the wsj guide to the 50 economic indicators that really matter: from big macs to "zombie...
TRANSCRIPT
THEWALLSTREETJOURNALGUIDETO
The50EconomicIndicatorsThatReallyMatter
FromBigMacsTo“ZombieBanks,”theIndicatorsSmartInvestorsWatchtoBeattheMarket
SimonConstableand
RobertE.Wright
Contents
CoverTitlePage
Introduction
Consumption(C)Chapter1.AutomobileSalesChapter2.ChainStoreSalesChapter3.ConsumerSentimentChapter4.ExistingHomeSalesChapter5.UnderemploymentOrSlack
Investment(I)Chapter6.Book-to-BillRatioChapter7.CopperPriceChapter8.DurableGoodsOrdersChapter9.HousingPermitsandStartsChapter10.IndustrialProductionandCapacityUtilizationChapter11.InstituteforSupplyManagement(ISM)ManufacturingSurveyChapter12.InstituteforSupplyManagement(ISM)Non-ManufacturingSurveyChapter13.JoC-ECRIIndustrialPriceIndexChapter14.LondonMetalExchangeInventoriesChapter15.PersonalSavingsRateChapter16.UnitLaborCosts
Government(G)
Chapter17.FederalGovernmentBudgetDeficitsandtheNationalDebt
NetExports(NX)Chapter18.BalticDryIndexChapter19.BigMacIndexChapter20.CurrentAccountDeficitChapter21.OilInventoriesChapter22.TankanSurveyChapter23.TicData
MultipleComponentsChapter24.BeigeBookChapter25.CrackSpreadChapter26.CreditAvailabilityOscillatorChapter27.FederalFundsRateChapter28.FertilityRatesChapter29.GrossDomesticProduct(GDP)perCapitaChapter30.LiborChapter31.M2MoneySupplyChapter32.NewHomeSalesChapter33.PhiladelphiaFed:TheAruoba-Diebold-ScottiBusinessConditionsIndexChapter34.PhiladelphiaFed:BusinessOutlookSurveyChapter35.RealInterestRatesChapter36.ShortInterestChapter37.Russell2000Chapter38.WeeklyLeadingIndexChapter39.YieldCurve
Inflation,Fear,andUncertaintyChapter40.GDPDeflator
Chapter41.GoldPriceChapter42.MiseryIndexChapter43.ProducerPriceIndexChapter44.RetailInvestmentActivityChapter45.CreditSpreads:TheRiskStructureOfInterestRatesChapter46.TedSpreadChapter47.Texas“ZombieBank”RatioChapter48.TIPSSpreadChapter49.CBOEVolatilityIndex(Vix)Chapter50.VixenIndexConclusion:PuttingItAllTogetherAppendix:UsefulEconomicIndicatorsWebsitesSelectedBibliographyAcknowledgmentsAbouttheAuthors
CopyrightAboutthePublisher
Introduction
THISBOOKISABOUTeconomicindicators.Itmustbe—itsayssoonthecover!Butit’smorethanthat.It’sabouthelpingyouprotectyourmoney.Nomatterhowmuchorhowlittlethatis,youdeservetokeepitand,withalittleluckandalotofsavvy,seeitgrow.Thebestwaytodothat,wethink,istowatchtrendsindata.Notjustafewkeymetricsfollowedbyeveryone(yes,thosetoo)butawholeslewofthem,manyofwhichmostpeoplehaveneverheardof.Wethinktoreallyhaveanedge,investorsneedtogetcreative,maybeevenalittlewacky,andlookattheeconomynotjustoutsidetheboxbutinsidethediner,thefast-foodrestaurant,andoutonthestreet.You’llseewhatwemeanbythatlateron,neartheendofthebook.AnyonewithanyinvestmentportfoliowhatsoeverknewpainwhentheGreat
CreditCrunchhurledstockmarketsintoturmoilin2008andinto2009.Investorslargeandsmallwatchedwhiletheirwealthshrankbytheday,andsometimesevenbythehour.Thisbookisaboutyounotlettingthathappenagain.Toachievethatwe’ll
showyouhowtheeconomicindicatorswe’vechosencanhelpyouseetheturnsintheeconomybeforetheyhappen.Withthatprescienceyoucanthenmakechangestoyourinvestmentsaheadoftimeandavoidthesufferingyouprobablyfeltduringthepastcoupleofyears.Protectingone’snestegginthiswayiscrucialtoinvestingsuccess.Afterall,
whatisthesenseofbeatingthemarketforfive,ten,ortwentyyearsonlytohavethemarketbeatyousenselessinafinancialcrash?Andaftertheuglinessisover,willyouhavetheforesightandthegutstojumpbackinwhilethegettingisstillgood?Thefinancialcrisisof2008–9anditsaftermathsuggestthatmostinvestorswereinsufficientlynimblebecausetheywerelookingatwhattheeconomywasratherthanwhatitwouldbecome.Whilecollectivelytheseinvestorslosttrillionsofdollars,theproblemisthat
manyappeartobenowiserabouttheeconomyorinvestingthantheywerebeforethecrisis.Theyseemdestinedtoplayittoosafewhentheyshouldbemakingriskytrades,andmakingriskyinvestmentswhentheyshouldbeplaying
itsafe.Inessencetheywillbuyhighthenselllow,andtheneventuallybuybackhighagain.Thatistheexactoppositeofaprofitableinvestmentstrategy.Suchanunhappyoutlookforinvestorswillremainthesame—unless,thatis,
theydigestthelessonsofthisbook,whichaimstoteachinvestorshowtoinvestacrossthebusinesscycle,notjustwhenpricesarerising.Inotherwords,thisbookintendstoprovideinvestorswithsophisticatedwaysofthinkingabouttheeconomy,nottoleadthembythenosetospecificinvestments.Youknowtheparableabouthowgivingamanafishonlyfeedshimforaday,butteachinghimhowtofishfeedshimforalifetime?Thesamegoesforinvesting.
UsetheClues
Discerningtheeconomy’sdirection—whetheritwillsoar,plummet,orstagnate—maysounddifficult,anditcertainlyisn’teasy,buttheeconomycan’thelpbutconstantlyprovidestatisticalcluesaboutitshealth.Thosecluescanbeseenusingeconomicindicators.Some,calledleadingindicators,pointtowheretheeconomyisheading.Others,calledcoincident,providecluesaboutitscurrentposition.Yetothers,so-calledlaggingindicators,telluswheretheeconomyhasbeen.Leadingindicatorsprovidethemostobviousbasisforprofit-makingideas,butconcurrentandlaggingindicatorsareimportant,too.Incaseyouhaven’tsensedityet,atthepointsatwhichwediscussspecific
investmentstrategiesandnotjustsimpleeconomics,wethinkmostlyaboutintermediateandlong-terminvesting,notdaytrading,foreignexchangedealing,derivativesswapping,orotherformsofshort-termspeculation.Thatsortofstuffisbestlefttotechnicalanalysts,computers,andlargesophisticatedplayers.Whowecanhelparepeoplewhowanttouseeconomicdataandindicatorsto
discernwhatisactuallygoingtohappentotheeconomynextmonthornextyearandinvestaccordinglynowtoreapgainslater.Ifyoulookaroundenoughbookstores,you’reboundtoencounterotherbooks
oneconomicindicators,includingonethatpurportstounlocktheirsecretcluesandatleastonethatexplicitlyaimstohelppeoplewithbelow-averageintelligenceunderstandsomeofthemostcomplexconceptsknowntohumanity.Wemakeneitherclaim.Thisbookiscertainlynotfornovices,butatthesame
timeyoudon’thavetoalreadyhaveaPhDineconomicstounderstandit.Italsocontainsno“secrets.”Theinformationcontainedinthisbook,thoughoftenobscuretosomepeople,
ismostlyreadilyavailable.Allwehavedoneistofind,compile,andexplainitinwhatwehopereaderswillfindasuccinctandentertainingway.Wealsobelievethatpeoplehavetodoatleastsomeresearchandforecasting
ontheirown.Awet-behind-the-earsbeginnercan’ttellthedifferencebetweenatrueexpert,aquack,andaknave.Soitisimportanttodevelopsomeexpertiseofyourown.
TheFantastic50
Whenwedecidedtoputtogetheralistofindicatorstohelpreadersunderstandwhatwasgoingonintheeconomywewantedtodeveloponethatcoveredtheentireeconomy.Wealsodecidedtoexcludesomeofthebigindicatorsthatyou’velikelyheardof.Soyouwon’tfindtheCPI(theConsumerPriceIndexmeasureofpriceinflation)inourlistbecauseeventhosewithjustacasualinterestintheeconomyhaveheardofthatcommonmeasureofinflation.Knowingwhateveryoneelseknowswillnotputyouaheadofthepack.Insteadyouneedtolookbeyondtheobvious.That’swhyourlistismostly
welloffthebeatentrack.Theindicatorsincludedcanhelpyouunderstandwhereinflation(andnotjustconsumerprices),GDP(grossdomesticproduct,themeasureoftheentireoutputofgoodsandservicesintheeconomy),and(un)employmentaregoingnext—butbeforetheygothere.Iffiftysoundsdaunting,keepinmindthattheeconomyisashape-shifting
beastbestexaminedfrommanyanglesandmultipleperspectives.Someperspectivesaremoreimportantthanothers,butallhelptoprovideamorenuancedandtexturedportraitofthebusinesscycle.Andyoureallydoneedasophisticatedportraitoftheeconomybecausethereisnoone-size-fits-allindicator.Manyindicatorsmovewildlyupanddownfrommonthtomonthforrandom
reasons,suchasafreakstormoraflukeorder.Moreover,duetopressuretoputnumbersoutquickly,manyindicatorsaremerelyguesstimatesthatwillberevisedlater,sometimesdrastically.Finally,manyindicators,likehousesales,havetobeseasonallyadjusted.Adjustmenttechniques,however,arefarfromfoolproofandmayover-orundercompensateforseasonalfluctuations.Analyzingaselectionofcarefullychosenindicatorsisabetterwayofsorting
outwhat’sknownas“statisticalnoise.”Theintuitionbehindourviewthatmanyindicatorsshouldbeconsultedissimple:themoreindicatorsthatpointinthesamedirection,themorelikelytheyarepointingtoarealeconomicphenomenonandnotarandomorseasonalchange.Weconsidertheindicatorswechosetobethebestbasedonfoursimplecriteria:
1.Timeliness:Iftheinformationisstalebeforeitisavailable,whybother?2.Accuracy:Ifthedataisunreliableorisfrequentlyrevised,whybother?
3.Exoticness:Ifmostinvestorsalreadyknowanduseit,whybother?4.Degreeoflinkagetotherealeconomyorthepracticalworldofinvesting:Ifitdoesn’ttelluswherethingsaregoing,wheretheeconomyisnow,orwhereithasbeen,whybother?
Havingspentacombinedperiodofoverhalfacenturyengrossedineconomicsandeconomichistory,wehadagoodsenseofwheretostart.Butthatalonewasn’tenough.Likeanyoneelsewearepronetohumanerror.Soweaskedcolleagues—journalists,financialmarketprofessionals,andacademics—toseewhattheythoughtofourlist.Wetooknoteoftheircommentsandmadethenecessarymodifications.Wearegratefulfortheinput.Onethingwenoteaboutourselectionprocess:Evenamongthepeoplewe
know—peoplewhospendallday,everyday,thinkingabouteconomicsandinvesting—noonewaspreviouslyawareofeveryoneoftheFantastic50.That’sright.Itseemedtherewasasurpriseforeveryone—aChristmascomeearlyforeconomistsifyoulike.Inshort,ifyouwanttoknowwheretheeconomyhasbeen,whereitis,and
whereitisheaded,starthere!
HowThisBookWorks
WedescribeourFantastic50inastandardizedfour-partformat.Section1providesashortdescriptionandsection2atimeseriesgraphorotherillustration.Section3iscalled“InvestmentStrategy”andprovidestipsonhowtousetheindicator.Finally,section4brieflysummarizestheindicator’skeyaspectsandprovidesashortdiscussionofwheretogetthedata.ThemostfamousequationinphysicsisEinstein’sE=MC2.Theequivalentfor
macroeconomicsisGDP=C+I+G+NX.ThisequationrepresentsthecomponentsofGDP,themostwidelyacceptedmeasureofeconomicactivityintheeconomy.Moreplainly,ittellsushowmuchstufftheeconomyproducedinagivenquarteroryear.Withthatequationinmindwearrangedourindicatorsalphabeticallywithin
thosebroadcategoriesofconsumption(C),businessinvestment(I),1government(G),andnetexports(NX).Thosecomponentsencompasseverythingthathappensinaneconomy,andwehaveindicatorsforeachone.Wealsoputtogetheranadditionalcategoryforindicatorsthatpoint
simultaneouslytomultipleGDPcomponents.Ontopofthatweincludedafinalcategoryforindicatorsthatpointtoinflation,fear,and/oruncertainty.Whilethiswayoforganizingthematerialwillbeintuitivetoanyonewhohastakenbasiccoursesineconomics,italsomeansthatthebookbeginswithsomeofthemoretechnicalindicators.Thoseinterestedinthesexierchaptersshouldnotfret,however,astheendingisspicierandcanbeskippedtoatanytimewithafewflicksofthethumbandforefingerorclicksonthecomputerkeyboard.TheFantastic50isnotalinearnarrativethatmustbeencounteredpagebypagebutratherawebthatcanbeexploredatwill.Aspartofourresearchforeachindicator,weinterviewedseasoned
professionalswhoareintimatewithhowdifferentstatisticsreflectchangesintheunderlyingeconomy.Youwillfindquotesandexplanationsfromthemtogiveyouthebenefitoftheirwisdomandtohelpgiveyouathree-dimensional,texturedviewoftheeconomyingeneralandinvestinginparticular.Asyouwillsee,wecastournetwideinthisendeavor.WehavealsoembeddedourFantastic50withafewhelpful“apps.”Forfaster
reference,eachindicatorisclearlylabeledasleading,coincident,lagging,orsomecombinationthereof.Cross-referencestorelatedorsimilarindicatorsare
prominentlydisplayedtoo.Finally,attheendofeachindicatoryou’llfindan“ExecSummary”boxthatconciselyreviewssevenofitsmostimportantattributes:
•Whentolookforthedata.•Wheretolookforthedata.•Whattowatchforinthedata.•Whatthatmeansintermsoftheoutlookfortheeconomyoraparticularsector.•Whattodotomakeyourselfsomemoneyortopreventyourselffromlosingsome:Someoftheadviceisveryspecific,likewhatinvestmentdecisionstomakeunderwhatcircumstances.Someofitismoregeneric.Inthesimplestterms,makesaferinvestmentswhentheeconomyisgoingintoarecessionandriskieroneswhenitiscomingoutofaslump.We’vealsoaddedamoretechnicalnoteatthebottomofthispagetohelpexplainotheraspectsfurther.2
•Riskleveloftheinvestmentstrategysuggestedabove.•Profitpotentialofassumingtherisksdescribedabove,whereeach$representsupto10%annualreturn:Riskandrewardareofcoursepositivelycorrelated—thehighertheriskassumed,thehigherthepotentialreward.Pleasenoteweusedtheword“potential”intheprevioussentence.Thehigherthepossiblepayoff,thelesslikelyitbecomes.Butyouknewthat(wehope!).
Isitreallynecessarytolearnaboutandtrackallfiftyoftheseindicatorsinordertothriveasaninvestor?No,youcouldgetreally,reallyluckyandstumbleontothenextGoogle,atechstockthatmadeearlyinvestorsrich.OfcourseyouarejustaslikelytobuythenextEnronorLehmanBrothers—bothnow-defunctfirmsthatwereoncebigplayersinfinancialmarkets.Insimpleterms,themoredatayoutrackthebetteranintuitivefeelyouwillhaveforwhatisreallygoingonintheeconomy.Atfirstitmayseemconfusingoryoumayfeelyouarelearninglessandless.Butprettysoonyou’llstartseeingthebigpictureandthatwillhelpyouinvestbetter.You’rehuman,soyou’llstillmakemistakesthatwillcostyoumoney.
However,ifyouusetheknowledgecontainedinthisbook,suchlosseswilllikelybesmallerandmorequicklyreversed.Additionally,ifyoulearntolistentotheeconomy’srhythmsyoucanpickappropriateassetsectorsbeforemostotherinvestors,givingyouadistinctadvantage.Theindicatorsexplainedinthefollowingpageswillhelpyoutomaximizeexposureintherightplacesandminimizeitinthewrongones,soreadonandneverstopstudying.
Consumption(C)
THISSECTIONDETAILSFIVEindicatorsofconsumption,acategorythatincludespersonalexpendituresondurablegoodssuchascars,furniture,andappliances;nondurablegoodssuchasfood,clothing,andfuel;andservicessuchashealthcare,transportation,education,andrecreation.Thesedays,consumptionconstitutesabout70%oftheU.S.economy,
makingitacategoryyoucan’tignore.Monitoringtheindicatorsinthissectionofthebookwillkeepyourfingeronthepulseofthishugecomponentofeconomicactivity.
B
Chapter1AutomobileSales
LeadingintoRecessions,CoincidentwithLaggingRecoveries(SeealsoISMManufacturingSurvey)
ACKIN1953THEheadofGM,CharlesWilson,saidthat“whatwasgoodforthecountrywasgoodforGeneralMotorsandviceversa.”It’sstilltruethatcars
(GM’sorotherwise)countwhenitcomestotheeconomy,especiallyforthemanufacturingsector.Justthinkaboutallthethingsthatareneededtomakeacarortruck:steel
sheetforbodypanels,paint,glassforwind-shieldsandlights,copperforelectricalwiring,rubberfortires,plastic,fabric,andpossiblyleatherforinteriors.WhatitallmeansisthatwhenthebigcarcompanieslikeFordMotor,Toyota,GeneralMotors,Chrysler,Honda,andHyundaiaremakingandsellingcars,thenbusinessesinalotofancillaryindustriesareworkinghardtoo.“Thisisnotanicheindicator,”saysCampbellHarvey,professoroffinanceat
DukeUniversity’sFuquaSchoolofBusiness.“Theautoindustryisinterconnectedwithsomuchelsethatbywatchingitsmovementsyougetsomeviewoftheoverallhealthoftheeconomy.”Formostpeople,thecostofacarortruckislarge—amajorpurchasesecond
onlytothecostofbuyingahouseorapartment.Anewcarthatcoststhirtythousanddollars(notanunreasonablepriceatthetimeofwritingin2010)wouldbealargechunkofmanyfolks’pretaxannualincome,andgreaterthanayear’spayforsome.Asaresult,manypeopleborrowmoneytobuycarsandtrucks.Whentheydo,ittellsussomethingabouthowconfidenttheyfeelabouttheireconomicandfinancialfuture.“Theyarenotgoingtogooutandbuyacariftheythinkthereisreasonablechancethey’llgetlaidoff,”explainsHarvey.
InvestmentStrategy
Carsalesareadecentleadingindicatorofimpendingrecessionsaspeopletendtobackoffbuyingcarswhentheydon’tfeelconfidentabouttheirjobs.Comingoutofarecession,carsalestendtolagbecausemostpeoplewaituntiltheeconomyhasclearlyturnedupwardbeforemakingsuchamajorpurchase.Asshownintheaccompanyingchart,salesofnewautosslowedbeforethe
2000–1downturn.Theypickedupalittleduringthemid-decadeboombeforedroppingdramaticallyin2007astheeconomybegantoshowsignsofweakness.Oneofthekeyswithautomobilesalesistofocusonsalesandleasesofnew
carsbecause,intheend,theydrivetheotherpartsoftheeconomy.Thesaleofausedcardoesn’tactuallymeananynewmaterialswereused,althoughit’sstillagoodsignthatpeoplewanttobuyanothervehicle.Thatsaid,whenparsingtheautomobilesalesdatayouneedtolookfortrends.“Trytodetectaclearmomentum,apositiveornegativetrend,”saysHarvey.
“Takealookatwherewearerelativetorecenthistoryandseeifthereisanyconsistency.”Ifthereisaconsistentdecreaseinsales,thenwearelikelyseeingtheeconomy
headintoaperiodofweakness,hesays.Likewise,ifthetrendishigher,thentheeconomymaybeimproving.Harveyalsonotesthatthefactthatsomanypeopleborrowtobuycarscanactuallydisturbthesalestrendsabit.Duringeconomicslowdownsinterestratestendtofall,thusmakingborrowers’carpaymentsmuchlower,sometimesdramaticallyso.Thataddedaffordabilitycansometimesdrivesalesupatadbetterthanexpectedwhentheeconomyisweak.Whenautomobilesaleslookliketheyaresignalingaslowdownorrecession,it
makessensetoavoidinvestinginassetsusuallysensitivetotheeconomiccycle.Inotherwords,shunstocksinfavorofgovernmentsecuritiesandhigh-qualitycorporatebonds.
