Electricity usage predicts stock direction: Paper

CNBC covers research by Mendoza Associate Finance Professor Zhi Da.

As an investor, it pays to know about power.

That's not just for deciding which oil stocks to play or whether now is the time when alternative energy can generate real returns.

Instead, tracking simple electricity usage is a helpful predictor in discerning broader market movements, according to a research paper released this month by a team at the University of Notre Dame.

"Simple year-over-year industrial electricity usage growth rate has strong and significant predictive power for future stock market excess returns in horizons ranging from one month up to one year," wrote the team led by Zhi Da and including Dayong Huang and Hayong Yun.

What they found specifically, when looking over data from 1956 to 2010 in the U.S., Japan and U.K., is that each 1 percent increase in electricity usage corresponds to a 0.92 percent decline across broad stock market measures, including the S&P 500, over the next year.

At the core is the concept of "countercyclical risk premium." Stated simply, that's the concept that the market and the business cycle, in nonextreme conditions like deep recession or runaway inflation, tend to move in different directions. Heightened electric use, then, would be considered a sign of bustling industrial production; the countercyclical would be modest stock market performance.

Recent history has been a good example, at least in a broad sense, as the U.S. stock market has roared back to life in the years following the Great Recession despite the weakest economic recovery since the Great Depression.

"High industrial electricity usage today predicts low stock returns in the future, consistent with a countercyclical risk premium." Da wrote. "Industrial electricity usage tracks the output of the most cyclical sectors."

The trend does not speak particularly well for the current state of the market.

Electricity usage in February, the most recent month for which data is available, showed a 3.3 percent gain over the same month a year ago, according to the Energy Information Administration.

"It would predict a lower than average market return from (March) this year to (February) next year," Da wrote in an email response to a CNBC.com question. "Basically, expansion today makes investors less risk (averse) and therefore they demand a lower return for investing in stocks."

In fact, Da and his team tested the electricity usage indicator against 10 other oft-used predictors including dividend-price ratio, earnings to price, book to market and others and found that only the output gap, or the difference between actual and potential output, served as a better forward-looking gauge.

"This is actually a very good paper—very thorough, properly references all the right predecessors," said Nick Colas, chief market strategist at Covergex. "When the economy is doing extremely well, future returns tend to be lower. When everybody's yelling, you should be selling. When everybody's crying, you should be buying."

To be sure, following such indicators is not without danger.

Da recommends using the trend to decide when to allocate away from stocks and into bonds. He acknowledges the practice is part of "market timing," which many investment professionals advise against.

Read this story on the CNBC website.