While there isn't a stock market crystal ball, there is a way to get a potential glimpse at what the stock market is likely to do in the future. Leading indicators move before the stock market does, giving you as an investor a window of opportunity to act. Leading indicators can indicate when the major stock market indexes are likely to turn down or usher in a period of prosperity.
Most of the time, bonds and stocks move together — as bond prices rise, so do stocks. When bond prices diverge with a stock market index, this is a warning sign that the current stock trend is likely near an end. Declining bond prices pull stock indexes lower because they are a sign of rising interest rates. On the other hand, rising bond prices signal that stocks are likely to rise as well. This relationship exists when inflation is present. When there is no inflation, known as a deflationary environment, bonds and stocks typically move in opposite directions. A change in the direction of bond prices can still be used to forecast directional changes in the stock market.
The Building Permits number released each month by the U.S. Census Bureau is a leading indicator. When the number of building permits is rising, the economy is trucking along, and stocks likely along with it. If the number begins to decline, though, it is an early sign the economy is slowing and stocks are soon to head lower, or may have already begun the descent.
As the stock market rises and falls, certain sectors perform better than others at peaks and bottoms. These sectors, representing stocks in similar lines of business, help isolate when the stock market is likely to change direction. "Consumer discretionary" stocks — companies selling things we don't need, but want — are usually the first stocks to begin performing well at a market bottom. Technology stocks usually follow shortly after, indicating the stock market indexes are on a roll and heading higher. When material- and energy-sector stocks are doing very well, a peak in stock market is likely near.
An oscillator is an analysis tool, added to a price chart, which either confirms the price direction or warns of a reversal. Common oscillators are the Relative Strength Index (RSI) and Stochastic. Using a mathematical formula, oscillators convert price movements into a fluctuating value between two extremes — usually zero and 100. Warning signals occur when the price of a stock or index is rising, but the oscillator is not. This is called negative divergence. Negative divergence indicates the price trend is weakening and the stock is likely to head lower. An oscillator rising and price dropping — positive divergence — signals the stock price is likely to stabilize and move higher soon.
Pros and Cons
If you give a stock or index at least a couple months to a year to react, leading indicator signals are quite accurate. The problem is, you don't know exactly how long it will take for a stock or index to react. The time lag between when the leading indicator signal appears, and when the stock or index follows, could be anywhere from a month to a year or longer. Leading indicators can also change direction at any time, giving you multiple signals and leaving you not knowing which signal to trust.
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