EXECSUMMARY:AUTOMOBILESALES
Whentolook:Autosalesfiguresarereleasedonthefirstbusinessdayofeachmonth.Thedatacoversthepreviousmonth’ssales.
Wheretolook:ReportersworkingforTheWallStreetJournalfilebreakingnewsstoriesonWSJ.comasthevariousautocompaniesreleasetheirdata.Whenallthedataisreleased,anoverallstoryispublishedthatexplainsallthefiguresandinterpretsthestateoftheindustry.GotoTheWallStreetJournalonline’s,“MarketDataCenter”foraquickread
ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandfindthe“AutoSales”link.OthersourcesincludethewebsiteoftheBureauforTransportationStatistics:
www.bts.gov/publications/national_transportation_statistics/.Thecar-makingcompanies,suchasGeneralMotors,FordMotor,Chrysler,Hyundai,Honda,andToyota,alsoprovidedetaileddisclosuresoftheirsalesfigures.
Whattowatchfor:Decreasesinnewautomobilesalesandleases.
Whatitmeans:Peoplearepullingbackduetofearsabouttheirfutureemploymentstatus.
Whattodo:Avoidinvestinginassetsusuallysensitivetotheeconomiccycle.Inotherwords,shunstocksinfavorofgovernmentsecuritiesandhigh-qualitycorporatebonds.
Risklevel:Medium.
Profitpossibility:$$
Chapter2ChainStoreSales
A
Coincident
MERICANSLOVETOCONSUMEstuff,andconsumptionisavitalpartofouroveralleconomicwell-being.Becausemostofusgotoretailersinorderto
buygoodsandservices,wecangaininsightsintothehealthofconsumptionbylookingatretailsales.Althoughmuchofthedataontheretailsectorisavailableonlylongafterthe
fact,someofitisverytimely,anditcomesfromsomeofthemostsophisticatedretailersintheworld,includingchainstoreslikeSaks(SKS)andTheGap(GPS)andmembershipwarehouseretailstoressuchasBJ’s(BJ)andCostco(COST).Together,thechainstoresrepresentonly10%ofoverallretailsales,butthedataaboutthesecompanies’salesisavailableeveryTuesdayfortheweekthroughthepriorSaturday.Thisdataisimportantformorethanjustitstimeliness.Chainstorestendto
operateacrosstheentireUnitedStatesandnotjustregionally.Sowecangetanationalreadonthestateofconsumption.Inaddition,chainstoresaremastersellers.Theyusethelatestselling
techniquesandhirethesavviestmarketers.Theyalsohavethefinancialweightandtherobustdistributionsystemstogetfirstdibsonthelatestnewgadgets.Whydoesthismatter?Becauseifthebigguysaren’tselling,thentherestoftheretailworldstandslittlechance.Therearetwosourcesofbasicdata:theJohnsonRedbookIndexandtheICSC-
GoldmanSachsWeeklyU.S.RetailChainStoreSalesIndex.Bothentitiesalsoputoutmonthlyfigures.(Forabroaderviewthatincludessmallerretailersaswell,seetheCensusBureau’smonthlyretailsalesreport.)
InvestmentStrategy
EconomicforecastersshouldwatchthisdatacloselybecauseofthegiantportionofoverallGDPthatconsumptionrepresents.Whenthedatashowsthatchainstoresaleshaveincreased,thentheconsumptioncomponentoftheoveralleconomyisprobablydoingquitewell.Whenchainstoresalesareweakorfalling,thentheoppositeislikelytrue.Dataonchainstoresalescanalsobeusedwhendecidingwhethertoinvestin
retailstockslikeSaks(SKS),Target(TGT),andJ.Crew(JCG).Butyouneedtobecareful.“Youhavetobereallygoodandnimbletobuya
stockbasedonthisdata,”saysKristinBentz,aveteranretailindustryanalystattheConshohocken,Pennsylvania–basedinvestmentbankPMGCapital.
Still,shehassomeusefultipsforthewould-beinvestor.Inthefirstplace,notallofthechainstoresalesdataisthatusefultoinvestors.Salesofbigretailersgoupanddownformanyreasonsincludingtheopeningandclosingofdifferentstores.Togetusefulinformation,newstores(thoseopenlessthantwelvemonths)needtobeexcluded.Instead,investorsinretailcompanieslookatthesalesofstoresopenforayear
ormore.Thedataisknownasthesame-storesalesintheUnitedStatesand(like-for-likesalesinBritain).It’sameasureoftheefficiencyofretailingoperations.ThisdataisavailablethefirstThursdayeverymonth,soit’snotastimelyastherawdatabutit’sfarmoreusefulforinvestors.“Whenpickingastocktobuyyouwantsequentialandyear-over-yearsame-
store-salesgrowth,”Bentzsays.Moresimply:Thedatashouldshowincreasedsaleswhencomparedtothesameperiodayearagoandwhencomparedtothepriormonth.“Thattellsyoutheproductisright,thetrendisright,andthecustomersare
comingbackmonthaftermonth,”sheexplains.Ontopofthatit’simportanttolookatwhatexpectationsofsame-storesales
wereforthatperiod.Acompanycanhavetherightyear-on-yearandsequentialresultsbutstillfallshortofwhatanalystswereexpecting,andinthatcasethestockwouldlikelysuffer.“Whenyougetsequentialandperiodgrowth,andthecompanyisbeating
forecasts,thenthat’sabuy,”notesBentz.Sheaddsthatduringtheboomyearsitmadesomesensetolookatexchange-
tradedfundsthattrackedthevalueofabasketofretailstocks,liketheSPDRS&PRetail(XRT)ETF.ButduringtheGreatRecessionthingschanged.Now,shesays,notallretailersarecreatedequalanditthereforemakessensetopickandchoosewhichstockstobuy.
EXECSUMMARY:CHAINSTORESALES
Whentolook:Formonthlysame-store-salesdata,beonwatchthefirstThursdayofthemonth;weeklydatafromICSCandRedbookdataareavailableearlyTuesdaymornings.
Wheretolook:TheWallStreetJournalcloselyfollowsretailsalesfigures.Journalreportersfilebreakingnewsreportsonretailsalesfiguresasthenumbersarereleased.Checkforarticlescoveringtheentireindustry,aswellasthosewithcompany-by-companydetail.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickread
ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”section,lookfor“U.S.EconomicEvents,”andfindthelinkstoICSCandRedbookonTuesdays.Monthlysame-store-salesdataisavailabledirectlyonmanypubliclytradedretailers’websites.TheJohnsonRedbookIndexisavailabletoclientsofRedbookResearch,
althoughtherearesomesamplesavailableatnochargeonitswebsite:
www.redbookresearch.com.Forthosewillingtopay,BentzrecommendsgoingtoRetailMetrics,where
proprietorKenPerkinsprovidesan“enormous”spreadsheetofallthedata.
Whattowatchfor:Increases(declines)inyear-over-yearsame-store-salesgrowth,aswellasmonth-to-monthincreases.
Whatitmeans:Storesaredoingwell(struggling).
Whatstepstotake:Buy(sell)asexpectationsofyear-over-yearsame-storesalesimprove(degrade).
Risklevel:Medium.
Profitpossibility:$$
Chapter3ConsumerSentiment
T
Leading
HEUNITEDSTATESMAYbemanythings,butifnothingelseitisanationofspenders.Asaresult,investorsandeconomistsdevoteamassiveamountof
timeworryingwhat“theconsumer”thinks,orhowheisfeeling.Simplyspeaking,whenconsumersfeelbettertheyspendmore.Despiteallthatangst,veryfeweconomicindicatorsjustplainaskthe
proverbialmanonthestreet,“Howareyoufeeling?”Mostotherindicatorsmeasurewhatpeoplehavedoneoraredoing.ThesimpleideaofaskingwhatyouandIarethinkingorfeelinghasbeen
takenupbytwoinstitutions:TheConferenceBoardandtheUniversityofMichigan,whichpublishtheConsumerConfidenceIndex(CCI)andtheMichiganConsumerSentimentIndex(MichiganSentiment),respectively.Thesetwoindicesprettymuchmeasurethesamething:Howgoodareyou
feeling,economicallyspeaking,rightnowandhowdoyoufeelaboutthefuture?Thedataiscollectedbypollinghouseholds.Simplyspeaking,highernumbersontheseindicatorsindicatethatconsumers
believetheeconomywillimproveorthatitwillcontinuetochugalong.Forinstance,iftheCCIincreasesfrom49inAprilto55inMay,consumersbelievethatconditionsareimproving.Likewisealowerorfallingnumberdoesnotaugurwellforthefutureoftheeconomy.TheMichiganSentimentsurveyispublishedtwiceeachmonth,withthefirst
readingoutslightlyaheadoftheCCI.Inaddition,theMichiganSentimentisincludedinothergovernmentstatistics,whichgivesitaddedweightwithobservers.Butforthosewillingtodigbeyondtheheadlinefigures,theCCIisusefulalso.
Itincludessurveydataonspendingplansforbig-ticketitemssuchascarsandmajorappliances.Thereisalsodataoninflationexpectationsandabreakdownofsentimentbyageandincome.Aminorproblemwithbothoftheseindices:Theyareveryvolatile,andthere
isfrequentlysomuchnoise,somanyrandomupsanddownsintheresultsthatitmakesthemhardtointerpret.Partofthereasonforthisvolatilityisthatthepsycheoftheindividualbeing
polledcanbeaffectedbymanythings.Forinstance,aspikeingasolinepricesor
terroristattackscanweighdownonconsumersentiment.ThechartofUniversityofMichigan’sindexvisuallyillustratestheshort-runvolatility.Butitalsoshowsthatsentimentgenerallyfallsdramaticallygoingintorecessions.
InvestmentStrategy
Becauseofthehugevolatilityinthetwosentimentindicators,investorsneedtoproceedwithcautionwhenusingthem.“Whatwereallytrytodoislookatthetrend,notasinglepointintime,”saysArtHogan,chiefmarketanalystatinvestmentbankingfirmJefferiesinNewYork.Ormoresimply,onesunnydatapointdoesnotsignalaneconomicsummer.Ajumpinsentimentcouldoccurforanynumberofreasonsthatdon’treflectasustainabletrend.“Trytoblendoutthatone-monthfigureandlookatathree-monthmovingaverageandthatwillmakeawiserinvestmentdecision,”Hogansays.Sometimes,asin1980and2001,theindexaccuratelyreflectsdipsinthe
market.However,duringthe1981–82,1990,and2008–9recessions,bycontrast,consumerconfidenceincreasedandfellbackonce,twice,eventhreetimesbeforethoserecessionsended.Becauseofthetremendousnoiseinthedatait’salsogoodtousethese
indicatorsinconjunctionwithothereconomiccluesliketheindicatorsfoundinthisbook.Forinstance,lookatconsumerdurablesalesorwhetherbanksareincreasingtheavailabilityofconsumercredit.Whenyouarefairlysurethatsentimentisimproving,theobviousplaceto
lookforinvestmentopportunitiesistheretailsector.Hogansayscomingoutofarecessionhefirstlooksatconsumer-staplestocks—storeslikeWalmart(WMT)thatsellnecessitieslikebasicfoodstuffsandsundries.Hethenmovesontoretailerssellingso-calleddiscretionaryproducts—storeslikeCoach(COH)andTiffany&Co.(TIF)—thatsellproducts,oftenluxuries,thatdon’tabsolutelyneedtobepurchased.Likewise,whenitlooksliketheeconomyisheadedsouth,investorsshould
takethereversetackandgetoutoftheluxurynamesfirst.
EXECSUMMARY:CONSUMERSENTIMENT
Whentolook:At10a.m.ET,onthelastTuesdayofthemonth,lookforConferenceBoardConsumerConfidencedata.FortheinitialreadingoftheMichiganSentimentinformation,bealertonthesecondFridayofthemonth.
Wheretolook:TheWallStreetJournalcloselyfollowsconsumersentiment
surveydata.Journalreportersfilebreakingnewsreportsonthesemetricsastheinformationisreleasedbythedifferentorganizations.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickreadofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,
you’llneedtogotothe“Calendars&Economy”section.Lookfor“U.S.EconomicEvents”andfindthelinkstoConsumerSentiment(forMichigannumbers)andConsumerConfidence(forConferenceBoarddata)onthecalendar,postedonthesecondFridayandlastTuesdayrespectively.Inaddition,Briefing.comreportsbothindicatorswhentheyarepublished.The
FederalReserveEconomicDatabase(FRED)attheSt.LouisFedprovidesbasicdetailsontheMichiganConsumerSentimentdata.TheConferenceBoardinformationcanbefoundatConference-Board.org.
Whattowatchfor:Increases(decreases)inconsumersentimentoverseveralmonths.
Whatitmeans:Consumersfeelexuberant(prefertakingitcautiouslyforawhile).
Whatstepstotake:Buy(short)retailstocks,starting(ending)withsellersofnondiscretionaryitemsandending(starting)withsellersofdiscretionaryitems.
Risklevel:Low.
Profitpossibility:$
A
Chapter4ExistingHomeSales
Leading(SeealsoNewHomeSales,CopperPrice)
NENGLISHMAN’SHOMEISsaidtobehiscastle.ForAmericans,owningahomeisthedream.Eitherway,homesalesmatteronsomanylevels.Because
homesaresuchamassivepartofmanypeople’swealth,whathappensinthehousingmarkethasanimpactonthepsychologyandspendingpatternsofthenation.That’swhyeconomistsandmoneymanagerspaycloseattentiontothe
NationalAssociationofRealtors’(NAR)reportsonexistinghomesales.Asthenamesuggests,thereportindicateshowmanyhousesthathadpreviouslybeenoccupiedweresoldduringthemonth,andittypicallyrepresentsthevastmajorityofactivityinthehousingmarket(therestissalesofnewhomes).Butitdoesmuchmorethanthat!“Itcontainsthelevelofinventoriesanditgivesthemedianpriceofahomein
thecountry,”saysJoeBrusuelas,aneconomistatBloombergL.P.inNewYork.Thepriceofhomesingeneralisimportanttotheeconomybecauseof
somethingknownasthe“wealtheffect.”Whatitmeansisthatashousepricesrisehomeownersfeelwealthier,andthataffectshowtheyviewtheirfutureeconomicprospects.Specifically,whenpeoplefeelwealthier,theyspendmoreonaverage,eveniftheirregularincomehasnotchangedinanyway.Buttheswordcutsbothways.Fallinghomepricescanhaveanegativeimpactbyinducingpeopletocuttheirspending,sometimesdrastically.Thiswholephenomenongotoutofcontrolduringthehousingbubbleofthe
mid–2000s.“Consumersincreasinglyreliedontheincreasingvalueofthehomestofundcurrentandfutureconsumption,”saysBrusuelas.
Itwasn’tthatconsumersjust“felt”wealthier.Theyactuallywenttoabankandborrowedmoneyagainsttheincreasedvalueoftheirhometofundcurrentconsumption.Inadditiontothe“wealtheffect,”thereareothermoredirectimpacts.“Typicallywhenanindividualbuysahome,theybuynewfurniture,newhousingwares,andnewelectronics,”saysBrusuelas.“Inthatwaythesalesofexistinghomesreverberatethroughtheeconomy.”
InvestmentStrategy
Historically,homesaleshavebeenkeytotheeconomicrecovery.“Inthetenpostwarrecessions,housinghasbeenoneoftheleadingdriversofarecovery,”saysBrusuelas.HesaysitshouldbeintuitivelyobviousthatthishappensbecausetheFederalReserve,America’scentralbank,typicallycutsinterestratesduringarecession.Forpeoplewhoneedtoborrowtobuyahouse—andthat’smostpeople—the
cutininterestratesreducesmonthlymortgagepaymentsandoftenresultsinaboostinsales.(Salesofautomobilestypicallygetaboostfromlowerinterestratesaswell.)Inthewakeofthehousingbustof2008andonward,thebigquestioniswhat
role,ifany,housingwillcontinuetoplayineconomicrecoveries,saysBrusuelas.Itwillplaylittlerole,hethinks,butmaybemorethanamerecameo.Onetricktotrytodeterminewhetherthehousingmarketislikelytoimprove
soonistolookatthelevelofinventoriesofunsoldhomes.Inparticular,looktoseehowmanymonthsitwouldtakeforallthehomesavailabletosellatthecurrentrateofselling.Thisisknownasmonthsofavailableinventory.Clearlyifthenumberof“monthsofinventory”islow,thenthatcanauguran
improvinghousingmarketandperhapsanimprovingeconomy.Ifit’shigh,thenthereverseistrue:perhapsadeterioratinghousingmarketandaworseningeconomy.
EXECSUMMARY:EXISTINGHOMESALES
Whentolook:Existinghomesalesdataispublishedat10a.m.ETaroundthe25thdayofeachmonth.
Wheretolook:TheWallStreetJournalcloselyfollowsthehousingmarketandpublishesbreakingnewsreportsonsalesofpre-ownedhomesimmediatelyaftertheNationalAssociationofRealtorsreleasesthedata.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickread
ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”section,lookfor“U.S.EconomicEvents,”and
findthelinksto“ExistingHomeSales.”YoucouldalsogodirectlytotheNationalAssociationofRealtors,which
makesthedataavailableatwww.realtor.org/research/research/ehsdata.Otherdataworthlookingatispendinghomesales,orsalesthataresettogothroughbuthaven’tyet.Itcanbefoundatwww.realtor.org/research/research/phsdata.Pendinghomesalesdatacanprovidecluesaboutwhatactivityiscomingdowntheroadinrelativelyshortorder.
Whattowatchfor:Increases(decreases)inexistinghomesalesanddecreases(increases)ininventorylevelsmeasuredinmonthsofavailableproperty.
Whatitmeans:Theeconomyislikelylookingup(headingforthedepthsofhades).
Whatstepstotake:Ifthehousingmarketisperkingup(andothermetricsindicatearobusteconomy),buyeconomicallysensitiveinvestments,suchasstocks.Iftheoppositeishappening—existinghomesalesdataandotherdatapointto
aslowdown—avoidstocksingeneral(especiallyhomebuildersandindustrials)andholdcashorbuygovernmentsecuritiessuchasU.S.Treasurybonds.Ifyoumustownstocks,gowiththoselesssensitivetoeconomiccycles,includingcompaniesthatmakeconsumerstapleslikeshampooandsoap.
Risklevel:Medium.
Profitpossibility:$$
F
Chapter5UnderemploymentorSlack
LeadingRecession,LaggingRecovery
ORMERPRESIDENTBILLCLINTONsortofgotitwrongwhenheadoptedthecampaignslogan,“It’stheeconomy,stupid!”Itshouldhaveread,“It’sthe
jobs,stupid!”Why?Becauseforpoliticiansaweakeconomyissynonymouswithalackofjobs.It’simportantforinvestorstoo,butthewidelyreportedrawunemployment
rateisjusttoobluntameasure.Wecanlearnmuchmore—andmakemuchmoremoney—bydiggingdeeper.What’smuchmoreinterestingistheunderemploymentrate,whichmeasures
howmanypeopleworkparttimebecausetheycan’tfindafull-timegig.Thisindicatorisusefulbecauseithelpsustoseeintothefuture.Forexample,thenumberofemployeesworkingfewerhoursthanmakeupanormalworkweekrisesbeforeactuallayoffsbegin.That’sbecausemanagersaretypicallyreticentaboutfiringworkersatthefirstsignofabusinessslowdown.“You’regoingtotrytopreserveyourworkforcebecauseyou’vetrainedthem
andthereisacosttotrainingthem,”saysMarcPado,amarketstrategistatbrokeragefirmCantorFitzgeraldinSanFrancisco.Managersknowitcanbehardtorehireandexpensivetoretrainnewworkersifthebusinesslullturnsouttobejustablip.Itistypicallyonlywhenbusinesshasslumpedoffforanextendedperiodthat
managersstarttofiretheirworkers.Thatlagmakestrackingpart-timeworkaveryusefulindicatoroffutureunemployment.Fortunately,theU.S.BureauofLaborStatisticsbreaksoutthoseworkerswho
areworkingparttimeandspecifiesthosewhoaredoingsoeitherbecausetheycouldonlyfindpart-timeworkorbecausetheiremployerscutbackonthehoursofworkavailable.Collectivelythisisknownas“slack.”Economistsare
understandablymoreconcernedaboutpeoplewhowanttoworkmorehoursbutcan’tthanthosewhovolunteertoworkless.Ofcoursethereareexceptionstotherulethatpart-timeworkrisesbefore
firingbegins.Sometimesmanagerslayoffworkerswithoutsteppingthemdowntoparttimefirst.Soanuptickinslackdoesnotmapontofutureunemploymentclaimsone-to-one.Itis,however,agoodindicatorgoingintoaneconomicslowdown.Youcanseetherelationshipinthechartbelow.
