“The road to despotism is paved with ‘fairness’”. – Thomas Sowell

Howdy, gang!  In the last installment of Know Good Things, we took an initial look into the world of macroeconomic analysis by discussing lagging economic indicators, which don’t really provide much assistance in the development of a market/economic forecast, but have value especially when trying to make sense out of the present.  Lagging indicators aren’t completely worthless because they still provide data, which we try to use in order to help make sense out of what we see going on in the world (market) around us.  Lagging indicators should confirm our personal market assessments and when they don’t we need to ask ourselves “why”?  It should be noted that we will sometimes see a divergence of lagging economic data compared to current market developments simply because of the sheer size of the economy.  It would be a folly to assume that a change in economic data will manifest itself in the markets the same way every single time.  We will always have miniscule anomalies because the markets are changing minute by minute…second by second, but economic data only changes monthly (in most instances).  Be patient and remain vigilant in your efforts to become more economically literate because it certainly can’t hurt by adding the ability of economic analysis into your developing arsenal of tools and tactics.

Today’s installment of Know Good Things will be an attempt to investigate the more “interesting” reports found on the economic calendar: leading (economic) indicators.  Bear in mind that I will be using images and examples from a while ago in order to help solidify what I’ll be attempting to explain.  I’m trying to use the most “obvious” examples to help illustrate a point and we had some extremely obvious data just prior to the economic fiasco of 2008.  Learning how to implement economic analysis into your daily/weekly market forecasts is a process that takes time and practice.  Since the majority of macroeconomic data are only reported on a monthly basis, it’s not something we can rush!

Leading economic indicators are macroeconomic events or reports that are believed to change in advance of the changes we see in the economy and by extension, the markets.  These events give us a preview of what is (likely) going to happen in the economy before the change actually takes place.  These types of indicators are carefully scrutinized by nearly every major governmental agency, political party, financial institution, as well as by us…the individual investor.  The Federal Open Market Committee (FOMC), for example, watches many of these indicators as it decides what to do about interest rates and we all know how direct the relationship (and impact) of the Federal Funds Rate is in regards to market activity!

To use an example, let’s take a look at Housing Starts, which is considered a leading economic indicator and is issued as a report every month.  A housing start is registered and ultimately reported for consideration into this announcement at the start of construction of a new building intended primarily as a residential building.  The start of construction is defined as the beginning of excavation of the foundation for the building.

As we peer into this particular report, it would be important to keep in mind the idea of “ripple effect”, which the housing starts report can create.  Contained in this report is an innate and powerful multiplier effect through the economy, and therefore across the broad markets!  By tracking macroeconomic data such as this, traders and investors alike can gain rather specific investment ideas, not to mention guidance for managing a large portfolio.  Also, keep in mind that home builders usually don’t start construction on a house unless they are somewhat confident it will sell upon (or before) its completion.  If you take the simple nature of this report and expand it then you might begin to think about the “ripple effect” the construction of a new home could have on other segments of our economy.  For example, each time a new home is started, construction employment rises, landscaping jobs increase, retail sales for appliances go up, and incomes generated from this “ripple effect” will be pumped back directly into the economy.  The housing starts report is the most closely followed report on the housing sector and it reflects the commitment of builders to new construction activity.  Since we all know what happened to our economy in late 2008 as well as why it happened, it goes without saying that the construction/housing industry is one of the largest, most vital segments of our economy.

Source: Bloomberg.com/markets/ecalendar

A careful look into the historical data of this report clearly shows a drop off in the housing starts beginning in the early to mid-part of 2007!  It also looks like it might have bottomed out in January 2009.  A comparison of this information with the broad market activity of the same time period clearly shows that the broad markets (DOW, S&P500, for example) lagged behind housing starts in both its descent and incline.  In fact, the markets didn’t fully explode to the downside until September/October 2008, but did show signs of consolidation beginning near the end of 2007.  It really doesn’t take a careful examination of this graph to see that it was decreasing long before the broad markets began their decline.  It (the “housing starts” report) began contracting while the markets were still flirting with bullishness.  It wasn’t until more than a year later that we were all informed of the major economic/market contraction which was heading our way.  This is a great example of how this type of economic data is considered a leading indicator!

If you focus solely on one leading economic indicator then you’re missing the big picture.  Since our economy is so dynamic, it would be a folly to assume that the careful studying of just one leading indicator will give us enough information to make reasonable and accurate market forecasts.  It will be to everyone’s benefit to begin keeping a steady eye on as many leading indicators as possible.  Putting the pieces together in an effort to stay on top of market activity is a steady process that will inevitably take some time to grow accustomed to.  It is time that will be well spent, however.

Other leading indicators include: New Construction (issued monthly); New Private Housing and Vacancy Rates (issued monthly); Business Sales and Inventories (issued monthly); Manufacturers’ Shipments, Inventories, and Orders (issued monthly); and Stock Prices and Yields (issued weekly and monthly).

You might notice that the last item I mentioned in the paragraph above is Stock Prices and Yields.  That’s right, the stock market is a leading indicator of the economy!  Many would argue, myself included, that the stock market and general equity prices are the best leading economic indicator that we have access to.  The only problem is that we’re generally not given very much time to assess a major economic change based on the markets because of the “human factor”.  People will always try to hang on to the status quo as long as possible before admitting that change is inevitable.

We will never be able to predict or forecast the future at a 100% level of accuracy, but with the help of certain economic indicators and a talent of reading the footprints of money (in the stock market) we can gain a full accounting of where we’ve been, where we’re at, and a reasonable understanding of where we’re heading.  Macroeconomic data is oftentimes overlooked by the individual investor, but it doesn’t need to be.  I have made it a personal effort to exploit the information we can gain through economic analysis and implement it into my normal trading routine as best I can.  I still feel like I’m learning, too!

My next installment in this series of macroeconomic articles will include coincident indicators, which rounds out the three major classifications.  I will then (hopefully) try to delve into the descriptive relationships that these categories share with the markets.  It is my sincere hope that through these articles you will be able to gain a clearer sense of macroeconomic analysis and be able to utilize it in your own trading endeavors.

Be good.  Do good.  Know good.

 

Kleiny (@KnowGoodThings)

Columbus, Indiana