Is the Economy Overbought?

In uptrends the overbought condition doesn't mean you should be selling, as the market can stay overbought for a long time. However, in downtrends the overbought condition is the best time to bet against the market. By the same principles, could we say that the economy is overbought and in a downtrend?

The chart above shows the yearly percent change in Industrial Production (purple) plotted against the ISM New Orders Index (green) - click to enlarge. These two series are correlated but the New Orders Index leads Industrial Production by 6-7 months as shown in the table below:

source: AAR Rail Time Indicators

Since the New Orders Index registered its high in January this year, and this reading is about as high as it goes, we can expect Industrial production to reach its high sometime in the middle of the year, which is currently happening since the series for Industrial Production is above the horizontal black line representing a level associated with the highest readings.

So we could safely say that the economy is overbought.

But is it in a downtrend? It would be in a downtrend if it didn't finish adjusting.

The black arrows in the first chart point to past recoveries. Note that usually, after the first thrust up, the series stayed in a range and, as we know, economic expansion continued.

The red arrow highlights the recovery after the recession in 1980. After reaching the black line, industrial production started falling and the economy slipped in a second recession in 1981. This seems to be a time when economy was overbought and in a downtrend.

There is a big similarity between now and then: the financial crisis. As Mr. Bernanke stated recently: "bank lending standards remain tight". Also, from the most recent FOMC minutes: "consumer credit contracted again in recent months", which is particularly indicative of weakness since consumer credit is the first to rebound in a recovery.

Magnifying the perspective of economic weakness, is the austerity hysteria that has hit the Western world, especially Europe. Paul Krugman has been writing a lot about this on his blog.

Consequently, the economy has not finished adjusting and can be considered in a downtrend.

What to do about it? Buy intermediate-term exposure to the market, since the gloomy picture described above is fully discounted by media and investor sentiment. The media pessimism on the economy is so thick that you could cut it with a knife (sentiment play- more in a future post). Also, sell long term exposure as soon as the market becomes overbought.