Comingoutofarecessionthisindicatorislessreliable.Someemployerswillhireworkersparttimebeforehiringthembackpermanently,butmanywillwaituntiltheyclearlyneedanothersetofhandsfulltimebeforehiringagain.Soduringrecoveriesitisbesttochecktheemploymentreportforgrowthinovertime.Ifovertimeworkisstrongforseveralmonths,employerswilllikelystarthiringnewworkersbecausetheywillbecheaperthanpayingtimeandahalftoincreasinglyworn-outworkers.
InvestmentStrategy
Ifyouknowchangesinthelevelofunemploymentarecoming(becauseyouhavebeenassiduouslywatchingtheunderemploymentnumbers),thenyoucanadjusthowyouinvest.Thekeytosuccessisinunderstandingwhichpartsoftheeconomywilldowellandwhichwilldopoorly.“Asunemploymentrises,yougotothedefensivesectors,”saysCantor’sPado.
“Drugs,food,andalcohol:themainstaysofhumannature.”Bythathemeansitmakessensetoinvestincompaniesthatsellitemsthatpeoplekeepbuyingevenwhenjobsarescarce.Specificallyhepointstohealthcare,pharmaceuticals,food,andutilities,likegasolineandelectricity.Thesecompaniesalsotendtohavefairlystableearnings.Twoimportantthingstonotewhenusingthisindicator:First,don’tbefaked
outbythedata.Itispossiblefortemporaryworktoincreaseforashortperiodthathasnothingtodowiththeeconomyapproachingarecession,saysPado.Everydecade,forexample,theCensusBureauhiresscadsoftempsbutsoonafterreleasesthembackintotheemploymentpool.Makesureyouareconfidentthatthechangeintemporaryworkingisreflectiveofthebusinesscyclebylookingatsomeoftheotherindicatorsinthisbook.Second,Padonotesthatwhenbuyingdefensivestocks,it’saboutprotecting
yourassetsasthevalueofmoststockstendtofallgoingintoarecession.“It’samatterofwhatgoesdownless,”hesays.Orputanotherway,defensivestockswilllikelyloselessthanotherriskierstocks.
EXECSUMMARY:UNDEREMPLOYMENTRATEORSLACK
Whentolook:ThefirstFridayofthemonthat8:30a.m.ET.
Wheretolook:TheWallStreetJournalcloselymonitorsthejobssituationintheUnitedStates.AllacrossWSJ.com,headlinesandarticleswilldetailtheoverallemploymentsituationassoonasthedatacomesout.Toreallygetintotheweedsfordataonslack/part-time/underemployment,
you’llbebestservedgoingdirectlytotheBureauofLaborStatistics’swebsite,www.bls.gov,andsearchingforatabletitled“EmployedPersonsbyClassofWorkerandPart-TimeStatus.”
Notecarefully:Inearly2010,theBLSchangedsomeofitsstatistics.Investorsneedtowatchforsuchchangesbecausestatisticsareonlycomparablefromperiodtoperiodiftheyarecollectedandpresentedinthesamewayeachtime.Thatmattersbecauseanunawareinvestormightmistakeachangeinthenumbersforarealchangeineconomicconditionswheninrealityit’sjustachangeincollectionmethodorpresentation.
Whattowatchfor:Increasesinunderemployment.
Whatitmeans:Theeconomyisweakening.
Whatstepstotake:Buydefensivestockslikedrugmakers(legalones!),food,andalcohol.
Profitpossibility:Low.
Risklevel:$
Investment(I)
THISSECTIONISCOMPOSEDofelevenindicatorsthatprimarilytrackchangesinbusinessinvestment,whichinthiscontextmeansinventoryonshelvesandinwarehousesaswellasso-calledfixedinvestmentsinbuildings,vehicles,machinery,andevencomputersoftware.Theconstructionofnewresidentialhousing,bothsingleandmultifamily,isalsoincludedininvestment.Businessinvestmentconstitutesbetween15and20%ofGDP.Thatmay
seemtrivialcomparedtoconsumption,butinvestmentfluctuatesmassively,soitisveryimportant“atthemargin,”whichiswheretheactionis.Consumersmightcutback,butultimatelytheyhavetoconsumefood,clothes,andsoforthnomatterhowbadthefuturelooks.Businesses,bycontrast,donothavetoinvestinanynewplant,inventory,orsoftware.Likewiseindividualsdon’thavetobuynewhouses.Whenthegoinggetsrough,businessescutwaybackordon’tinvestatall.
Chapter6Book-to-BillRatio
H
Leading
ALFACENTURYAGOtheideaofacomputerinalmosteveryhomewouldhavebeenthestuffofsciencefiction,withtheemphasisonfiction.Nowit’snot
onlynonfiction—wehavelittlecomputersineverythingfromwatchesanddesktopandlaptopcomputerstoautomobilesandtelephones—butit’salsobigbusiness.Thoselittlecomputersarepoweredbymicroprocessors,alsoknownaschips
orsemiconductors,withamarketestimatedatbetween$300billionand$350billiongloballyin2010,accordingtoTripChowdhry,atechnologyanalystatSanFrancisco–basedspecialtyresearchboutique,GlobalEquitiesResearch.Becausesemiconductorsareusedinsomanycoolgadgets,bothathomeand
intheworkplace,wecangainsomeinsightintothehealthofthebroadeconomygenerally,andmorespecificallyintosomepartsofthetechsector,bylookingatthehealthofthesemiconductorbusiness.It’srelativelysimpletomeasurethehealthofthechipbusinessusingtheso-
calledbook-to-billratio,whichmeasurestherelationshipbetweenbookingsandbillings.Probablythebestwaytounderstandthosetwosomewhatobscurebusiness
termsistoexamineanexample.Ifacompanyhadordersfor100microprocessorsinamonth,thenthebookings,orbookedsales,wouldbe100.Butifduringthesamemonthonly80chipsweremadeanddelivered,thenthebillingswouldbe80.Thecompanybillsthecustomerfortheproductonlyafterit’sshipped.Inthisexample,thebook-to-billratiois100/80,or1.25.Thecompanyhasan
orderbacklog.That’sfrustratingforthecustomersbutisactuallyagoodpositiontobeinforthechipmanufacturer.TheSemiconductorIndustryAssociationcompilesabook-to-billratioforthe
entireindustry,ratherthanjustonecompany.Thattellsuswhethertheindustryhasanorderbacklogorisproducingmorechipsthancustomershaveordered.
InvestmentStrategy
Inthesimplestterms,abook-to-billratioof1.0orhigherisafavorablereading.Itmeansthatordersaregreaterthanwhattheindustryisabletofulfill.“Thatsaysweareinanexpansion,”saysChowdhry.Orputanotherway,
industry-widethereisabacklogofordersduetoincreaseddemandfromthetechsectortomakeallthosecoolgadgetslikePCs,iPads,cellphones,cars,andservers.Whentimesarebad,bycontrast,chipmakershaveexcesscapacity,sothey
manufacturemorechipsthancustomerscurrentlywant.It’sabadsignfortheindustryandtheoverallstateoftheeconomy.Aquicklookattheaccompanyingchartshowshowthebook-to-billratio
droppedprecipitouslyduringtheGreatRecession.Itfelltoalowof0.47inJanuary2009,meaningthatchipmakersweremanufacturingtwiceasmanymicroprocessorsastheywereselling.Itreflectedadireeconomicsituation.Thechipsthatweremade,butnotsold,
werepresumablyheldininventoryintheexpectationofbettertimestocome.Itwasableakeconomicpicture,butthecomingmonthssawasustained
improvementinthebook-to-billratiothatmovedaheadofthewholeeconomy.ByJuly2009thebook-to-billratiowasabove1,indicatingthattheindustryasawholehadorderbacklogs.Thatsignifiedstrongdemandfromthebroadeconomyastheworldretooled
andgotbacktowork.It’simportanttobecarefulwhenusingthismetricnottoinfertoomuch,
specificallywhenlookingatindividualstocks.Chowdhrysaysabook-to-billratioover1.0isgood,orders-wise,inthecellphoneindustry,thepersonalcomputermarket,andthemarketforthecomputerserversthatpowertheInternet.That’sausefuldatapointtohelpbuildathesisforbuyinganindividualstock.Butaloneit’snotenough,hesays.Anotherthingtorememberwiththebook-to-billratioisthatovertimethe
inventorymanagementphilosophyhaschanged.Leaninventoriesarealltheragenowinawaytheyweren’tinthepast,hesays.Thatmeansthatovertime,readingsofthebook-to-billratiomightnotbe
directlycomparable,saysChowdhry.
Still,greaterthan1isagoodsign.
EXECSUMMARY:SEMICONDUCTORBOOK-TO-BILLRATIO
Whentolook:Aroundthemiddleofthemonthforthepriormonth(mid-AugustforJulydata,forexample).
Wheretolook:TheSemiconductorIndustryAssociation(SIA)publishesthebook-to-billratio.Checkoutitswebsiteatwww.sia-online.org.Thesameinformationcanbefoundatwww.semi.org.
Whattowatchfor:Increases(decreases)inthebook-to-billratioabove(below)1.00.
Whatitmeans:Theeconomyisheatingup(coolingdown);thechipmanufacturingsectorisdoingwell(dyingbydegrees).
Whatstepstotake:Buy(sell)chipmanufacturerequitiesif,andonlyif,otherindicatorssupportthebook-to-billnumbers.
Risklevel:Mediumorhigh.
Profitpossibility:$$or$$$dependingonthestrategychosen.
Chapter7CopperPrice
I
Leading
T’SANINVESTINGMAXIMthatcopperisthemetalwithaPhDineconomics.Whyso?Well,itisn’treallythemetalitself,butratheritspricethatisthe
smartpartoftheequation.Broadlyspeaking,ifthepriceisrelativelyhighandrising,thentheindustrial
economyisdoingwell.Ifit’slowandfalling,thenthemanufacturingsectorishurting.Why?“Because,”accordingtoFrankHolmes,chiefinvestmentofficerofSanAntonio–basedU.S.GlobalInvestors,“copperhasuniquephysicalpropertiesthatmakeitthebackboneoftheindustrialeconomy.”Holmespointsoutthatcopperpricesarehighlycorrelatedwiththehealthofhousing,infrastructurespending,andmanufacturing.Itworkslikethis:Thesupplyofcopperisrelativelystable(andtypicallynot
toosensitivetochangingpricelevels),soasdemandincreases—foruseinelectricalwiringinhousesorbusinesses—thepricetendstogoup.That’swhatmakesthepricesocloselyalignedwitheconomicactivity.
Thegoodnewsisthatthiscloserelationshipislikelytostayaroundforawhile.Copperisoneofthemostcost-effectiveelectricityconductorsavailableandseemsunlikelytobedethronedfromthatpositionanytimesoon.(Goldis
betteratconductingthancopper,butit’snotcost-effectiveatallformostpurposes.Aluminum,ontheotherhand,hasanastyhabitofcatchingfirewhenusedforwiringhomesandoffices.)Aswellasbeingusedforwiringbuildings,copperisalsovitaltothemanufactureofautomobilesandsmallelectricappliances,whereitselectricalandheatconductivityiskey.
InvestmentStrategy
Watchingcopperpricescanhelppredictrecessions,saysBrianHicks,portfoliomanagerandcolleagueofHolmesatU.S.GlobalInvestors.Infact,Hicksgoesatadfurther,explainingthatthereisnow(intheearlytwenty-firstcentury)anextremelytightbalancebetweensupplyanddemand.Thatmeansthepricewillbeevenmoresensitivetochangesinsupplyanddemandthanithasbeeninthepast.Thekeytolookingatcopperpricesistolookforatrend,hesays.Ifpricesare
highandrising,thenthat’sasignofanexpansion.Ifpricesareonaplateau,thenthat’sasignthatperhapstheeconomywillbesomewhatsluggish.Asarecentexample,Hicksnoticedthepriceofcopperstartingtodropoffin
early2010.HethoughtthismightbebecausetheChineseeconomywasbeginningtoslowdown.Basedonthefallingcopperpriceaswellasotherfactorsthatconfirmedhissuspicion,Hicksmanagedtodumphisholdingsofcopper-relatedinvestmentswhilethemarketwasstillcresting.BythetimethemarketcaughtuptoHicks’sviewoftheworldandstockpriceshaddropped,he’dalreadysoldout.Highpricesarethosearound$3apoundor$6,600ametricton.Under$2a
poundoraround$4,400atonisconsideredlowandisalsobelowthepriceatwhichmostnewsuppliesofthemetalcanbedeveloped,Hickssays.Anoteofcautionwhenwatchingthepriceofcopper:Sometimespricespikes
havelittletodowithimprovingeconomicconditions.Insteadsuchmovementscanbecausedbyearthquakes,orindustrialactionbyworkersthatinterruptthesupplyofthemetal.Typically,pricesfallbackwhenfullproductionisrestored,notindicatingarecessionbutratherareturntosomenormalcyinthecoppermarket.
ExECSUMMARY:COPPERPRICE
Whentolook:Everybusinessday.
Wheretolook:ReportersofTheWallStreetJournalkeepacloseeyeontheindustrialmetalsmarketsandfilestorieswhennoteworthypricechangestakeplace.
Ifit’sjustthepricesthatyouwant,gotoTheWallStreetJournalonline’sMarketDataCenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“CommoditiesandFutures”sectionandlookunder“Metals.”Copperpricescanbefoundinaslewofotherplacesaswell.TheLondon
MetalExchange(LME),whichdominatesglobaltradingincopper,hasdataavailableonitswebsite,www.LME.co.uk.LikewisetheCOMEXdivisionofCMEGroupalsohasdataoncopperprices.Also,pricescanbefoundonwww.KitcoMetals.com,acommercialwebsitededicatedtoprovidingmetalsmarketinformation.Thetrickwithwhateversourceofdatausedforcopperpricesistomakesure
youuseaconstantbenchmarkprice.OntheLMEit’sthethree-monthprice(i.e.,thepricenowformetaldeliveredinthreemonths’time);forCOMEX,thebenchmarkdeliverypricemovesaround,makingittrickyforthenovicetogetahandleonthings.Forfurtherreference,theWorldBureauofMetalStatisticshasaproprietary
databaseatwww.world-bureau.com/searchlink.htm.Also,investorsonabudgetcangleansomehistoricaldatafromtheIMF’sPrimaryCommodityPricessiteatwww.imf.org/external/np/res/commod/index.asp.
Whattowatchfor:Increases(decreases)incopperprices,especiallyabove$3(below$2)perpound.
Whatitmeans:Housingandmanufacturingaregearingup(headedforsometoughtimes)andtheeconomyalongwithit.
Whatstepstotake:Ifyouaresurethepricemovementisduetoanincrease(decrease)indemandandnotasupplyshock,investin(getoutof)copperandmanufacturingstocksandrebalanceyourportfolioinfavorofeconomicexpansion(contraction).
Risklevel:High.
Profitpossibility:$$$
Chapter8DurableGoodsOrders
W
Leading
HENITCOMESTOlookingintothefuturewecanlearnalotbylookingathowbusinessesandconsumersarespendingonbig-ticketitems,orso-called
durablegoods.Forconsumers,“durablegoods”typicallymeanfridges,freezers,washing
machines,anddishwashers.Theyaredurable,whichmeanstheyareexpectedtolastawhile.Theyalsotypicallycostalotandsorequirethatconsumershavetheconfidencethatshellingoutafewhundreddollarsonasingle-useitemwon’tleavethemtooshortelsewhereintheirbudget.Forbusinesses,durablestypicallymeancapitalequipment.Inlayman’sspeak
thatmeansmachinesthatcanbeusedtomakestuffthatcanbesoldforaprofit.Itcanalsobeaircraft,whichareverybig-ticketitems,likeBoeing747s.Aswiththeconsumerdurables,ordersforcapitalequipmentareconsidereda
measureofsentiment.Ifbusinessequipmentordersarehighorrising,thenthattellsyouthebusinesscommunityasawholeisgettingmoreconfident.“Ittellsyoupeopleinbusinessareputtingtheirownmoneyatrisk,”says
MiltonEzrati,chiefeconomistandmarketstrategistatNewYork–basedassetmanagementfirmLordAbbett.“It’sagoodindicationofwherebusinessisgoing.”Morespecifically,businesseslikelywouldn’tordernewandtypically
expensiveequipmentiftheydidn’tseeareasonablechancethatthey’dhaveenoughcustomerstobuyallthethingsthenewmachinewasgoingtomake.
InvestmentStrategy
Oneimportantwrinkleisthatthetotaldurablegoodsordersindicatoralsoincludesveryexpensivedefenseproductslikewarshipsandjetfighters.Theseitemscomeandgoatthewhimsyofthegovernment,sotheytypicallydon’ttellusalotabouttheeconomy,orratherthesustainableprivatesectoreconomy.Fortunately,it’seasytostripoutthosebigDefenseDepartmentpurchases.It’s
alsoeasytoremovetheimpactofaircraftorders.Theytypicallyaresobigandsometimesseeminglysorandomthattheycanplayhavocwhentryingtointerpretthedata.Ezratinotesthat“evenifyousweepawayaircraftordersitisextremely
volatilefrommonthtomonth.Itisverylumpy.”That’swhyhesuggestsusingathree-monthandafive-monthmovingaverageaswellaslookingatthedatafromthepriormonth.Thatwayyoucanseeifthetrendisbeingbroken,hesays.Ingeneral,though,strongdurablegoodsorderstendtobeabullishsignfor
stocks.“Ithelpssupportthegeneraleconomy,”saysEzrati.Drillingdownfurther,Ezratisayshepaysparticularattentiontothecapital
equipmentspendingfigures,whichmeasurewhatbusinessesaredoingratherthanwhattheyaresaying.That’sararelookintothepsycheofbusinessesthatsomeotherindicatorsdon’tgive,hesays.IfEzratiisconvincedthatarecoveryisintheworks,hetriestofindsuitableinvestmentsinstocks.“Ifit’sbroad-basedstrengthacrossthedifferentcomponentsofdurablegoods,
thenthatspeakstothegeneraleconomy,”hesays.InsuchaninstanceitmightmakesensetolookatinvestmentstrackingbroadstockindicesliketheS&P500orperhapslookatthoseindicesthatfocusoncreatingdurablegoods,likebigmanufacturingconglomeratessuchasGeneralElectric(GE).Eventhen,Ezratisays,it’simportanttokeepaneyeonthepriceofstocks.Or
putanotherway,eveniftheeconomyisimprovingthatdoesn’tmeanoverpricedinvestmentsaresensible.
EXECSUMMARY:DURABLEGOODSORDERS
Whentolook:At8:30a.m.ETaroundthe26thdayofthemonth.Thedatacoversthepriormonth.
Wheretolook:EditorsandreportersatTheWallStreetJournalwatchthestateofthedurablegoodsmarketclosely.AsthedataisreleasedbytheCensusBureau,JournalreportersfilebreakingnewsstoriesforWSJ.com.Ifit’sjustthedatayouwant,gotoTheWallStreetJournalonline’s“Market
DataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“DurableGoodsOrders.”Alternativelyyoucangostraighttothesource:TheU.S.CensusBureau,at
www.census.gov/manufacturing/m3/.Historicaldataishere:www.census.gov/manufacturing/m3/historical_data/index.html.Forasimplifiedandeasy-to-useversion,tryBriefing.com’sEconomic
Calendarinitsfree“Investor”section.
Whattowatchfor:Increases(decreases)indurablegoodsorders,excludingdefenseandaircraftpurchases,overthreetofivemonths.
Whatitmeans:Theeconomyislikelytogrow(shrink)inthenearterm.
Whatstepstotake:Golong(short)abroadbasketofstocksliketheS&P500.Alternatively,themoreadventurousinvestormightconsiderbuying(selling)specificdurablegoodsmanufacturerslikeGeneralElectric(GE).
Risklevel:Mediumtohigh,dependingontheinvestmentstrategychosen.
Profitpossibility:$$or$$$forthestockpickers.
B
Chapter9HousingPermitsandStarts
Leading(SeealsoCopperPrice,NewHomeSales)
UYINGAHOUSEISabigpurchaseformostpeople.Forsomeothersit’sjustplainmassive.That’swhytheycallowningyourownhometheAmerican
dream.Notethe“dream”partofthat:Formanyitwillremainjustasunrealasadream.Housesareaspecialcaseofconsumerdurablesbecausetheyareexpectedto
lastyearsandyears.Fromstarttofinish,theytypicallytakeatleastayeartobuild.Thereasonwelookatthispairofindicatorsisthatanincreaseinthenumber
ofhousingpermitsappliedforandthecommencementofbuildingthosehouses(knownas“starts”)signalsconfidenceintheeconomyoverthenearandthemediumterm.Afterall,buildersusuallydon’tconstructnewhousesunlesstheyarefairlysurethatpeoplewillhavetheconfidencetobuythem.Remember,mostpeopleborrowthemoneytobuyahouseanddoingsoshowsthatpurchasersareoptimisticthattheywillkeeptheirjobsandincomeforasustainedperiodoftime.Duringthedepthsofarecessionthecostofborrowingmoneyistypicallyquite
lowandthatcanmeanthatbuyingahouseischeaperthanrentingone.That’showthecyclestarts:Cheapmoneyluresinhomebuyers,andhomebuildersknowthissotheyconstructhousesinanticipation.Increasesinthenumberofhousingstartsandhousingpermitsthathavebeen
issuedclearlyindicatethatincreasesinoveralleconomicinvestmentareintheoffingasbuildersbuylumber,bricks,cement,roofingmaterials,pipes,andsoforth.Inshort,thehousingbusinesscanturnthelightsbackoninmanydifferentindustries.
