Wednesday, July 15, 2009

Shrinking Trade Deficit: A Bullish Sign for Stocks?

The economic fundamentals in the United States are showing signs of life. One of the latest such indicators is the shrinking U.S. trade deficit. Last week's number came in below expectations, which many se as a good sign:

July 10 (Bloomberg) -- The U.S. trade deficit unexpectedly narrowed in May to the lowest level in almost a decade... “Trade looks like it’s going to be a big plus for second quarter GDP,” said ... a senior economist at UBS Securities... “It looks like the plunge in exports is over, which is of course consistent with the goal of the economy starting to stabilize after a dramatic collapse.”

That news article didn't claim that the smaller trade gap would boost the U.S. GDP number and therefore be bullish for the stock market. But it's not a stretch that many (if not most) analysts and investors see it that way. Really, how can better "fundamentals" not be good for stocks?

If you are familiar with the Elliott Wave Principle and the writings of EWI's founder and president Robert Prechter, you already know that looking at "fundamentals" to gauge the stock market's direction is like trying to drive a car while looking through the rear-view mirror. "Fundamentals" lag the stock market, not lead it.

Consider, for example, what Bob Prechter writes about trade gap as an economic indicator in chapter 19 of his "Wave Principle of Human Social Behavior" (excerpt; italics added):

In 1988, investors became “fixated” and “riveted,” according to The Wall Street Journal, upon the monthly reported U.S. balance of trade with foreign nations. As with the other figures... is derived from outside the market. It has an apparently logical explanation: trade deficits (a negative value of U.S. exports minus imports) are bad for our country’s “balance of payments,” so they are bad for the country, so they are bad for stocks. There is only one problem: The facts are once again in direct opposition to the assumption.

Figure 19-3 reveals that in fact the trade gap has followed the rises and falls of the U.S. stock market and economy very closely, but in precisely the opposite way that economists assume. The bigger has been the deficit, the stronger have been the stock market and the economy, and vice versa. Despite countless reports that “the trade deficit is slowing economic growth,” statistics reveal the opposite experience for decades.

Bob Prechter updated that trade deficit chart for the February 2005 issue of his monthly Elliott Wave Theorist:

As demonstrated in "The Wave Principle of Human Social Behavior," economists have been on the wrong side of the trade balance figures for 30 years. The trade deficit has expanded all the while that stocks have risen.

USA Trade Deficit
This is a fact. What economists have on their side is lots of logic. When do facts contradict logic? When one’s premises are wrong. The premise that an expanding trade deficit is bad for the economy has been wrong for at least a third of a century. When the trade deficit begins shrinking again, economists will assign it a bullish value when in fact this time it will go hand in hand with the onset of a depression.

A good chart can do wonders for your understanding of the financial markets. Elliott wave analysis is a visual method, and if you liked this chart, you should see the others we have.

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