MORGAN STANLEY: 3 powerful indicators are reliable forecasters of future stock and bond returns - and 2 of them are flashing red

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MORGAN STANLEY: 3 powerful indicators are reliable forecasters of future stock and bond returns - and 2 of them are flashing red

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  • Andrew Sheets, the chief cross-asset strategist at Morgan Stanley, relies on three time-tested leading indicators to forecast stock and bond returns.
  • He employs the US ISM Manufacturing Purchasing Managers Index (PMI), the Conference Board's US Consumer Confidence Index, and initial jobless claims to gauge the health of the markets and anticipate where trends are headed.
  • Out of the three: one looks bad, one looks troubling, and one looks okay.
  • Click here for more BI Prime stories.

It's been said that the reason why Wayne Gretzky was such an elite hockey player was because he had the foresight to skate to where the puck was going, and not to where the puck had been.

That same notion holds true in investing.

Market participants often fall prey to lagging indicators, as they rely heavily on information that may no longer be indicative of where things are headed. And although metrics like the consumer price index, gross domestic product, and the trade balance are useful, they provide a clear picture of the past without much insight to what the future holds.

That's why Andrew Sheets, the chief cross-asset strategist at Morgan Stanley, thinks investors need to shift their focus onto three different indicators - ones that can anticipate trouble well before it's reflected in pricing.

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The three indicators that top Sheets' watchlist are: the US ISM Manufacturing Purchasing Managers index (PMI), the Conference Board's US Consumer Confidence Index, and initial jobless claims. And after the latest data releases, Sheets' skepticism on the bull market's longevity is increasing at a rapid pace.

"One of them currently looks bad. One is worrying. And one still looks fine but bears watching," he said in a recent client note. "They are key barometers for many of our most sophisticated asset allocation clients."

Here's a deeper, individual look at the measures Sheets is paying most attention to.

US ISM Manufacturing Purchasing Managers index (PMI)

"Because the Institute for Supply Management has been running it since 1948, the PMI provides a uniquely consistent, long-term measure of US industrial health, and plenty of data to help to gauge forward-looking implications," he said. "And at the moment, those implications are troubling."

It's no secret that investors have been fretting over the health of PMI readings. In September, the metric dropped to 47.8 - its lowest level since June of 2009. For reference, a reading below 50 indicates a contraction.

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In order to smooth out any outliers, Sheets' employs a six-month moving average to the readings - but that's not helping him sleep any better. It's currently below average, and continuing to fall.

The Conference Board's US Consumer Confidence Index

Right now, consumer confidence is riding high in the US. But Sheets thinks that investors adhering to this metric as a sign of strength are misinterpreting it.

"Markets peak when optimism peaks, and market and consumer optimism can frequently peak together," he said. "US consumer confidence made major tops in 1988, 2000 and 2007, all periods that were followed by decidedly worse-than-average equity and credit market returns."

Consumer spending makes up about 70% of the US economy, so it's important to know how consumer confidence is trending. A breakdown in confidence will often precede a slowdown in spending - and a sharp slowdown in spending portends an economic contraction.

As a result of these optimistic readings, Sheets thinks consumer confidence may be nearing an inflection point with dangerous implications.

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Initial Jobless Claims

If there's a silver lining to any of this, it's initial jobless claims. The measure has held up nicely despite recent hiccups in nonfarm payrolls data.

To Sheets, an upturn in claims could spell the beginning of the end.

"This number reflects the health of the labour market, but importantly tends to move earlier than the official unemployment rate, making it a potentially more useful indicator for stock markets that are also trying to look ahead and anticipate," he said.

The chart below depicts the slow and steady decline in the number of jobless claims from 2009's peak.

U.S. Employment and Training Administration

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With all of that under consideration, Sheets' remains skeptical on the market's future.

"All three are components of our US cycle indicator, and their readings are one of several reasons why we remain cautious on the market," he said.

He added, "Why does that matter? Short-term investors can help the market to rally over a given day or week. But the troubling signs from key long-cycle data, in our view, have made it harder for asset allocators to make a major positive shift in their exposure. This may be one reason why global equities are repeatedly failing to break out higher."

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