Itworksviceversatoo.Duringmosteconomicexpansionsthecostofborrowingmoneyincreasesastheeconomygetshealthier.Thathastheknock-oneffectofslowingnewbuildingandsoslowingtheeconomydown.
InvestmentStrategy
Typically,thenumberofbuildingpermitsissuedandthelevelofhousingstartsbegintoincreasebeforetheeconomyimproves.Asustainedpullbackinthesectortypicallycomesaheadofaneconomicslowdownorarecession.Thatmovementaheadofthechangesintheoveralleconomyisthereasonwethinkofhousingconstructionasaleadingindicator.(Note:Althoughhousingusuallybeginstoimproveaheadoftheeconomic
cycle,thatdidn’thappenduringtheeconomicexpansionthatgotunderwayin2009.ThatwasbecauseoftheexceptionalnatureofthehousingbubblethatprecededtheGreatRecession.Herewepresentwhatnormallyhappensbecausewewantthisbooktobeusefulacrossmanybusinesscycles,notjustthemostrecent.)
Therearemanywaystoprofitfromtheupsanddownsinthehousingmarket.Butthefirstthingtodoistoworkoutwhetherthesectorisimprovingordeclining.“Don’tjustlookatonemonth’sworthofdata;insteadlookatthetrend,”says
VinnyCatalano,chiefinvestmentstrategistatNewYork–basedBlueMarbleResearch.Catalanosuggeststhatinvestorslookatafewmonths’worthofdataataminimumtobesurethatthetrendisrealbeforelookingwhereinthestockmarkettoinvest.Theobviousfirstplacethatwilldowellinahousingrecoveryisthehome-
buildingcompaniesthemselves.CatalanopointstotheSPDRS&PHomebuilders(XHB)exchange-tradedfundasagoodfirstportofcall.Thevalueoftheso-calledXHBisdeterminedbythevalueofabasketofthesharesofcompaniesthatbuildhouses.Asthehousingsectordoeswell,sodothesestocks.Theso-calledbasketapproachmakessenseformostpeoplebecauseittakesawaytherisksofpickingthewrongstockevenifyougotthesectorcorrect.Catalanocautions,however,thatthevalueofstocksisdeterminedbyother
factorsaswell,suchasinterestratesandtheoveralleconomicclimate.“Pricesofhome-buildingstockscanzoomupinanticipationbeforethedataconfirmtherecovery,”headds.Inadditiontohome-buildingstocks,Catalanoalsosaysitmakessensetolookatothersectors.Forinstance,hesuggestsconsideringlumbercompaniesthatmakehouseframingmaterialsandminersthatdigup
coppertomakeelectricalwiring.
EXECSUMMARY:HOUSINGPERMITSANDSTARTS
Whentolook:At8:30a.m.ETaroundthe16thofthemonth.Thedatacoversthepriormonth.
Wheretolook:TheWallStreetJournal’seditorsandwriterswatchthehousingmarketclosely.Asnewsabouthousingpermitsandstartscomesout,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“HousingStarts.”Forthepermitsdatayou’llneedtogothesource,theCensusBureau,thesame
folksresponsibleforkeepingtrackofhowmanyAmericansthereare.Thedatacanbefoundatwww.census.gov/const/www/newresconstindex.html.
Whattowatchfor:Increases(decreases)inbuildingpermitsoverseveralmonths.
Whatitmeans:Theeconomyisheatingup(coolingdown).
Whatstepstotake:Buy(short)home-buildingstocksdirectlyoranETFliketheSPDRHomebuilders(XHB).
Risklevel:MediumfortheETF,highforpickingindividualstocks.
Profitpossibility:$$or$$$
T
Chapter10IndustrialProductionandCapacityUtilization
Coincident,Leading
HEWAYSOMERABBLE-ROUSERSandpoliticiansbemoanthestateoftheindustrialeconomyyou’dbeforgivenforthinkingthatmanufacturingof
goodsofalltypeswasonitslastlegsintheUnitedStates.Well,it’snotdeadyet.Thevalueofindustrialoutputtotalsabout$1.7trillion,ormorethanone-tenthofGDP.It’sstillasignificantandvitalpartoftheoveralleconomy.That’swhybothsavvyinvestorsandpointy-headedeconomistsalikepayclose
attentiontothehealthofthemanufacturingsector.Theydosobylookingattwocloselyrelatedeconomicindicators:industrialproductionandcapacityutilization.Wepresentthemtogetherhere.Industrialproduction(IP)measureshowmuchphysicalstuffisproducedinthe
economyeachmonth.IPincludeseverythingfromprescriptionmedicines,telephonehandsets,andTVstoingotsofgold,barsofsteel,andplanksofwood.Itisconsideredacoincidentindicatorsincetypicallyitneitherleadsnorlagsthestateoftheoveralleconomy.Bycontrast,capacityutilizationcomparesactualindustrialproductionwiththe
absolutemaximumamountofstuffindustrialcompaniescouldproduceiftheyraneverysinglefactoryflat-outallthetime.(Phew!Itsoundsexhausting.)Capacityutilizationisreportedasapercentagefigurewithamaximumpossibleutilizationof100%.Thisindicatoralsodoesagoodjobofmeasuringthecurrentstateoftheindustrialeconomy:Thehigherthepercentageutilization,thehealthiertheeconomyisrightnow.Increasesinthepercentageutilizationrateareseenasagoodsignforbusinessesbecauseitmeanscompaniesarenotlettingmachinesandotherassetssitidle.
INVESTMENTSTRATEGY
It’seasytoseehowcapacityutilizationandindustrialproductionriseandfallwiththestateoftheoveralleconomy.Utilizationratesfellmeaningfullyduringtherecessionsof1990–91,2001,and2008–9.It’snotablethatutilizationonlystartedincreasingamonthaftertherecessionended.Thefollowingtableshowsmonthlydata.Therecessionisindicatedbytheshadedareas:
Capacityutilizationcanalsobeusedtohelpseethefutureintwoways:First,highlevelsofCUtendtosignalfuturebusinessinvestment,possibleemployeehiring,andnewordersforcapitalequipment(newmachinestomakeevenmore
stuff).Asbusinessesmoveclosertomaximumcapacity,businesschiefsfindthemselveslessandlessabletomanagewiththeircurrentresources.“Companiesbridgethegapbyhiringpeopleandgettingbiggerorbetter
machines,”saysBillStone,chiefinvestmentstrategistatPNCWealthManagementinPhiladelphia.Thecompaniesthatsupplyindustrialmachinerydowellinthisenvironment.
“Thinkaboutwhosuppliescapitalequipment,”saysStone,pointingtoCumminsInc.(CMI),ABBLtd.(ABB),FluorCorporation(FLR),andtheircompetitorsasprimeexamples.It’sworthnotingthatthisindustrytendstoseebigcyclicalswingsinearningsandstockprices.Sotimingisthekeyforinvestors,hesays.Inadditiontoconsideringindividualcompanies,investorsmightalsowantto
lookatexchange-tradedfundsthattrackabasketofstocksinthesectorsuchastheVanguardIndustrialsETF(VIS).Thisisn’tanexactmatchforthesector,butitisbroadlyclose.Thesecondwaythisinformationcanbeusedtoforecast:“Whencapacity
utilizationgetsnearitsupperrangesyouneedtostartworryingaboutcostpressures,[orrisingpricesforinputmaterials],”explainsStone.Althoughtheoreticallyutilizationcanreach100%,therealityisthefigurestypicallydon’texceedthemid–80s.Whenutilizationneared90%inthe1970s,costpressuressoared,notesStone.Why?Theclosercompaniescometorunningtheirfactoriesatfullcapacity,
believesStone,themorecomfortabletheyfeelinincreasingthepricestheychargetocustomers.Butwhenallcompaniesdothattheremaybeanoverallbumpincosts.“Itmightcauseyoutofavorcommodity-basedcompaniesthatwouldbenefit
fromrisingrawmaterialscostsratherthanthosethatwouldsufferfromincreasedcosts,”saysPNC’sStone.Twoinvestmentsthatcoulddowellundersuchcircumstances:theVanguardMaterialsETF(VAW)andtheiSharesS&PNorthAmericanNaturalResourcesETF(IGE),bothofwhichtrackabasketofunderlyingstockstiedtonaturalresourcesandcommodities.
EXECSUMMARY:INDUSTRIALPRODUCTIONANDCAPACITYUTILIZATION
Whentolook:At9:15a.m.ETaroundthe15thofthemonth.Thedataisforthe
priormonth.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchindustrialproductionclosely.Asnewsaboutitandcapacityutilizationisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“IndustrialProduction.”Alternatively,youcanfinddataonindustrialproductionandcapacity
utilizationattheFederalReserve.Findthemostrecentdataatwww.federalreserve.gov/releases/g17/current.Historicaldataisavailableatwww.federalreserve.gov/releases/g17/current/table11.htm.
Whattowatchfor:Increases(declines)incapacityutilization.
Whatitmeans:Businessinvestmentisrising(falling)andtheeconomywillsoonfollow.
Whatstepstotake:Buy(short)capitalequipmentsupplierslikeFluor(FLR)orappropriateETFs.
Risklevel:Mediumtohigh.
Profitpossibility:$$to$$$
M
Chapter11InstituteforSupplyManagement(ISM)Manufacturing
Survey
Leading(SeealsoPhiladelphiaFed:BusinessOutlookSurvey,IndustrialProductionand
CapacityUtilization)
ANUFACTURINGISNOTASlargeapercentageoftheeconomyasitoncewas,butitisstillimportantenoughthatmuchoftheinvestingworldpaysclose
attentiontooneparticularsurveyouteachmonth:theISMManufacturingSurvey.ItmeasuresthehealthofthemanufacturingsectoroftheeconomyfromtheperspectiveofthepurchasingmanagerswhoworkatmanufacturingcompaniesthroughouttheUnitedStates.Purchasingmanagersarevitaltoanymanufacturerbecausewithoutthemthere
wouldbenorawmaterialsinplacetofabricateintofinishedandsemifinishedproducts.Thesemanagersspendmuchoftheirtimetryingtopredicttherawmaterialsneedsoftheirorganizations.Theythenmakedecisionsabouthowmuchofwhatstufftopurchasefromothercompanies.Forinstance,thepurchasingmanagersatFordMotor(F)mayneedtobuy
steel,paint,glasswindshields,andtires(amongmanyotherthings)inordertomakecars.Theybuyenoughofthosematerialstobuildthenumberofcarsthecompanythinksitwillbeabletosellinthecomingmonths.Asaresult,howpurchasingmanagersfeelaboutthestateoftheirbusinessrevealsalotabouttheoverallstateoftheeconomy.TheInstituteforSupplyManagement(ISM)surveysfourhundredcompanies
intwentymajorindustriesaboutneworders,production,employment,supplierperformance,inventories,pricesofmaterials,backorders,imports,andexports.Fromthedataonneworders,production,employment,supplierperformance,andinventoriesitcreatesaPurchasingManagersIndex(PMI),theISMsurvey’s
headlinefigure.InvestorsshouldlooktoseewhetherthePMIisinexpansionorcontraction
territory,explainsSophiaDrossos,astrategistatNewYork–basedinvestmentbankMorganStanley.Afigureabove50indicatesanexpansioninthesector.Afigurebelow50indicatesacontraction.Oneimportantnote:TheInstituteforSupplyManagementwaspreviously
namedtheNationalAssociationofPurchasingManagers(NAPM).So,ifyouseereferencestoNAPMinoldnewspaperreportsyou’llknowwhatitmeans.
InvestmentStrategy
WhenanalyzingtheISMindexit’simportanttodigdeeperthanjusttheheadlinefigure.That’sbecausewhiletheheadlinefigureisimportant,thesubindicescanbeevenbetterindicatorsofwhatisgoingtohappen.“Youcanlookattheneworders[index]asaleadingindicatorforfuture
economicactivity,”saysDrossos.Inotherwords,ifnewordersarestrong,orabove50,thenfutureactivityislikelytobegoodalso.Shealsopointstothe“employmentindex”asafairgaugeofthehealthofthe
marketformanufacturingjobs.Again,afigureover50showsgrowthinmanufacturingemployment.“Whenthose[theheadlinefigures,neworders,andemployment]are
expandingatthesametime,that’sconsistentforgrowthinthemanufacturingeconomy,”shesays.Drossosalsoaddsthatsuchanenvironmentwouldfavorso-calledhigh-betaassets,meaningthoseinvestmentsthataresensitivetochangesinthehealthoftheeconomy.Specifically,ahealthyandexpandingmanufacturingsectorusuallymeansstockswoulddowellandbondswoulddopoorly.
EXECSUMMARY:INSTITUTEFORSUPPLYMANAGEMENT(ISM)MANUFACTURINGSURVEY
Whentolook:Thereportisavailableonthesiteatabout10:00a.m.ETonthefirstbusinessdayofthemonth.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchtheISMdataclosely.Asnewsaboutitandcapacityutilizationarereleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter.”You’llfinditatwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ISMManufacturing.”Alternatively,youcouldgotothesource,theInstituteforSupply
Management’swebsite,www.ism.ws.Ithasthemanufacturingsurvey
informationavailabletoanyonewithaccesstotheWeb.Inaddition,www.Briefing.comprovidesasummaryofthedatainatimelymannerataboutthesametime.Althoughmuchofthesiteisforsubscribersonly,the“Investor”sectionisfreeandformostpurposesit’sadequate.
Whattowatchfor:IncreasesinPMI,orders,andemploymentabovethebreak-evenlevelof50.
Whatitmeans:Themanufacturingsectorisgrowingandlikelytheeconomyalongwithit.
Whatstepstotake:Gowithhigh-betasecuritieslikemanystocks,especiallythoseheavilytiedtomanufacturing.
Risklevel:High.
Profitpossibility:$$$
T
Chapter12InstituteforSupplyManagement(ISM)
NonManufacturingSurvey
Leading(SeealsoISMManufacturingSurvey)
HEREAREALOTofbusinessesthatdon’tactuallymakeanythinginAmerica.It’sstrangebuttrue.Thinkaboutit.Retailerssellfoodtoyoubutdon’tgrow
it.Brokershelpyoutobuyrealestatebutdon’tconstructit.Fillingstationssellyougasolinebutdon’trefineitfromcrudeoil.Banking,retailing,wholesaling,andthenonconstructionpartsoftherealestate
business,likeRealtors,areallservicesandtheyareabigdealtoeconomistsandinvestorsbecausetheymakeupaboutseven-tenthsoftheprivate(nongovernment)economyintermsofbothemploymentandGDP,explainsKurtKarl,chiefU.S.economistatinsurancegiantSwissReinNewYork.That’swhytheInstituteforSupplyManagement’smonthlynonmanufacturing
survey,frequentlycalledtheISMServicesIndex,issoimportant.“Itrepresentswhat’sgoingonintheservicessectorfromthepurchasingmanagers’viewpoint,”saysKarl.TheISMServicesIndexiseasytoreadtoo,justlikeitssisterindex,theISM
ManufacturingSurvey.TheheadlinefigureforthenonmanufacturingsurveyisasinglenumberknownastheBusinessActivityIndex.“Above50ismeanttobegrowthintheservicessector,”saysKarl.Likewise,
below50indicatesacontractionorslowinginthenonmanufacturingpartoftheeconomy.“The50figureisnotperfect,however:Wedon’thavealongenoughhistoryto
knowifthatiscorrect,”addsKarl.TheISMServicesdataonlygoesbacktothelate1990s,incontrastwiththemanufacturingdata,whichgoesbacktothe1930s.Thatlackofhistoryisseenasapotentialweaknessfortheservicesdata.
However,itdoescomeoutverysoonaftertheendofthemonthandsolotsofeconomistslikeKarltendtooverlookthatdrawback.OnebiggerproblemKarlpointsoutisthatpurchasingmanagersarenowhere
nearasimportantinservicesastheyareinthemanufacturingsector.Forinstance,theamountofpaperabankneedstoordergivesyoulittleclueastohowhealthythecompanyis,whereastheamountofcoalandironoreasteelmakerordersverymuchtellsyouhowwellthatfirmisdoing.
InvestmentStrategy
Karlsayshelikestolookatthe“neworders”figureasitis“moreforwardlooking”thantheheadlinefigure.Orinotherwords,thenewordersfiguretellsyoumoreaboutthefuturestateoftheservicesectorthandoestheheadlineISMServicesfigure.Bythesametoken,exportordersareanimportantindicatoroffutureeconomic
activity.Ifoneorbothofnewordersandexportordersshowconsistentreadingsover50,thenyoucanbe“reassured”thattheservicessectorwilllikelyseegrowthinthenearfutureifitisn’tgrowingalready.AsISMServicesDataisrelativelynew,Karlwarnsthatithasatendencyto
jumparoundlikeoneofthosebeansfromMexico.That’satleastpartofthereasonhelikestomakechartsoutofthedataandtheneyeballthem.Whenhehasachart,Karllooksfora“level”andnotatrend.Hesaysmovesofacoupleofpercentagepointsupanddownshouldnotbeseenasaproblemaslongasthefiguresstayabove50.
EXECSUMMARY:INSTITUTEFORSUPPLYMANAGEMENT(ISM)NONMANUFACTURINGSURVEY
Whentolook:Thethirdbusinessdayaftertheendofeachmonthatabout10:00a.m.ET.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchISMServicesDataclosely.Asnewsaboutitisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ISMNonManufacturing.”Alternatively,gostraighttotheInstituteforSupplyManagement’sown
websiteatwww.ism.ws,wherethedataandcommentaryarefreelyavailable.SeealsoBriefing.com,asreferencedpreviouslyforotherindicators.
Whattowatchfor:Increases(decreases)innewordersand/ortheheadline
figureabove(below)theputativebreak-evenlevelof50.
Whatitmeans:Theservicesectorisprobablygrowing(shrinking)andtheeconomyalongwithit.
Whatstepstotake:Nowisthetimetopurchase(sell)riskierassetslikestocksandtosell(purchase)old,recession-proofstandbyslikegovernmentbonds.
Risklevel:Low.
Profitpossibility:$
S
Chapter13JoC-ECRIIndustrialPriceIndex
Leading(SeealsoCopperPrice)
OMETIMESTOGETAreadontheeconomyyouneedtogetdownanddirty.Inthiscasethatmeanstakingalookatahodgepodgeofgrittyindustrial
commodities.Ugh?Wellmaybenot,becausealotofthedirtyworkhasalreadybeendonebythecompilersofthehelpfulJoC-ECRI(JournalofCommerce-EconomicCycleResearchInstitute)IndustrialPriceIndex.Itmightbeobscure,butthewaytheJoC-ECRIsignalschangesinthe
industrialeconomycertainlyisn’t.Thatpartoftheeconomyisn’tasbigastheservicesector,butit’salotmorecyclical.That’sgoodnewsforeconomicforecastersbecauseitmeanschangesinthatsectorcanbemucheasierforforecasters,economists,andinvestorstoidentify.TheJoC-ECRIIndustrialPriceIndexmeasuresthepricesofkeyindustrial
commoditiesthatgointomakingallthestuffproducedintheeconomy.Asindustrialcompaniesincreasetheirpurchasesofthesematerials,thepricesgetbidup,signalinganexpansion.Astheydecreasetheirpurchases,thepricespullback,foreshadowingaslowdownorevenperhapsarecession.Thenetresultisthatthepricesofindustrialcommoditiesactasaleadingindicatortotheeconomyasawhole.Theindexincludesenergyprices,basemetals(likecopper,tin,steel,nickel,
andaluminum),textiles,andamiscellaneouscategory(includingtallow,rubber,andplywood).Randomasthatlistmightseem,theelementsonitwerenotrandomlypicked.
