A stock represents ownership in a business. Bonds represent the ability of a company to repay debts. The ability to operate a business and honor obligations depends on many factors. Although a company’s industry and management team are important, one factor drives all others–the economy.
For most people, tracking leading economic indicators is numbingly complex. With the markets’ focus flipping between how reports are interpreted and governments changing how data is measured, many glance at the latest news but remain confused on how to act. However, the economy will ultimately drive the business cycle. Therefore, we should learn how to process the data.
When facing mountains of competing data, the trick is to cut through the clutter and focus on what truly matters. With that goal, I have identified five key economic indicators and the reports that convey the data. They are:
- Inflation – Inflation measures the cost of goods and services. Inflation has a key effect on economies and markets. For economies, high inflation discourages savings and investment, leads to higher interest rates, and ultimately limits growth. In markets, higher inflation may initially lead to asset price increases, but ultimately investors will pay lower multiples and real wealth will decline. The key reports to focus on are the Producer Price Index (PPI) and Consumer Price Index (CPI). Use a moving average of the year-over-year change and watch for results that are negative (signaling deflation) or over four percent.
- Employment – People with jobs can spend and invest. Ultimately, both of these actions are needed to drive the economy. Each month, the Bureau of Labor Statistics (BLS) releases a report that shows the change in payrolls and the unemployment rate. While these statistics offer a glimpse at the labor markets, remember that employment is a lagging indicator. Recessions end before unemployment has bottomed, so those looking for a change in direction before acting will have already missed the market rebound.
- Housing – In a land of increasing house prices, banks lend and the economy booms. However, the housing game has changed. Having lived through the housing collapse, I expect banks to become more prudent for many years. Weakness in housing will lead to a drop in lending and economic contraction. Many reports track housing. New home sales and existing home sales are the most popular. However, I prefer to look at housing starts and building permits. Permits are a leading indicator and offer an assessment of housing demand. When permits are rising, house prices should appreciate as well.
- Spending – We live in a consumption-based society. As consumers increase their expenditures, the economy grows. While many surveys attempt to capture people’s feelings about the state of the economy, behavior is what counts. Look to the monthly retail sales report for an indication of actual consumer activity.
- Confidence – Although it is elusive, confidence drives everything. When people are confident, they spend and the economy grows. While many reports try to gauge sentiment, I rely upon the University of Michigan report as a proxy for consumers’ moods.
You can use this list as a guideline to help you analyze the stream of data and complex, conflicting reports. Like every other investor, you must determine which of these items you think will have the greatest effects on the economy and markets.
Sean Hannon, CFA, CFP is a professional fund manager.
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