per annum between 1969 and 2012. The second chart compares the cumulative return with that of the excess money investment rule.
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 G7 longer leading indicator was above its long-run average in August but has fallen since May – third chart.
Both investment rules, therefore, currently still favour equities over cash but, if recent trends are sustained, may issue warning signals over the next 12 months. The rules, it should be noted, are designed to capture the bulk of gains during market upswings while limiting losses during downswings – they rarely mark the exact top of a bull run or bottom of a bear market.
*US dollar index. The return index including reinvested dividends is 11.4% above the October 2007 peak.