Intheearly1980s,theguysattheNewYorkCity–basedEconomicCycleResearchInstitute,whichspendsallitstimestudyinghowdifferentpartsoftheeconomychangethroughthebusinesscycle,wenttogreatlengthstoinclude
onlycommoditieswithpricesthataresensitivetochangesintheeconomy.Forthatreason,ECRIexcludedagriculturalcommodities,wherepricestendto
shiftbasedonweather,andpreciousmetals,wherepricemovementsaresometimesbasedonspeculationandnotindustrialuse,explainsLakshmanAchuthan,managingdirectoratECRI.Ontopofthat,ECRImadeanothercriticaldecision.Notallofthe
commoditiespickedwouldbetradedonfuturesexchanges,althoughabouthalfofthem,likecopper,are.Thereason?“Normallyitdoesn’tmatter,butonceinawhilecommodities
becomeahotinvestmentclassandthatleadseveryoneandtheirbrothertopilein,”Achuthanexplains.“Theycangetreallyvolatile.”Iftheindexincludedonlyexchange-tradedcommodities,thenajumpinthe
indicatorcouldfalselyindicateacomingeconomicboomwhentherealitywasaspeculativefervor,heexplains.Havingabouthalfthecomponentsnottradedonexchangeshelpsguardagainstfalsereadsintheindex,hesays.
InvestmentStrategy
ECRI’sAchuthansayshelikesusingthisindexbecauseit’sreallysensitivetochangesintheeconomyandbecauseitmovessubstantially.Thetrick,hesays,istocharttheindexandthenhesaysaturnintheeconomywillbe“undeniable.”Forinstance,whentheeconomyreboundedfromtheGreatRecession,the
JoC-ECRIIndustrialPriceIndexranup50–60%.Thatsortofmovehelpsgiveyou“theconvictiontogoagainsttheconsensus,”hesays.Butmakingacallonaturnintheeconomyfromexpansiontorecessionor
slumpbacktoboomneedsmorethanachart.Achuthansaysit’simportanttofollowtheECRIanalyticalphilosophyofmakingsurethatthemoveintheindexispronounced(i.e.,itmovedalot),persistent(itcontinuestomoveinthatdirection),andpervasive(it’snotjustdrivenbyonecomponentoftheindex).Ifthechangeintheindexmovesaccordingtothese“threeP’s,”thenit’sprobablysafetocallaturningpointintheeconomy.Thegoodnewsforinvestorsisthatthestocksthatproducesuchindustrial
materialstendtomoveasviolentlyastheunderlyingcommodities.Orputanotherway,swingsinthepriceofcommodity-chemicalsmakerDuPont(DD)willbelargerthanthoseofcompanieslikeProctor&Gamble(PG),amanufacturerofconsumerstaplesliketoothpaste.
EXECSUMMARY:JOC-ECRIINDUSTRIALPRICEINDEX
Whentolook:Weekly.
Wheretolook:ECRIprovidesitsup-to-dateJoC-ECRIIPItoitsmembersforafee.Alternatively,Barron’smagazinepublishestheIPIdataeachweek.Again,you’dhavetopayforasubscription,butifyouneedup-to-datedatainatimelymanner,thenthatmaybethewaytogo.However,ifyouhavemoretimethanmoneyitprobablypaystoscourthe
pressfornuggets.ECRI’sAchuthansaysthatonewayoranotherabout70%oftheinformationonECRI’soutlookavailablethroughmediasources.Thecompanytriestokeepanarchiveofpresscoverageonitswebsiteatwww.BusinessCycle.com/news/press.
Whattowatchfor:ThethreeP’s(pronouncedandpersistentmovementintheindexdrivenbyalarge—orpervasive—numberofindustrialcommodities).
Whatitmeans:Theoveralleconomyisabouttosoar(tank).
Whatstepstotake:Buy(short)industrialstocks.
Risklevel:High.
Profitpossibility:$$$
S
Chapter14LondonMetalExchangeInventories
Leading(SeealsoCopperPrice,ISMManufacturingSurvey)
OMESMARTINVESTORSlookatthepriceofcopperasacluetothehealthoftheeconomy.That’sgreatstufftoknow,insofarasitgoes.Buthowcoolwouldit
beifyoucouldpredictthepriceofcopperandothermetals?Thewaysomesavvyinvestorsdothisistolookattheamountofmaterialthat
isn’tbeingconsumedandjustremainsidle.Orputanotherway,howmanytonsofcopperorofaluminumarejustsittinginglobalstockpiles?It’scounterintuitive,butit’simportant.Traditionally,therehasbeenaninverserelationshipbetweeninventorylevels
andprices.Wheninventoriesarelow,thenpriceshavetypicallybeenhighorrising.Itworksviceversaalso.Theproblemhasalwaysbeenthatit’shardtogetatruereadonwhat
inventoriesthroughouttheeconomyreallyare.Forinstance,howmanytonsofcopperdoesthewiremakerinBrooklyn,NewYork,reallyhaveinhisshed?Individually,suchthingstendnottomakemuchdifference,butwhenallthelittleplayersareaddedup,theircollectiveimportanceemerges.Inotherwords,gettinggooddatatoanalyzemetalsmarketsistricky.Oneclue
tosolvingthepuzzleisfoundattheLondonMetalExchange,acommodityfuturesorganizationthatdominatestheglobaltradinginfutures-stylecontractsofindustrialmetalssuchascopper,aluminum,zinc,lead,tin,andnickel.EachbusinessdaytheLMEprovidesdataontheamountofmetalthatisavailableinitswarehouses.Tobesure,itisn’tthewholepictureofworldwidemetalsinventories.Butitis
transparent(i.e.,whatyouseeiswhatyouget),timely(daily),and,inouropinion,agoodindextomonitor.
Notecarefully:Verylowinterestratescandistortthetraditionalinverserelationshipbetweenpricesandinventories.Whenthecostofborrowingmoneyisabnormallylow—likeduringtheGreatRecessionof2008–9anditsaftermath—speculatorssometimesdecidetosnapupcommoditiesasaninvestment.Asaresult,inventoriesstayhighwhenpricesdoalso.That’sinpartbecausethemetalownedbyspeculatorsisn’tavailableforfabricationbymanufacturers.
InvestmentStrategy
ThesizeofLMEinventoriescanindicatealotaboutthefuturehealthofthemetalsandminingbusiness.Ifinventoriesarehigh,thenit’slikelyasignthatbusinesswillslowdownasminersandrefinerscutbackonproduction.Likewise,ifinventoriesarelow,thenitcouldportendafuturepickupinbusinessforminersandrefiners.Thereisawrinkle:Dataaboutmostcommodities,includingmetals,canbea
bitmurky.Butthatmeansthesavvyinvestorwhoispreparedtoputinsomelegworkcanreallywinbig.Why?Becausethedatasituationisequallycloudyforallinvolvedandmostwon’tgotoanyextraefforttogetaclearerpicture.Ifyoudo,you’llhavetheadvantage.NeilBuxton,managingdirectoratLondon-basedconsultingfirmGFMS
Metals,sayshestartshisanalysisbylookingatLMEinventorylevels“asanindicatorofthemarketbalance.”Inshort:Isthemarketwellsuppliedwithlargestockpilesofmetal,orisittightwithlowlevelsofinventories?Inanyevent,whileitisuseful,theLMEinventorydatashouldbeaugmented
withstockpilefiguresfromtheCMEGroup’sCOMEXdivisionandalsofromtheShanghaiFuturesExchange,saysBuxton.TheirstatisticsaresimilartothoseprovidedbytheLMEandhelpprovideamorecompletepictureofmarketbalance.Bydoingthisextralegworkandcollectingadditionalnuggetsofdata,smartinvestorscangainamorecompletepictureofthemurkyworldofmetals.Ontopofthat,savvyinvestorsshouldlookatindicatorsthatreflectpossible
futuredemand.Inparticular,BuxtonsayshewatchesthevariousPurchasingManagersindices,orPMIs,liketheISMManufacturingSurveydescribedelsewhereinthisbook.ThesePMIstelluswhatmanufacturingbusinessesareplanningtodointhenearfuture.Ifbusinessconditionslookgoodtothepurchasingmanagers,thenthatwilllikelybegoodformetalsdemand.Inaddition,thehealthoftheChineseeconomyhasbeenaveryimportant
factorindeterminingmetalsprices.BuxtonsaysthatChinarepresents30–40%ofglobaldemandforsomeofthesemetals,andhenotesthattradedatafromthatcountryfrequentlyimpactmetalsprices.“Whenlookingatthesemarkets,theunderlyingfundamentalsdomatter,and
thatcomesthrough,”hesays.
EXECSUMMARY:LONDONMETALEXCHANGEINVENTORIES
Whentolook:Everybusinessday.
Wheretolook:TheLondonMetalExchangeprovidesprice,inventory,andothermarketdataonitswebsite,somefree,someforafeeatwww.lme.co.uk.TheCOMEXandtheNewYorkMercantileExchangearenowadivisionoftheCMEGroupatwww.cmegroup.com.TheShanghaiFuturesExchangewebsiteshowsweeklydataoninventorylevelsatwww.shfe.com.cn.
Whattowatchfor:Increasesordecreasesininventoriesofdifferenttypesofmetal.Inaddition,lookforincreasesordecreasesinChinesedemandandtherelativehealthofthemanufacturingsectorintheindustrializedeconomies(seevariousPurchasingManagersindices).
Whatitmeans:Typically,lowinventoriessignalathrivingmanufacturingsector.Highinventoriessignalastagnatingmanufacturingsector(exceptwheninterestratesareabnormallylow).
Whatstepstotake:Wheninventoriesarehigh,typicallyavoidstocksthataresensitivetothemanufacturingeconomy.Wheninventoriesarelow,buymanufacturingstocks.
Risklevel:High.
Profitpossibility:$$$
Chapter15PersonalSavingsRate
F
Coincident
ORMANYAMERICANSIT’Skindofboringtosave.Whybotherwhenyoucanspendnowandpaylater?Anyway,itkeepstheeconomyrevvingalong,
right?Well,almost.“Savingstodaycanhelplonger-termgrowthinthefuture,”
explainsDerekBurleton,deputychiefeconomistatTDBankFinancialGroupinToronto.Inshort,moresavingsinaneconomymeansmoreinvestment.Thatmoneyhas
togosomewhere,and,inthiscase,itgetsfromyoursavingsaccountintoloansandsecuritiesthatfinancetheconstructionofnewfactoriesortheretoolingofoldones.Savingsareimportanttoeconomistsforthisreason,buttheyarealsooften
difficulttocalculatebecausetheso-calledpersonalsavingsrateisn’tactuallytrackedanywhere.Instead,statisticiansbackintothenumberbylookingattheoverallincomeofallpeopleintheUnitedStatesandthensubtractingoverallspending.Theyassumethatifyouearneditbutdidn’tspendit,thenyoumusthavesavedit.It’salsoworthnotingthatahighsavingsrateinacountrycanhelpprotecta
governmentthatisdeepindebt.Forheavilyindebtedgovernments,thebigquestionis:Whereisthemoneygoingtocomefrom?Well,ifthemoneycomesfromsaverswithinthecountry,thenthereismuchlesstoworryabout.Atthetimeofwriting,Japan’sgovernmentisheavilyindebted,with
borrowingsofabout200%ofitsnationaloutputorGDP.That’sabouttwicethelevelofU.S.governmentindebtedness,percentage-wiseanyway.Buthere’sthething:InsomewaystheJapanesegovernmenthaslesstoworryaboutthantheU.S.governmentdoes.WhileJapan—anationofbigsavers—mostlyborrowsfromitsownpeople,theUnitedStatesisheavilydependentonforeignerslendingitthemoney.Americansarenotasthrifty.Asaresult,theJapanesegovernmentdoesn’thavetoworrythatforeignerswillsuddenlystoplendingtoit,whiletheU.S.governmentisconstantlyonguard.
InvestmentStrategy
Thereisabigproblemwiththesavingsratedata.It’sveryvolatile.That’sbecauseofthewayit’scalculated.Burletonexplainsthattheincomeandspendingfiguresarebothjustestimates.Ontopofthat,theyarebothverylargenumbers.Becausesignificanterrorscanbemadeintheestimates,thederivedsavingsratenumberscanoftenjumparoundviolently.“Wetrynottoreadtoomuchintolevelsofsavings—morethedirection,”says
Burleton.Or,inotherwords,helooksatwhetherthesavingsrateisgoingupordown,ratherthanwhetheritis3%or1.5%.Hesaysinvestorscanusethetrendinthesavingsratetoassessthemoodof
consumers.Ifthetrendisformoresavings,thenconsumersareprobablyprettynervous.Ifthetrendshowsprogressivelylowerlevelsofsavings,thenit’sagoodsignthatconsumershavetheconfidencetospend.
EXECSUMMARY:PERSONALSAVINGSRATE
Whentolook:At8:30a.m.ETaboutfourweeksafterthemonthreported.Itcomesintheformofthe“PersonalIncomeandOutlays”reportfromtheCommerceDepartment.
Wheretolook:EditorsandwritersatTheWallStreetJournallookcloselyatthedataonincomeandspending,therawmaterialsofthesavingsfigures.Asthedataisreleased,reportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatayouwant,gotoTheWallStreetJournalonline’s“Market
DataCenter.”Thereyou’llfindsummarydataonpersonalincomeandoutlays.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“PersonalIncomeandOutlays.”Foraderived“savingsrate”figureaswellastheincomeandspending
numbers,gototheU.S.BureauofEconomicAnalysisatwww.bea.gov/national/index.htm#personal.Forhistoricaldata,trytheSt.LouisFed’sFREDdatabase.
Whattowatchfor:Anincrease(decrease)inthesavingsrate.
Whatitmeans:Consumersareprobablyprettyjittery(feelingconfident).
Whatstepstotake:Ifthesavingsrateistrendingupward,thenit’slikelythattheconsumptionpartoftheeconomywillbeweak.Therefore,it’sbesttoavoidstocksofconsumer-drivencompanies.
Risklevel:Medium.
Profitpossibility:$$
S
Chapter16UnitLaborCosts
Coincident(SeealsoISMManufacturingSurvey,PhiladelphiaFed:BusinessOutlook
Survery)
OMEWORKERSARELAZYorunproductiveandsomearehardworkingandefficient.Anyonewhohasheldajobknowsthat.Althoughsometimesonan
individual-by-individualbasisthatphenomenoncanbehardtomeasure,overallwecanknowhowefficientwearebylookingatsomethingcalled“unitlaborcosts.”Thisindicatormeasuresthecostofthelaborcomponentofmakingaunitof
industrialoutput.Probablythebestwaytothinkofitis:Howmuchofthecostofmakingasinglewidgetwasfromlabor?Overtimewhatbusinessesreallywanttoseeisdeclinesinunitlaborcosts.
Suchaneventmeansthatbusinessesarebeingmoreefficient.Andthat,inshort,iswhatunitlaborcostsare:ameasureofefficiencyandproductivity.“Bettermachinesmeanbetterproductivity,andthatwillmanifestitselfin
lowerunitlaborcosts,”saysCampbellHarvey,professoroffinanceatFuquaSchoolofBusinessatDukeUniversity.“Butthechangesinproductivitydon’thappenquartertoquarter;theyaremoreofalong-termfunction.”Ifthereisanoticeablechangeinunitlaborcostsoveraperiodof,say,threeyears,someofthatmightbeattributabletoimprovementsinproductivity,saysHarvey.Theexactoppositeofwhatmostbusinesseswanthappenedinthe1970sand
early1980s(seefigurebelow),whenunitlaborcostssoared,sometimesover10%ayear.Itwastheresultofhighwageinflation.Ifthisindicatorsoundscomplicated,don’tworrytoomuch.TheBureauof
LaborStatistics,agovernmentagency,calculatesitforyoubydividingemployerlaborcosts(wagesandbenefits)byrealvalue-addedoutput.Ifworkersproduce
morevalueandtheirwagesstaythesame,unitlaborcostswillfall,whichisgoodforbusinesses.
InvestmentStrategy
Thebiggestwrinklewiththeunitcostdataisnotinreadingwhetherlaborisgettingmoreorlessefficient.Bynowthatshouldbeeasy.Rather,therealknottyproblemisdeterminingwhatitmeansforthebroadereconomy.Thebigissue:Exactlythesamephenomenonmeanspreciselyoppositethingsdependingonwhereyouareinthebusinesscycle,explainsHarvey.Talkaboutdiabolical!Forthatreason,youneedtolookatthismetricinconjunctionwithotherindicators,likethoseinthisbook,totellwhereyouareinthebusinesscycle.Ifyouareinarecessionandunitlaborcostsaredrivenup,itcouldbeagood
thing.Thereasoning:Itmaybeasignthatworkersarebeingpaidbetter.Thatcaneventuallyshowupinincreaseddemandforgoodsandservices.Sounderthosecircumstancesinvestorsmightviewrisingunitlaborcostsasapositivesignofaneconomicrebound.Sagginglaborcostsduringarecession,however,couldalsosignaldeflationandanevendeeperdownturntocome.Conversely,inaneconomicboom,risinglaborcostsmightbeconsideredbad.
Thereason:Itmightbeasignofinflation.Specifically,ifthelaborcostcomponentofmakingstuffgoesupandthematerialscoststaysthesame,thenbusinessesmustincreasesellingpricesinordertomaintainthesamelevelofprofit.Lowerlaborcoststhataretheresultofimprovingworkerefficiencyduringaneconomicboom,however,wouldbeaverybullishsign.AsHarveyrecommends,itmakessensetoconsulttheotherindicatorsinthisbook.Ifitlooksliketheeconomyisimprovingandtheunitlaborcostsarefalling,
theninvestorsmightwanttoconsiderpurchasingassetsthataresensitivetotheeconomy,likestocks,especiallymanufacturingcompanies.Forinvestorswhodon’twanttopickindividualstocks,aninvestmentfund
thattracksabasketofindustrialstocks,liketheIndustrialSelectSectorSPDR(XLI)exchange-tradedfund,mightmakesense.
EXECSUMMARY:UNITLABORCOSTS
Whentolook:Thisdataispublishedquarterlyat8:30a.m.ETnearthebeginningofthemonth.ThedataisforthepriorquarterandcomesoutinFebruary,May,August,andNovember.Eachalsohasarevisiononemonthafter
thefirstread.
Wheretolook:ReportersandeditorsofTheWallStreetJournalcloselywatchlabortrends.AsnewsisreleasedbytheLaborDepartment,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter.”You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ProductivityandCosts.”Toseethedatadirectly,gototheU.S.BureauofLaborStatisticsat
www.bls.gov/bls/newsrels.htmandlookfor“ProductivityandCosts”newsrelease.
Whattowatchfor:Changesinunitlaborproductivity.
Whatitmeans:Thisalldependsonwherethebusinesscycleis.Risinglaborcostsduringarecessionmightsignalarecoveryoranastyboutofinflation.Fallinglaborcostsmightmeanhigherproductivityoradeeprecession.
Whatstepstotake:Ifarecessionyousee,safetyyoumustseek.Arealexpansionoftheeconomyshouldbeanticipatedbyamoveintoriskierassets,likeequities.ButiftheexpansionismerelynominalduetoinflationthentakesomeTreasuryInflation-ProtectedSecurities(TIPS)andmineforgold(orbuyagoldETF).
Risklevel:Lowtohighdependingonhowwellyouintegratethisindicatorwithotherstodiscerntheeconomy’struedirection.
Profitpossibility:$to$$$$
Government(G)
GOVERNMENTHASAVORACIOUSappetiteforconsumptionofallkindsofstuff.Together,allthedurableandnondurablegoods,services(likeresearchanddevelopmentandeducation),andinvestmentinequipment(muchofitmilitary),buildings,andhighwaysaccountforabout15–20%ofGDP.We’veincludedonlyoneindicatorofitsactivity:thefederalgovernment
budgetdeficit.It’saparticularlyinterestingindicatorbecausewhileintheshortrundeficitsoftenpointtoincreasesinthegovernmentcomponentoftheeconomy—andhenceincreasesGDP—theyalsoportendproblemsaheadforotherpartsoftheeconomy.Notably,whenthegovernmenthasbigdeficitsittypicallyresultsin
decreasesintheconsumption(C)andinvestment(I)alittlefurtherinthefuture.Thatisbecauseasgovernmentexpandsitdoessousuallybyacombinationofincreasingtaxes,borrowing,orprintingpapermoney.Taxesofcoursedecreasefutureconsumptionandinvestment.Borrowingisnothingmorethanfuturetaxation,andprintingmoneycausesinflation,whichalsoactsasaformoftax,albeitasilentone.Taxesarenecessaryevils,thepricewepayforcivilization,inthewordsof
SupremeCourtjusticeOliverWendellHolmes(andtheIRS),buttheycanbeverydistorting.Aswellasinducingstrangearchitecturaldesigns(toavoidtaxesonwindows),hugehouseholds(todiminishtheimpactofataxonhouseholds),andbigformatnewspapers(todecreaseataxonthenumberofpages),poorlydesignedtaxeshavewreckedeconomies.Itusuallytakessometimetodosoandisn’tabusinesscyclephenomenon,butwefiguredthatwhileweareatitweshouldwarninvestorsthatbigdeficits(andtheinevitablechangesinthetaxcode)areworthworryingabout.
Chapter17FederalGovernmentBudgetDeficitsandtheNational
Debt
S
Coincidenttoleading
OMEPEOPLEHAVEMONEYleftattheendofthemonth,butthesedaysmostpeoplefindthattheyhavemoremonthleftattheendoftheirmoney.Well,if
youfeelabitstrappedforcashthesedays,don’tdespair,asyouarenotalone.Nationalgovernmentsaretoo.Whengovernmentspendsmoremoneythanitreceivesintheformoftax
revenues,theresultiscalledadeficit.It’slikeagapingholeinthebudget.Tofundthedeficit,governmentsborrow,andtheaccumulatedborrowingsformthenationaldebt.Atthetimeofwriting,theU.S.nationaldebttotaledover$14trillion.That’safourteenwithtwelvenumbersafterit.It’sawholelotofmoney,anditcouldbecomeaproblem.Thereasondeficits,andultimatelynationaldebt,areworrisomeisbecausethe
biggerthedebtgets,andthehigherinterestratesongovernmentbondsgo,theheaviertheburdenofthegovernment’sdebtservice.Inotherwords,agreaterportionofeachtaxdollarmustgojusttopayinterestonthedebt.Alsoproblematic,governmentsthatbecametooheavilyindebtedhaveoften
resortedtoprintingmoney.Whilethathelpsthempaythedebts,itultimatelycausesinflation.Tomakemattersworse,whileit’seasytoseeconsequencesofrunninglarge
deficits,it’sactuallyquitedifficulttointerpretdeficitdata.Thetroublewithlookingatoneyear’sdeficitofanycountryinisolationisthatagovernment’staxrevenueishighlycorrelatedtothebusinesscycle.Inarecessionthegovernmenttendstobringinfewertaxrevenues,andinaboomyearittakesinmuchmore.That’swhyyoucan’tgiveanyoneyear’sdeficitanyrealmeaning,saysDavidRanson,headofresearchatBeverlyFarms,Massachusetts–basedeconomicsconsultingfirmH.C.Wainwright&Co.EconomicsInc.Hesaysit’sbettertolookattheannualdeficitasapercentageofGDP.Thekeynumberis3%.“It’sconventiontoregard3%asanormaldeficitbecausetheeconomygrows
3%normally,”saysWainwright’sRanson.“Thatmeansthegovernment’sdebtisrisingonlyasfastasGDP,whichishealthy.”Inotherwords,itisn’tabigdealifthenationaldebtstaysataconstant
percentageofGDP.Butwhatifdeficitsgrowfasterthantheeconomy?
InvestmentStrategy
Thenationaldebtisaharbingerofinflation,butitslevelisnotcorrelatedwiththebusinesscycle.Annualbudgetdeficits,however,arecloselytiedtothebusinesscycle.“Overtime,thehigheryourdeficit,thenthehigherareinflationrates,andyoucouldgethyperinflationratesifthegovernmentisunabletoextricateitselffromthatpredicament,”explainsRanson.Orputanotherway,continualdeficitsleadtoarisingnationaldebt,andahighlevelofnationaldebtisaharbingerofinflation.Asalreadymentioned,thekeytoavoidinginflationisforaverageannualdeficitstostaybelow3%.Theproblemisthat,basedonprojectionsatthetimeofwriting,thecurrentU.S.deficitisover10%andprojectedtofallto4%andriseagain.“Itprobablywon’tgetmuchbetterthanthat,”hesays,andthatworrieshim.Ransonpointstogoldasagoodbetagainstinflationiftherearesustained
budgetdeficitsinexcessof3%ofGDP.Ontheotherhand,hesayscountriesinwhichthegovernmentcankeepalidonspendingandkeepdeficitsbelow3%willattractcapitalandasaresultgrowatafasterrate.“Thatincludesalotoftheemergingworldthesedays,”hesays.Accordingly,investorsmightwanttoconsidermutualfundsthatspecializein
investinginstocksofemergingmarketcompanies.
EXECSUMMARY:FEDERALGOVERNMENTBUDGETDEFICITSANDTHENATIONALDEBT
Whentolook:Fordeficitfigures,theU.S.Treasuryprovidesmonthlystatementsofitsreceiptsandoutlaysat2p.m.ETonthe8thbusinessdayofeachmonth.Inaddition,continuousestimatesforthenationaldebtareavailableviavarious
nationaldebtclockslikeUSDebtClock.orgatwww.usdebtclock.org/.
Wheretolook:EditorsandwritersatTheWallStreetJournalkeepacloseeyeonthefinancesoftheU.S.government.AstheU.S.Treasuryreleasesitsdata,reportersfilestoriesforpublicationonWSJ.com.Foralookatthedata,youcangostraighttotheU.S.Treasurymonthly
statementatwww.fms.treas.gov/mts/index.html.Toanalyzeitappropriatelyyou’llneedtoannualizethemonthlydata(i.e.,sumupthepriortwelvemonthsofdeficits)andthencomparethattotaltooverallGDP.Inaddition,theFREDdatabaseattheSt.LouisFederalReserveenrichesus
withhistoricaldataathttp://research.stlouisfed.org/fred2/series/FYFSD?cid=5,andmajornewsoutletsalsocoverbudgetnegotiations.Ifyouwanttotakeanin-depthlookatthecurrentfederalbudget,browsewww.whitehouse.gov/omb/budget/.
Whattowatchfor:Increases(decreases)inthenationaldebtasapercentageofGDP,usuallysignaledbyrecurringdeficitsgreaterthan3%ofnationalincome.
Whatitmeans:Thegovernment’sincentivetocauseinflationisincreasing(decreasing).
Whatstepstotake:Short(buy)traditionalgovernmentbondsandbuy(short)gold,and/oremergingmarketequitymutualfunds.
Risklevel:High.
Profitpossibility:$$$
NetExports(NX)
TheUnitedStatesdoesn’Texistinisolation.Wesellstufftoforeigncountriesandbuystufffromthem.Inshort,therestoftheworlddoescount.That’swhyweincludehalfadozenindicatorsofnetexportshere.Thedifferencebetweenwhatwesellabroad(exports)andwhatwebuy
(imports)iscallednetexports.EconomistsusethesymbolNX.Forsmall,openeconomieslikeIreland,NXispositiveandamajor
contributortoGDP.ForAmerica,however,NXistypicallynegative,shrinkingGDPbyabout5–10%.ImprovementsgenerallyentailNXbecominglessnegative,butstillbelowzero.Exportsandimports,itshouldbenoted,notonlyincludemerchandisebutalsoservicessuchastourism,consulting,andbanking.ThebiggestinfluenceonU.S.netexportsisthedollar.Whenthe
greenbackisweak,exportsimprove,andthenetpositionbecomeslessnegativebecauseU.S.goodslookcheaptoforeigners.LikewiseforeigngoodslookexpensivetoAmericans.Therefore,exportsincreasewhileimportsdecrease.Itworksviceversatoo.Intheshortterm,economictheoriststellus,thebiggestinfluenceon
exchangeratesisinterestrates,orrathertheexpectationofchangesinrelativeinterestrates.Longer-termexchangeratesrespondtorelativechangesintherealeconomy,thingslikepricesandproductivity.Tounderstandwhatisgoingtohappentoexchangerates,onemustknowwhatishappeningonthegroundintheworld’sothermajoreconomies,whichalsohappentobeAmerica’sbiggesttradingpartners.Thatiswhywehavealsoincludedinternationalandforeignindicatorsinthissection.Suchindicatorscanbeusedtogetafeelfordevelopmentsintheglobal
economy.Intimespast,onecountryorregioncouldsufferrecessionwhileanotherboomed.Today,we’reallconnected—aphenomenoneloquentlydiscussedbyauthorThomasFriedmanandothers.
Chapter18BalticDryIndex
T
Leading
HEFUNNYTHINGABOUTtheBalticDryIndex(BDI)isthatitinvolveslotsofwater.Specifically,it’sameasureofthepriceofmovingrawmaterialsacross
theworld’soceans.InthatsensetheBDIisquitewet.The“dry”referstothestateofthethingsshipped:ironore,coal,andgrains,typically.Theyaredrycargoes,asopposedtowetoneslikecrudeoil.The“Baltic”partofthemonikerreferstotheLondon-basedBalticExchange,
whichcalculatesandpublishestheBDIweek-days.It’snotlimitedtocargoesshippedacrosstheBalticSea,however.TheBalticExchangetracksthecostofmovingfreightalongkeyshippinglanesaroundtheglobe.Theindexitcreatesreflectsthecosttorentashiptodayintheso-calledspotmarket,ratherthanapricetorentoneatsomepointinthefuture.Theseso-calleddry-bulkshipsarereallylike“massiveoceangoingdump
trucks,”saysUrsDur,seniorequityanalystformarineshippingandlogisticsatLazardCapitalMarketsinNewYork.Howbig?Thelargestofthesevesselsissobigitcan’tsailthrougheitherthePanamaortheSuezCanal.InordertotraversetheglobetheseoversizeshipsmusttravelaroundtheCapeofGoodHopeorCapeHornatthebottomofAfricaandSouthAmerica,respectively.Asaresulttheseshipsarecalled“Capes.”OthershipcategoriesindescendingorderofsizearePanamax,Supramax,andHandysize,allofwhichcanmovethroughthecanalsandareincludedintheBDIalongwiththeCapes.ThesimplestwaytothinkaboutmovementsintheBDIisthatitgoesupand
downaccordingtothedemandforthevessels.Asdemandincreases,thepricetocharterashiprises.That’sbecauseintheshortrun,thenumberofshipsavailableistypicallyfixed.Sowhentheglobaleconomyhumsandtheneedforrawmaterialsincreases,thepricetorentashiprises.WetracktheBDIbecauseitgivesaninsightintothestateoftradeinthemost
basicindustrialmaterials.Notably,ironoreandcoaltogethermakesteel—anessentialinputforconstructionandakeytothemanufactureofautomobilesaswellasmanyotherconsumerdurables.LatelythatmeanswatchingChina.Lazard’sDursayshewatchesChineseiron
oreinventoriesandtheoverallhealthofthateconomy.Inparticular,whenironoreinventoriesarelowbuttheChineseeconomyisstillhealthy,increased
importsoforemightbeinthecards.
InvestmentStrategy
DursaysinvestorscanprofitfromchangesintheBDIbyfindingapubliclytradedshippingcompanywithrevenuesthatfluctuatedaytodayjustliketheBDI.SuchacompanywouldseeitsrevenuesincreaseastheBDIrises,anditsearningsfallastheBDIsinks.Findingsuchacompanyiseasiersaidthandonebecausesomeshipperslockin
therateatwhichtheyrentouttheirvesselsforyearsatatime.Theresult:TheirrevenuegyrateslessthandoestheBDI.OnecompanythatfitsthebillisBalticTradingLtd.(BALT).Dursaysthe
firm’sstatedgoalistorentoutshipsatspotmarketrates,ratherthanlockinginpriceswithmultiyearcontracts.“ThisisapureBalticplay,”hesays.Atthetimeofwritingthefirmhasnodebtandintendstopayoutmostofwhat
itearnsindividendstoshareholders,Dursays.OthercompanieswithsomespotmarketexposureincludeEagleBulkShipping(EGLE)andNaviosMaritimeHoldings(NM),hesays.SomeanalystsalsousechangesintheBDItopredictfuturecommodity-price
movements.Forexample,aslumpintheBDImightsuggestafalloffinmetalspricesinthenearfuture.Butthatcanberisky,Durcautions.HesaysBDIchangessometimeshavelittle
todowithchangesinunderlyingdemand.Forinstance,aspikeinpricesmightsimplyindicatethelimitedavailabilityofshipsintheareaneeded.Atanygivenmoment,thesupplyanddemandforshipsislocal.Ifanavailableshipishalfwayaroundtheworldfromwhereit’sneededthatcancauseapricespikeincharterrates,butitwillbeonlytemporary.Anotherwrinkletowatchfor:adropintheBDIcausedbynewly
manufacturedvesselshittingthewater.Theywilllikelyweighdownoncharterratesforallships,regardlessofunderlyingdemandforthecargoes.
EXECSUMMARY:BALTICDRYINDEX
Whentolook:Eachbusinessday.
Wheretolook:TheunderlyingdataisproducedbytheBalticExchangein
Londonatwww.balticexchange.com/,butthereisafeeifyouwantthedata.Alternatively,youcansnagachartfromInvestmentTools.comat
www.investmenttools.com/futures/bdi_baltic_dry_index.htm,orlookatthepublicsitesofthemajorwireservices.
Whattowatchfor:Increases(decreases)intheBDI.
Whatitmeans:Increased(decreased)demandforrawmaterialsusedinmanufacturing.
Whatstepstotake:Buy(short)publiclytradedshippingcompaniesthatareexposedtodailyfluctuationsinthecostofrentingdry-bulkships.
Risklevel:Medium.
Profitpossibility:$$
Chapter19BigMacIndex
I
Leading
N1986AJOURNALISTatTheEconomistnewspaperinLondonwonderedwhatdifferentcurrencies,liketheJapaneseyenortheBritishpound,wouldbe
worthifaBigMacburgercostthesameineverycountry.TheideabecametheBigMacIndex(BMI).“TheBigMacIndexwasanamusingwaytomakeeconomicsmorefun,”says
PamWoodall,asenioreconomicswriteratthepublication,andtheinventorofthisindicator.“Peopleloveditandwekeptdoingityearafteryear.”Whileitlooksstrangeatfirstglance,thereissomeseriouseconomicsbehind
it:thetheoryofpurchasingpowerparity(PPP).Thistheorysaysthatifinternationaltradeisunfettered,thengoodsandservicesinallcountriesshouldeventuallycostapproximatelythesameamount.Inthiscasethe“good”ofchoiceistheubiquitousBigMacburgersoldbyfast-foodretailerMcDonalds.IfBigMacscostthreeeurosinFranceandthreedollarsinNewYork,thenthelogicalexchangerate,accordingtothePPPtheory,shouldbeonedollar=oneeuro.ThebeautyofusingtheBigMacisthattheyare(moreorless)identical
everywheretheyaresold.Thatmeansnoadjustmentsneedtobemadefordifferingqualityorsize,aswouldbethecasewithnonstandardgoods.Totheextentthattheactualpriceoftheburgerinanothercountrydiffersfrom
pricesintheUnitedStates,thatcountry’scurrencyiseitherovervaluedorundervalued.IfthesameBigMaccostsfiftycentsinBeijingbutthreedollarsinNewYork,
thenbythisindicator’sreckoningtheChinesecurrencyisundervalued.
InvestmentStrategy
ThemostusefulinvestingideabehindtheBigMacIndexistopredictthevalueofforeigncurrenciesoverthelongterm.LatelyabigquestioninforeignexchangemarketsandpolicycircleshasbeenwhethertheChinesecurrency,theyuan,isundervalued.Aquicklookatthe2010BigMacIndexprovidesadefinitiveanswer.Notonlyistheyuanundervalued,itisthemostundervaluedcurrency—possiblybyasmuchas50%.Bythesamemeasure,theMexicanpesoisalsoundervaluedbyover25%.SoshouldyouinvestincurrenciesthatareundervaluedaccordingtotheBMI?TheEconomist’sWoodallsayssomepeopleclaimthattheBigMacIndexisa
betterpredictorofthevalueofacurrencythanmoresophisticatedeconomicmodels.Shealsonotesthatmanyacademicstudiesshowitsvalidity.ButWoodallcautionsthatthereisawrinklethatdistortstheBMI.The
problem:AlthoughBigMacsaresoldlikeanyothergood,theycan’treallybestoredforuseweekslater.Weknow.Oneofustriedanditdoesn’tendhappily.ThatmakestheBigMacmorelikeaservice,somethingtobeconsumedwhereit’spurchasedlikeabackmassage.Sowhat?Well,therearesoundeconomicreasonswhyservicesshouldbecheaperinemergingmarkets:Wagesarecheaperthereandwagesareabigcostcomponentinservices.SothepriceofaBigMacshouldbesomewhatcheaperinBeijingthaninNewYork.Italsomeansthatevenwhencurrenciesarefullyvalued,theBMIwillshow
thatemerging-marketcurrenciesareundervalued.Sousethisindicatorasaguidetowhethercurrenciesareegregiouslyovervaluedorundervalued.Ifacurrencyisvastlyundervalued,expectittoriseinvalue,eventually.Viceversa,ifit’sovervaluedexpectitsvaluetofall.IfthesecaveatsaboutTheEconomist’sBigMacIndexmakeyounervous,
UBSWealthManagementResearchhasdevelopedaBMIvariant:ItcalculatesthenumberofhoursalocalworkermusttoiltopurchaseaBigMac.Adecreaseinthenumberofhoursmightindicateanincreaseinproductivityandhenceaneventualappreciationofthedomesticcurrency.Carefulthough—otherthingscanhaveanimpactonhowfastaworkerearnsthevalueofaBigMac,likechangingtastesordownwardmarketpressureonretailprices.Ifyoudecideyoudowanttoinvestincurrencies,asafewaytogoistolookat
thevariousexchange-tradedfundsthattrackthevalueofdifferentcurrencies
relativetotheU.S.dollar.ExamplesincludeCurrencySharesEuroTrust(FXE),CurrencySharesBritishPoundSterlingTrust(FXB),andtheCurrencySharesCanadianDollarTrust(FXC).ThereareotherfamiliesofETFsthatserveasimilarrole.Noviceinvestorswoulddowelltoavoidinvestingdirectlyinthecurrencymarketsortradingwithborrowedmoney.
EXECSUMMARY:BIGMACINDEX
Whentolook:WeeklyonFridays,whenTheEconomistispublished.
Wheretolook:TheonlineversionofTheEconomistnewspaper,Economist.com,publishestheBigMacIndex.
Whattowatchfor:CountrieswhereBigMacscostsignificantlyless(more)indollartermsthantheydointheUnitedStates.
Whatitmeans:Thelocalcurrencyisundervalued(overvalued)andhencelikelytoappreciate(depreciate)inthelongrun.
Whatstepstotake:Buy(short)undervalued(overvalued)currencies,possiblythroughacurrencyETF.
Risklevel:Astronomical.
Profitpossibility:$$$$+
T
Chapter20CurrentAccountDeficit
Leading(SeealsoTICData)
OSAYTHATU.S.consumersloveimportedgoodswouldwoefullyunderstatethesituation.No,thetruthisthatforatleastthepasttwodecadesAmericans
havegorgedthemselvesonimports,notablyfromChina.Asaresult,giganticimbalanceshaveemergedintheglobaleconomy.Theproblem,however,isnotinitselfthatAmericansbuylotsofforeign
knickknacks.Buyingstuffiswhatmakestheworldeconomygoround.TheissueisthatAmericanshavespentsomuchmoremoneyonforeignproductsthanforeignershavespentonU.S.goodsandservices.Suchasituationcanpersistforyearsbutnotforever.WecanmeasureexactlyhowmuchmorestufftheUnitedStatesbuysfrom
othercountriesthanforeignersbuyfromusbylookingattheso-calledtradebalanceorthe“currentaccount.”Formostcountriesthetradebalanceisroughlyequivalenttothecurrent
account.Inthenationalaccountsthecurrentaccountistechnicallythetradebalanceplusnetincomefrominterestanddividendsplusnetforeignaid.Sowhenpunditsandeconomiststalkaboutacurrentaccountdeficittheyalmostalwaysreallymeanatradedeficit,somethingAmericahasrunformanyyears.“Wepayforthoseimportsbyborrowingmoneyorbysellingassetstotherest
oftheworld,”saysPaulWachtel,professorofeconomicsatNYUStern.Insomewaysthisislikesellingthefamilysilvertoputfoodonthetable.Youcandoitonce,butit’snotsustainable.BecausetheUnitedStateshasrunarelativelyhightradedeficitforsolong,a
hugeimbalancehasbuiltup,explainsWachtel.Specifically,hemeansthatforeignershavelentAmericaalotofmoneytofinancethepurchaseofthose
imports.ThatcanspelltroubleaheadforthevalueoftheU.S.dollarandthehealthoftheoveralleconomy.“Themorewedothat,themoreyearsweareaccumulatingdebtstotherestof
theworld,”saysWachtel.“Thenthequestioncomesup:‘Gee,canyoupaytheinterestonthosedebtsandcanyoupaythemback?’”
InvestmentStrategy
Therealkeytomakingsenseofthecurrentaccountdeficitistolookatitssizerelativetothatoftheoveralleconomy.Inadditionitmustbelookedatoveraperiodoftimeandnotjustatonemoment.That’sbecausethetradebalancetendstofluctuatewiththebusinesscycle.Typicallyatradebalanceimprovescomingoutofarecessionandworsens
goingintoone.Soit’smoreimportanttolookatthetrendthanasinglemonthofdata.Wachtelsaysagoodruleofthumbisthatahealthyongoingtradedeficitis
under5%ofannualGDPforacountry.Whenit’sbiggerthan5%,itcanbeaproblem.“Whenwelookatsmalleremergingmarketcountriesit’sastrongindicatorof
aloomingexchangeratecrisis,”saysWachtel.Orinsimplerterms,thevalueofacountry’scurrencycouldfallprecipitouslyifthecurrentaccountdeficitexceeds5%ofGDP.HepointstoHungaryasarecentexampleofacountrythathadacurrentaccountdeficitofabout10%ofitsGDPrightbeforearapidcurrencydepreciation.HealsonotesGreecehadasimilarproblem.Theothersideoftheequation,saysWachtel,isthatcountrieswithconsistent
tradesurplusestendtoattractmorecapitalfrominvestorsand,asaresult,havefaster-growingeconomies.Thatshouldmeanthatemergingmarketeconomieswithbigsurpluseswillgrowfastinthefutureandthatmightbeagoodplacetoinvest.Americahashistoricallybeenaspecialcasewhenitcomestothetradebalance
becauseofthespecialroleoftheU.S.dollarastheworld’sreservecurrency.ThathasmeanttheUnitedStateshasbeenabletohavedecadesofsurgingimports(andhencemassivetradedeficits)withoutprecipitatingacurrencycrisis.Butlatelypeoplehavebeguntoaskthequestion:Canthistradedeficitgoon
forever?“Itmightnot,”saysWachtel.“Ifyougodowntheroadfiveortenyears,thingsmightchange.”Or,inotherwords,iftheUnitedStatesdoesn’tfixthetradebalanceproblemrelativelysoon,thevalueofthedollarcoulddrop—alot.
EXECSUMMARY:CURRENTACCOUNTDEFICIT
Whentolook:Thecurrentaccountdataisreleasedonceaquarterat8:30a.m.ETaroundthemiddleofthemonth,March,June,September,andDecember.
Wheretolook:EditorsandwritersatTheWallStreetJournalcloselymonitorthecurrentaccountdata.Whenit’sreleasedbytheCommerceDepartment,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“CurrentAccount.”Alternatively,trytheFREDdatabaseattheSt.LouisFederalReserve,which
haslotsofhistoricaldata.
Whattowatchfor:Tradedeficitsgreaterthan5%ofGDP(exceptfortheUnitedStates).
Whatitmeans:Anexchangeratecrisismayloom.
Whatstepstotake:Shortthatcountry’scurrency.
Risklevel:Astronomical.
Profitpossibility:$$$$+
Chapter21OilInventories
M
Leading
UCHASFORMERU.S.vicepresidentAlGoreorPresidentBarackObamamightwantittohappen,Americahaslittlechanceofkickingitsaddiction
tooilanytimesoon.Theentireindustrialcomplexisanoil-guzzlingmonster:Trygettingtowork,
heatingyourhome,runningafactory,orbuyinganythingwithoutusinganyoil.Heck,halfthestuffinourhomes—forexample,anythingmadeoutofplastic—ismadefromit!Becauseourlivesdependsoheavilyonouroiluse,theoilmarketis
consideredasuperbandsensitivebarometerofthehealthoftheU.S.economy.Fortunatelyforthebuddingeconomistandwould-betraderthereisawealthofinformationontheenergymarket.NotablytheEnergyInformationAdministration,partoftheU.S.government,providesregularlyupdateddetailsoftheenergybusiness.Specifically,eachweek(usuallyonWednesdays)theEIAreleasesdataonthe
levelofenergyinventories.Orputanotherway,ittellstheworldhowmuchcrudeoil,gasoline,andfueloil(plusotherproductsrefinedfromoil)areonhandandavailableforuse.Thebeautyofthisregularreleaseofdataisthatanalystscancomparethestockpilelevelsweektoweek.“Lowoilinventoriesand/orabigdrawdowninthoseinventories[fromweek
toweek]isgenerallyeconomicallypositive,”saysEdwardMeir,aseniorcommoditiesanalystatNewYork–basedfuturesbrokerMFGlobal.“Itmeansyouhavestrongindustrialproduction,withfactoriesusingenergy,utilitiesusingenergy,peopledrivingtowork,flying,andboating.”Hesaysthat’sjusthowthingswerein2007and2008.Duringthattime
inventoriesweredrawndown,andthepriceofcrudeoilreachedarecordof$147abarrel,alevelthatremainsarecordatthetimeofwritingin2010.Meiralsonotesthatsuchhighpriceseventuallycrimpdemandaspeopleseektoavoidthecostofhigherenergycosts.
InvestmentStrategy
WhenwatchingtheoilinventoryfiguresthatcomeouteachWednesday,Meirsaysthekeyitemtowatchisthecrudeoilinventories(sometimesreferredtoasstocks)thatexcludethegovernment’sstrategicpetroleumreserve(SPR).TheSPRisnoteasilyavailableforuseunlessthegovernmentdecidestoreleasesomeandsoitdoesn’treallyrepresentapotentialsourceofsupply.MeiralsosaysmarketexpectationsplayabigpartinreactiontotheEIAdata.
If,forinstance,oilinventoriesareexpectedtofallbyacertainamountandtheyfallbyless,thenthatcanbeseenasasignthattheeconomyisweakerthanpreviouslythought.Likewise,abiggerdrawdownthanforecastcanleadpeopletobelievethattheeconomyisaheadofwhereinvestorsseemedtothinkitwas.Onecommoditiesmarketwrinkletowatch:Whenthecostofborrowing
moneyisabnormallylow,distortionscanoccurinthemarket,explainsMeir.Asmuchofthecostofowningcommoditiesisinhavingcapitaltiedup,whenborrowedcapitalischeapspeculatorsoftenfinditadvantageoustobuyoilasahedgeagainstinflation.Thatcanresultintheunusualphenomenonofrisinginventories(someof
whichareheldbyspeculators)andrisingpricesatthesametime.Normally,risinginventoriessignalasurplusofsupplyandgohandinhandwithfallingprices.Anotherwrinkletowatchforistemporarysupplyinterruptionscausingadip
ininventorieswhenithaslittletodowiththeunderlyingeconomicfundamentals.Sucheventscanincluderefineryexplosions,wars,drillingmoratoriums,andshipwrecks.Tobeclear,whilethesethingswillaffectthemarketpriceandinventorylevels,sucheventsfrequentlydon’treflectthehealthoftheunderlyingeconomy.
EXECSUMMARY:OILINVENTORIES
Whentolook:TheweeklydataisreleasedWednesdayat10:30a.m.ET.
Wheretolook:MarketseditorsatTheWallStreetJournalcloselywatchoilinventorydata.WhentheEIAreleasesthedata,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.
Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“EIAPetroleumStatusReport.”Alternatively,youcangettheinformationyourselfatwww.EIA.gov.
Whattowatchfor:Increases(decreases)inoilinventories(notcountingthegovernment’sstrategicreserves).
Whatitmeans:Demandisprobablyweakening(strengthening)duetounderlyingweakness(strength)intheoveralleconomy.
Whatstepstotake:Cyclicallyappropriateinvestments.Thatmeansavoid(embrace)riskyinvestmentslikestocks.Sell(buy)stocksthataresensitivetoeconomicconditions,likeindustrialcompanies.
Risklevel:Medium.
Profitpossibility:$$
Chapter22TankanSurvey
I
Leading
FYOUAREOVERthirty,youmightjustrememberatimewhenAmericanstrembledinfearthattheJapaneseweregoingtobuyupallofAmerica’s
landmarksandthatJapanInc.wouldannihilateU.S.businesses.Itdidn’tturnoutthatway.Itseemsfunnynowaftertwodecadesofstagnation,butJapanisstill
important.It’sestimatedtobethethird-largesteconomyintheworld,justbehindChina,which,byvirtueofitsenormouspopulation,edgeditswayintothenumbertwoslotin2010.However,whileChina’seconomymaybelargernow,Japan’sisactuallymoreimportantinsomeways.That’sbecauseonaperpersonbasis,Japanisvastlyricher.ItmeansthatwhenJapaneseconsumersdecidetospendmoneyitcanhaveabigimpactontheglobaleconomy.ForanyonewantingtogetadeepunderstandingoftheJapaneseeconomy,the
TankanSurveyisthebestplacetogo.Everyquarter,Japan’scentralbankasksbusinessmeninaboutninethousandsmall,medium,andlargefirmswhattheythinkaboutbusinessconditionsinJapanandwhattheirexpectationsareregardingfuturechangesinprices,sales,employment,andexchangeratesaswellascreditconditions.It’sprobablythemostcomprehensiveeconomicindicatorontheplanet.Insomewaysit’slikeagiantJapaneseversionoftheInstituteforSupplyManagement’ssurveysonmanufacturingandservices.ThemainTankanSurveyindex,thebusinessconditionsdiffusionindex,is
easytoread:Anythingabovezeroisseenaspositiveorindicativeofeconomicgrowth,saysKurtKarl,aneconomistinNewYorkforinsurancegiantSwissRe.Likewise,areadingbelowzero,negative,isindicativeofaslowdownorrecession,hesays.Karldescribesthesurveyas“wideanddeep,”meaningthereislotsof
informationforeconomiststodigintoshouldtheyfeelthedesire.
InvestmentStrategy
IfyouareinterestedininvestinginJapan,theTankanisafantasticleadingindicator.TheaccompanyinggraphshowsJapaneserecessionsinlightgray,andthelinesshowthebusinesscommunity’sreadontheeconomy,brokendownbysmall,medium,andlargebusinesses.Togetherthesebusinessexecutivescalledrecessionandrecoveryinadvance,sometimesonlybyalittlebutsometimes,asin1990–94,wellaheadoftime,andwithnofalsesignals.NotonlyistheTankanagreatleadingindicatorbutitalsotakesongreater
weightthanitwouldinothercountriesbecauseinJapansomeothergovernmentdataisn’tasreliableas,say,intheUnitedStates.Forexample,KarlnotesthatJapan’sGDPfiguresaresubjecttowhatwouldelsewherebeconsideredwildrevisions.“It’ssomethingyoustrugglewithwhenforecastingJapan’seconomy,”saysKarl.HepointstoaninstanceofstrongpositivegrowthforJapaneseGDP
eventuallybeingrevisedtoacontraction,ornegativegrowth.Orinotherwords:Astrongexpansionwaslaterrevisedintobeingarecession.That’sprettyridiculousifyouaskus.NotonlydoestheTankanSurveynotgetrevised,butitalsoisaveryreliable
indicatorofthehealthofJapan’seconomy,Karlsays.Infact,heprefersittothegovernment’sGDPfigures.YoucanlearnalotfromjustreadingtheheadlinenumbersoftheTankan
Survey.Butyoucanlearnevenmorebydiggingdeeperandreallygettingintotheweeds.Thereareseparatedataseriesforthedifferentpartsoftheeconomy.Forinstance,inadditiontotheheadlineTankandatathereisalsoinformationthatrelatessolelytothemanufacturingsector.KarlsayshisfavoritepieceoftheTankanSurveyisthemanufacturing
indicator.Hesaysit’s“thebestindicatorofthehealthofthewholeeconomy.”HealsosaysthatwhiletheoverallqualityoftheTankandataisgood(and
betterthanthegovernment’sGDPdata),thequalityofthedatathatissubmittedbythecountry’slargemanufacturersisevenbetter.That’sinpartbecauseit’seasierformanufacturerstomeasureoutputthanitisformanagersworkingintheservicesector.Whenthereisaclearindicationofimprovingeconomicgrowthaheaditcan
makesensetolooktoinvestinJapanesestocks.Smallinvestors,orthosewithouttheresourcestoresearchindividualJapanesestocks,mightconsidertheiSharesMSCIJapanIndex(EWJ)exchange-tradedfund.IttracksabasketofJapanesestocks.Thereareothersimilarproductsavailablefromothercompaniesaswell.
EXECSUMMARY:TANKANSURVEY
Whentolook:ThebeginningofApril,July,andOctober,andmid-December,at8:50a.m.Japanesetime(that’seither6:50p.m.ETor7:50p.m.ET,dependingontheseason).
Wheretolook:ThedataispostedinTheWallStreetJournaldatacenterasitisreleased.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“InternationalEconomicEvents”for“TankanSurvey.”Alternatively,youcangototheBankofJapan,whichcreatesandpublishes
theTankanSurvey.ThankfullyitputsoutanEnglishversionatwww.boj.or.jp/en/type/stat/boj_stat/tk/index.htm.AnotherimportantindicatorforJapanistheIndustrialProductionreport,whichcanbefoundhereatwww.meti.go.jp/english/statistics.
Whattowatchfor:Surveyresultsinpositive(negative)territory.
Whatitmeans:TheJapaneseeconomyisgoingtogrow(shrink)soon,regardlessofwhatofficialgovernmentstatsmightsay.
Whatstepstotake:Buy(sell)someJapanesestocksorETFs.
Risklevel:High(duetoexchangerateuncertaintiesmostlyandJapan’soverallpooreconomicperformancesinceca.1990).
Profitpossibility:$$$
A
Chapter23TicData
Leading(SeealsoCurrentAccountDeficit,FederalDeficit)
MERICANSLOVETOSPEND,notjustconsumersbutthegovernmentalso.It’sbeenabigpartofwhathasmadeAmericathewayitis.Butthebigdirty
secretisthatnoneofthiswouldbepossibletoquitetheextentithasbeenifitweren’tforawillingnessbyforeignerstolendusthemoneytodoit.Ifforeignersweren’teagertolend,thenyoucanbesurewe’dallhavetopaya
lotmoretoborrowmoneyforeverythingfromcreditcardbalancestomortgagesandcarloans.OrthevalueoftheU.S.dollarwouldhavetobealotlowertoboostourexportsandcurbourseeminglyinsatiabledesireforoilandChinese-madestuff.Thatwillingnessbyforeignerstolendusmoneyisquantifiedindollartermsin
theTreasuryInternationalCapital,orTIC,data.TICgivesusasnapshotoftheflowsofcapitalintoandoutoftheUnited
States,explainsFrankWarnock,professorofeconomicsattheDardenBusinessSchoolattheUniversityofVirginia.Warnockdidn’tinventtheTICdata,buthedidworkondevelopingthecurrentincarnationtomakewhattheTreasurypublishesmoreusefultoresearchers.ThisdatanotonlytellsushowmuchcapitalflowedthroughAmerica’sborders
inagivenmonth,butalsoitsvariousoriginsanddestinations.Morespecifically,thedatatrackscross-borderpurchasesandsalesofstocksandbonds,pluscross-borderflowsofloansandrepaymentsbetweenbanks.Itdoesn’t,however,includeforeigndirectinvestment,wherecompaniessetuporclosedownfactories.Thisindicatormattersbecause,inthemostsimpleterms,themoreforeigners
wanttopurchaseU.S.securitiesthebetteritisforeveryoneintheUnitedStates.
That’sbecausetherateofinterestchargedtoborrowersisinlargepartdeterminedbythesupplyofanddemandfordebtsecurities.Investorspayparticularlycloseattentiontohowmuchforeignersarewillingto
paytobuyU.S.governmentsecurities.Suchsecuritiesareconsideredrisk-freeinvestmentsandallotherborrowersofnon-tax-advantagedU.S.dollarspaymoretoborrowmoney.Ifthereisasustaineddrop-offindemandbyforeignersforU.S.governmentbonds,thenit’slikelyonlyamatteroftimebeforeinterestratesriseacrosstheboard.Intheearlytwenty-firstcentury,thebigworryofinternationalinvestorsisthe
fiscalconditionoftheU.S.government.Thefederalgovernmentborrowsindollarsandcanmakedollarsatwill,sounlike,sayGreece,itstechnicalsolvencyisnotatissue—atleastnotyet.Whatinvestorsfretaboutisthefuturepurchasingpowerofthedollar,whichcandropveryquicklyindeed,notonlyathomebutespeciallyabroad.Thebigquestionintryingtopredictexchangeratemovementsoverthelonger
termis“whetherforeignersaresatiatedwithU.S.securitiesand,ifso,wouldtheythenpulloutofdollar-denominatedassets?”saysWarnock.
InvestmentStrategy
WarnocksayslookingattheTICdatafromtheyears2004–5helpedexplainaphenomenonthathadbeenpuzzlingsomeeconomists.Specifically,whywasitthatU.S.interestratesweresoloweventhoughtherewereanumberofeconomicindicatorsthatsuggestedthatinterestratesshouldgohigher?Thereason?“ForeignerswerebuyingmassiveamountsofU.S.treasury
bonds,”saysWarnock.Thatwasdrivingbondpriceshigherandinterestrateslower.“TheTICdatawerebestsuitedtocapturingthatphenomenon.”SowhenlookingattheTICdata,trytofigureoutwhetherdemandisstrong
andclimbingorwhetherit’sslackandfallingbylookingathistoricalflowsaswellascurrentones.Ifdemandlooksslack,thenit’shighlylikelyinterestrateswillrise,andeconomicgrowthinAmericawillbelower.ThereareacoupleofissueswiththeTICdata,mostnotablyitslackof
timeliness.Althoughthedataispublishedeverymonth,theperiodcoveredis,onaverage,sixweeksago.Soit’sliketryingtodrivewhileonlylookingintherearviewmirror.
EXECSUMMARY:TICDATA
Whentolook:TICdataisreleasedat9a.m.ETaroundthemiddleofthemonthforflowstakingplaceamonthandahalfearlier,(e.g.,mid-DecemberforOctoberdata).
Wheretolook:ForTICdata,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“TreasuryInternationalCapital.”Alternatively,youcangetTICdatafromtheU.S.TreasuryDepartmentat
http://treas.gov/tic/.ForTIC-likedataforothercountries,theIMF(InternationalMonetaryFund)istheplaceatwww.imf.org/external/data.htm.
Whattowatchfor:Increases(decreases)inforeigndemandforU.S.securities.
Whatitmeans:Pressureoninterestrateswillbedownward(upward).
Whatstepstotake:Watchforadditionalsignsofinterestratemovements,andthenmakeappropriateinvestments,e.g.,buying(selling)fixedincomefundsifratesappeartobeheadingdown(up).
Risklevel:Medium.
Profitpossibility:$$
MultipleComponents
MANYECONOMICINDICATORSPOINTtochangesinmultiplecomponentsofGDP:consumption,investments,government,importsandexports(C,I,G,andNX),whichare,afterall,juststatisticalabstractionsofverycomplexandinterconnectedeconomicphenomena.Consumption,forexample,isintimatelylinkedtogovernmentviataxes—
whenweconsumemore,webuymorestuff,whichmeanssomebodysoldittousandsothatmeansprofitsgrowandcorporatetaxesarehigher.Likewise,whenbankslendmoneytobusinesses,thecompaniestakingon
theloansmightbuymachinery(boostinginvestment:I)andinturnwouldlikelygooutandhireworkerstooperatethosenewmachines.Theworkersnowemployedspendmoremoney(increasingconsumption:C)andpaymoretaxes(helpinggovernment:G).It’snotsurprising,then,thatweincludesixteenindicatorsthatpointto
multiplecomponentsofGDPinourFantastic50.
Chapter24BeigeBook
T
Coincident
HEVERYCOLORBEIGEsummonsimagesofinstitutionalmediocrityandblandneutrality.Butdon’tletthatdeceiveyouintothinkingtheFederalReserve’s
so-calledBeigeBookhasnothingtosay.Itdoes—andhow.Butunlikemanyoftheotherindicatorswecompiled,theBeigeBookdoesnotprimarilyconsistofaseriesofnumbers.RatheritisacompilationofanecdotesonthestateoftheU.S.economy.That’s
right,theFedactuallytalkstohumanbeings—specificallybusinesspeopleandeconomistsfromeachoftwelvedistrictsthatcovertheUnitedStates.Seethemaponpage133foreachdistrict’sboundaries.Thefinalreportincludesanoverallsummaryofthestateofthebroad
economy.Butmoreimportantlyitalsogivesanecdotaldetailoneachofthetwelvegeographicdistrictsseparately.It’sthatgranularinformationthatforecasterslikereading.Thebadnewsisthatmeansthereisalottoplowthroughforanyonewantingtousethisindicator.Thegoodnewsisthatthebookisonlypublishedeighttimesayearandit’s
freetoanyonewithaccesstotheWeb.OfcoursethemembersoftheFed’spolicy-makingteamgetitbeforeyoudo—abouttwoweeksbeforethescheduledFederalOpenMarketCommitteemeetings.“ItgivesusasenseofwhattheFedgovernorsarereadingandforthatreason
givesinsightintotheirownoutlookontheeconomy,”saysJoeBrusuelas,aneconomistatBloombergL.P.“Itcanbeusefulbecauseitcomesoutaheadofotherdata.”SpecificallyitcanhelpinvestorsworkoutwhethertheFedwillincreasethe
costofborrowing,leaveitthesame,orlowerit.Itcanalsoalertsmartinvestorstoforthcomingproblems.SometimesinformedpeoplewilltellyouthattheFedpublishestwomuch
moreimportantbooks:theBlueBookandtheGreenBook.Theproblemwiththosetwoisthatthepubliccan’tlookattheminatimelymanner.Thatfactmakesthemveryusefulforhistoriansbututterlyirrelevantforeconomicforecasting.Nomatterhowgoodtheinformationinanyreport,ifyoucan’tseeit,thenit’suseless.
InvestmentStrategy
Liketheotherindicators,theBeigeBookcanbeusedtohelpmakeinvestmentdecisions.CheckoutwhattheSanFranciscodistrictreportedintheNovember2006edition:
Creditqualitywashighingeneralwithfewdelinquencies.However,contactsprovidedscatteredreportsofdelinquenciesonloanstohomebuilders,andbankshaveincreasedtheirvigilanceovertheseloans.
Hindsightistwenty-twentyastheysay,butthewarningsignsabouttheapproachingfinancialcrisisthatledtotheGreatRecessionwerethereforthosesavvyenoughtospotthem.Inthatparticularcase,avoidinginvestinginhousingstocksandmortgage-relatedinvestmentswouldhavebeenprudent.Clearly,eventsliketherecentfinancialcrisisarerare,sofindingevidenceof
impendingdoomislikelytoberelativelyuncommoninthepagesofthispublication.ButtheBeigeBookdoesstillprovidenuggetsofpotentialgoldtoinvestors.“Signsofsofteningintheeconomyisbullishforbondinvestors,”says
Brusuelas.WhentheBeigeBook’sanecdotespaintapictureofaweakeconomy(oratleastaweakerthanpreviouslythoughtbusinessenvironment),thenitmaybeasignthattheFederalReservewilllowerthecostofborrowingbytrimmingshort-terminterestrates.That’sgoodforbondinvestorsbecausethevalueofbondsincreasesasinterestratesdecline,explainsBrusuelas.Thesamelogicapplieswhentheeconomyisimproving.“IftheBeigeBook
saystheeconomyisstrong,itprobablymeansinterestrateswillgoupsoonerratherthanlater,”saysBrusuelas,meaningtheFederalReservewilllikelyraisethecosttoborrowmoney.Itcouldindicateit’stimetoavoidbonds,whichwoulddeclineinvalueasinterestratesrise.TheBeigeBookcanalsobeusedtogaininsightintothestrengthofdifferent
sectorsoftheeconomy,suchastechnologyormanufacturing.That’sbecausedifferentindustriestendtobeconcentratedincertaingeographicareas.Forinstance,toseehowthetechnologysectorisdoingitwouldbesmarttoreadthesectionofthereportprovidedbytheSanFranciscoFed,saysBrusuelas.TechnologycompaniesareclusteredaroundSiliconValleyinNorthern
California.Ifthereportshowsfavorableeconomicconditionsfortechnologycompanies,thenitmightbeworthinvestinginthetechsectorofthestockmarket.Bywayofexample,theProSharesUltraTechnologyexchange-tradedfund(ROM)tracksthevalueofaslewoftechnologycompanies.Brusuelasnotesthatbecauseofitsanecdotalnaturethisindicatorshouldbeusedinconjunctionwithotherindicatorsratherthanalone.
EXECSUMMARY:BEIGEBOOK
Whentolook:At2p.m.ETtwoWednesdaysbeforethenextFederalOpenMarketCommitteemeeting.ForascheduleofitsFOMCmeetings,browse:www.federalreserve.gov/fomc/.
Wheretolook:ReportersandeditorsofTheWallStreetJournalreadtheBeigeBookdiligentlywhenitisreleased.ReportersfilesummarystoriesastheFedpublishesthereport.AsummaryisalsopostedatTheWallStreetJournalonline’s“MarketData
Center”atWSJMarkets.com.Gotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“BeigeBook.”Alternatively,youcangodirectlytotheFeditselfat
www.federalreserve.gov/FOMC/Beigebook/.
Whattowatchfor:Cluesinthereport’sanecdotesabouttheoverallhealthoftheeconomyandspecificsectors.
Whatitmeans:Afacelessbureaucratheardsomethingfromtheregionalbusinesscommunityandconsidereditimportantenoughtonote.
Whatstepstotake:Dependsonwhattheanecdoteis,e.g.,iftheeconomyappearstobeweakening,buybonds!
Risklevel:Varies.
Profitpossibility:Varies.
Chapter25CrackSpread
W
Leading
EKNOWYOUAREgoingtolovethecrackspread,butnotjustbecauseyoucanmakelotsofconstructionworkerjokes.Therearegoodeconomic
reasonsforgettingdownanddirtywiththisparticularindicator:gasoline.“Thecrackspreadisanindicatorofrefineryprofitability,”saysAdam
Sieminski,chiefenergyeconomistatDeutscheBankinWashington,D.C.Specifically,itisameasureoftheprofitabilityofrefiningcrudeoilintogasolineandheatingoil.Whenthecrackspreadiswide,it’smoreprofitabletorefine.Whenthespreadisnarrow,it’slessprofitable.Ifitwereevertogonegative,andstaythatway,thenrefiningwouldactuallybealoss-makingpropositionandwe’dlikelyhavenogasolineatthepumpswithwhichtofillourtanks.Still,there’dbeplentyoftimetoreaduponothereconomicindicatorsinstead.It’scalledacrackspreadbecausecrudeoilissaidtobecracked,orbroken,
intootherstuff,likegasoline,dieselfuel,heatingoil,andlotsofotherpetrochemicals.Thetruthisthattherearemanydifferentcrackspreads,buttheoneinvestors
mostcareaboutistheonebetweencrudeoilandgasoline.Itmakessense.Afterall,muchofoureconomyrunsongasoline.Thecrackspreadwidensandnarrowsbecausethepriceofgasolineandcrude
oildonotmoveinsync.Why?“Becausethethingsthatinfluencethecrudeoilmarketandthegasolinemarketaredifferent,”explainsDeutscheBank’sSieminski.“Ifarefineryshutsdownbecauseofafireorexplosion,thenheatingoilorgasolinepriceswouldlikelyreactbutnotthoseofcrudeoil.”Likewise,announcementsfromOPEC(OrganizationofthePetroleum
ExportingCountries)likelywouldaffectthepriceofcrudeoilbutprobablywouldn’thaveanimmediateimpactongasoline,hesays.
InvestmentStrategy
Thefirstimportantthingtonoteisthatcrackspreadsareseasonal:Moregasolineneedstobeproducedduringthespringandsummerandmoreheatingoilinthefallandwinter.Moreover,duringtheannualproductionfacilitymaintenanceperiod—traditionallyinlatewinter—crackspreadsriseasfewerrefinersaremakinggasoline.Thatmeansthefewthataremakingfuelcanchargemore.ManyobserversbelievethattotalU.S.oil-refinerycapacityisbelowthat
requiredduringpeakperiodsofdemand.Withthosecaveatsalwaysinmind,investorscanusethecrackspreadto
predictfuturesupplyanddemandconditionsforfossilfuels.Whenthecrackspreadislow,refinersarenotmakingmuchprofit.(Thespreadonlyoccasionallygoesnegative,butlongbeforethatitcanbecomeunprofitableforsomehigh-costcompaniestorefineoil.)Refinersarethereforenotlikelytoincreaseproductionanytimesoon,solookforadecreaseindemandforcrudeandadecreaseingasoline/heatingoilinventories.Whenthecrackspreadishigh,bycontrast,refinerstrytomakewhilethemakingisgood,sodemandforcrudewillrise,aswillsuppliesofgasolineandheatingoil.DB’sSieminskisaysinvestorscanprofitfromwidercrackspreadsbylooking
atthoseenergycompaniesthatareheavilyinvolvedintherefiningbusiness.InparticularhehighlightsValeroEnergy(VLO).Whencrackspreadsarewide,Valerowillbenefitfromtheimprovedprofitability.Whenthecrackspreadsarenarrow,thefirmwilllikelyseeitsprofitsdiminish,hesays.It’simportanttonotethatjustbecauseacompanyisintheoilbusinessdoesn’tmeanitisheavilyexposedtotherefiningbusiness.You’llneedtodoyourownresearchbeforebuyinganystock.Notealsothatthecrackspreadprovidesinformationaboutonlyonesideof
eachmarket,thedemandforcrudeandthesupplyofitsdistillates.Useotherindicators,liketheBalticDirtyTankerIndex,todiscernthefuturesupplyofcrudeanddemandforitsdistillatesandyou’llbepreparedtoprofitinthosemarketsandalsotobetterunderstandtheeconomy’spositioninthebusinesscycle.
EXECSUMMARY:CRACKSPREAD
Whentolook:Continuouslyforenergyprices.Energytradesaroundtheworldmostbusinessdays.
Wheretolook:EnergypricescanbeeasilyobtainedinTheWallStreetJournalonline’s“MarketDataCenter.”You’llfinditatwww.WSJMarkets.com.Whenyouarethere,you’llneedtogoto“Commodities&Futures”sectionandlookunder“Energy”for“Petroleum.”Thereyouwillfindpricedataonlightcrudeoilandgasoline.That’sjustthefirststep.Afteryouhavethepricesofthenear-termcontracts,you’llneedtodosomemath.Calculatingthecrackspreadisalittletricky,though.Crudeoilpricesarequotedbythebarrel,whilegasolineandheatingoilarequotedbythegallon.(Thereareforty-twogallonsinabarrel.)Thereisalsothequestionofweighting.Traditionally,threebarrelsofcrudewillproducetwoofgasolineandoneofheatingoil,butothercombinationsarepossible.Usingthetraditional3–2–1method,thecrackspreadequationis:(84gasolineprice+42heatingoilprice—3*crudeprice)/3.Alternatively,
theNewYorkMercantileExchangedivisionoftheCMEGroupprovidesahandycalculatoratwww.nymex.com/calc_crack.aspx/.Togetregularhistoricalchartsofcrackspreads,you’lllikelyhavetosubscribe
toafee-baseddataservice.
Whattowatchfor:Higher(lower)crackspreads.
Whatitmeans:Refiningoilintogasolineismore(less)profitable.
Whatstepstotake:Buy(sell)refinery-heavystockslikeValero.
Risklevel:High.
Profitpossibility:$$$
T
Chapter26CreditAvailabilityOscillator
Leading(SeealsoLibor)
HEFILMCABARET’sfamoussong“Money,Money”getsitalmostrightwhenitsays“Moneymakestheworldgoaround.”Thetruthisthatforbusinesses
andtheeconomyit’scredit,orborrowedmoney,thatreallykeepsthingsgoing.Theworldfoundoutexactlyhowmuchcreditkeepsthingsgoingwhenitall
driedupinthefallof2008duringtheGreatCreditCrunch,whichquicklywentontobecometheGreatRecession.Ifthecreditcrisisof2008taughttheworldanything,it’sthatwithoutthefree
flowofborrowedmoney,theworldofbusinessquicklycomestoastandstill,andwiththatsodoestheeconomy.Broadlyspeaking,whenloansaremoreavailabletobothbusinessesand
individuals,moreeconomicactivityoccursandtheeconomyexpands.Whenloansarehardtocomeby,youcanexpectbusinessactivitytoslowdownandtheeconomytofalter.Thatwastheideainmindin2007whensomesavvybondmarketanalystsat
PhiladelphiainvestmentbankJanneyMontgomeryScottdevelopedtheCreditAvailabilityOscillator.Thattheirworkpredatedthecreditcrisisonlyshowshowprescienttheywere.GuyLeBas,headoffixedincomestrategyatJanneyandakeyarchitectofthe
CAO,sayshewaskeenlyawareoftheeconomy’sdependenceoncredit.“Borrowingavailabilityisahugepartofconsumerspending,”saysLeBas.In
2007hewasparticularlyworriedaboutwhatwouldhappentospendingifhomeownerscouldn’trefinancetheirmortgages.That’swhyhedevelopedtheCAO,whichispronounced“cow.”Nojoke.AlthoughJanneykeepstheCAO’sexactinternalworkingstopsecret,LeBas
doesdetailsomeofthemanymetricsused,whichincludebothqualitativeandquantitativeinputs.Theyareallfocusedondetermininghoweasyorharditistoborrowmoney.Asurveyofqualitativedataiscollectedquarterlyonthedifficultyofobtaining
differenttypesofloans.Thatquarterlydataissupplementedwithdailyquantitativeinputs.(Thoseinputsshouldbecalledmoos—moosinthecao.Geddit!)TheresultisadailyCAOreading.Thequantdataincludesthepricesatwhichcertaintypesofbondsaretrading,
particularlythoseinvolvingautomobileloansmadetoconsumersaswellasborrowingbypeoplewithalessthanstellarcredithistory,so-calledsubprimeborrowers.Alsoincludedaretheinterestratesatwhichbankslendtoeachother,theLiborrate,akeymeasureofhowwellcreditisflowingbetweenlendinginstitutions.AlthoughtheCAOwasonlydevelopedin2007,Janneyhasdeveloped
historicaldatatoprovidecontext,asshowninthefollowingchart.
InvestmentStrategy
Unlikesomeothereconomicindicators,theCAOisrelativelyeasytounderstand.Zeroindicatesaneutrallevelofcreditavailability.Ittellsyouthatit’sneitherveryeasynorveryhardtoobtainaloan.Apositivereadingsayscreditisflowingrelativelyfreely.Inthemid–2000s,theindicatorregisteredinthe20sand30s,butinlate2006theindexplungedandturnednegativeforthefirsttimesince2002.“Itwastellingusthatlendingconditionswererapidlydeteriorating,”says
LeBas.“Theimplicationsareverybroadbecauseitsuggestsweakercorporateprofitability,lowerdemand,andsoftereconomicgrowth.Thosearethebigpictureimplications.”CAOdatathatincludesqualitativesurveydatafromtwoorthreequartersisof
coursemoreindicativeoftrendsthanasingledatapoint.BecauseLeBashasaccesstothecomponentdatainputs,hecanalsoseewhetheranypossibletrendisbroadlymatchedbythemajorityofinputsorwhetherit’stheresultofadataanomaly.Specialnote:AveryhighCAOmightbeusedtohelpidentifyanassetbubble,
suggestingthatinvestorsshoulddeleverage(orpaydowntheirloans)andmoveinvestmentstocash.
EXECSUMMARY:CREDITAVAILABILITYOSCILLATOR
Whentolook:WhenyourJanneyMontgomeryScottresearchreportarrives.
Wheretolook:TheCAOisaproprietaryindexofJanneyMontgomeryScott.That’sgoodnewsifyouareaclientofJanney’s.LeBassaysinformationontheCAOisprovidedtothefirm’sclientsthroughitspublishedresearch.Ifyou’renotaJanneyclient,thenfollowingtheCAOwillbemoretricky,but
notimpossible.ResearchreportsofallthemajorbankshavetypicallymanagedtofindtheirwayacrosstheWeb.SoscouringtheInternetmightbeausefulstart.Inaddition,thissortofindicatortendstogetfollowedbythepressespeciallywhentherearemarkedchangesinthelevels.That’spreciselythetimeyou’dwanttohearaboutit.
Whattowatchfor:TheCAOmovingup(down).
Whatitmeans:Borrowingiseasier(harder)sotheeconomywilllikelygrow(shrink)inthenearterm.
Whatstepstotake:Lookslikeagoodtime(reallystinkytime)togoforbrokeinthestockmarket.
Risklevel:Medium.
Profitpossibility:$$
W
Chapter27FederalFundsRate
Leading(SeealsoLibor,TedSpread,CreditSpreads,YieldCurve)
HENYOUDRIVEAcar,yousteponthegaspedaltomakeitgofasterandthebraketoslowthingsdown.Well,theFederalReserve,theU.S.central
bank,hasasimilargadgetfortheeconomy.IftheFedwantstoslowdowntheeconomy,itraisesitsso-calledFedfundsinterestrate,therateatwhichbankslendtoeachotherovernight.Ifitwantstospeeduptheeconomy,itlowerstherate.Ofcoursedrivingtheeconomythiswayisabittrickierthandrivingacar.The
FedfundsrateisatargetsetbytheFed’sFederalOpenMarketCommittee(FOMC).It’seffectivebecausetheratedirectlyaffectsotherinterestrates,includingmortgagepaymentsforadjustable-ratemortgages(so-calledARMs),creditcardrates,andtheinterestthatbankspaytocustomersontheirsavingsaccounts,explainsEllenZentner,aNewYork–basedeconomistattheBankofTokyo-Mitsubishi.“WhentheFOMCchangestherate,itchangesthecostofdoingbusinessfor
thebank,”saysZentner.“Whenthosecostsareraised,theyareimmediatelypassedontotheconsumers.”SoiftheFedraisesratesithasaquickimpactofincreasingthecostof
consumerloansandcreditcarddebt.Thatleavespeoplewithlessmoneytospendongoodsandservices.Forthatreason,theeconomywilltendtoslowdown—oratleastgrowthwillmoderate—whentheFedfundsrateishiked.AlthoughtheFOMCtendstoraiseratesinsmallincrements,itcanhaveabig
impactonsomepeople.“AtinychangeintheFedfundsratecouldrepresentthestrawthatbreaksthecamel’sbackforanyhouseholdthatisburdenedwithdebt,”explainsZentner.Likewise,adropintheFedfundsratecanbemannafrom
heavenforpeopledeepincreditcarddebt,asitlowerstheirmonthlypayments.
InvestmentStrategy
TheFedfundsrateissocloselywatchedthatotherbusinessatthebigbankscancometoahaltwhentheFOMCisexpectedtomakeadecisiononwhethertochangeinterestrates.Thevalueofstocksandbondsisdeterminedinpartbyinterestrates.In
general,lowerFedfundsratesmeanbondsareworthmore.Stockscanalsobeworthmorewhenratesarelowbecauseitmeansthecostofborrowingislower,meaningmoremoneyisleftforprofitsandlesspaidtothebank.Forthatreason,sometimesunexpectedlybadeconomicdataonjobs,
manufacturing,andsoforthcanactuallycausebondandequitymarketstomovehigherbyincreasingexpectationsthattheFedwillcutitstargetrateoratleastleaveitunchanged.TheFedfundsrateisnoteasytopredict.Butit’snotablethatnotasingle
recessionsinceWorldWarIIhasendedwithoutagood-sizereductioninFedfundsrate.Onseveraloccasionsinthe1960s,70s,90s,and2000s,theFedbegancuttingratesbuttoolatetopreventarecessionfromoccurring.Asshownintheotheraccompanyinggraph,therecessionof2008–9wasoneofthoseinstances.
EXECSUMMARY:FEDERALFUNDSRATE
Whentolook:At2:15p.m.ETondaysthattheFederalOpenMarketCommitteemeets,whichisatleasteverysixweeks.Foraschedule,browse:www.federalreserve.gov/fomc/.
Wheretolook:GotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Lookunder“Bonds,Rates&CreditMarkets”tabfor“ConsumerMoneyRates”andfindthe“FedFunds”targetrate.TheSt.LouisFed’sFREDdatabaseisanotherfavoritesourceforhistorical
dataontheFedfundstarget(andallotherinterestratesandlotsmorebesides).AnynumberofnewsoutletswillposttheFOMC’smostrecentannouncementwithinsecondsofitsrelease.ForexpectationsaboutfutureFedfundsratechanges,seethefederalfunds
futures.HowFedfundsfuturesworkisnicelydescribedbytheClevelandFedat
www.clevelandfed.org/research/data/fedfunds/.
Whattowatchfor:Increases(decreases)inthefederalfundstargetrate.
Whatitmeans:Theeconomyislikelytoslowdown(speedup)inthecomingmonths.
Whatstepstotake:Startselling(buying)manufacturingstocks.Alsothinkaboutwhichcompaniesaregoingtomakeitthroughthecomingeconomicstormrelativelyunscathed.
Risklevel:Low.
Profitpossibility:$
Chapter28FertilityRates
I
Leading
FSEXDOESN’TMAKEtheworldgoround,itcomesprettyclose.That’sbecausebirthsofpeople—thefrequentresultofhavingsex—drivesspendingpatterns
fordecadesafterward.Theideahereisthatpeopleasagrouptendtofollowdistinctpatternsof
activitydependingontheirage.Forinstance,Americanstypicallygetmarriedandhavechildrenintheirlatetwenties.Atthesametimetheytendtobuyhouses.Laterthechildrengrowup,leavehome,andthentheparentssavetogetreadyforretirement.However,eachgenerationisn’tuniforminsize.AfterWorldWarII,ahuge
spurtinbirthsintheUnitedStates—thebabyboom—createdademographicbulgethathasdrivenmanytrendsinthelatterhalfofthetwentiethcenturyandthefirstpartofthetwenty-firstcentury.“Thebabyboomgenerationhasraisedtheirfamilies,hasstartedsavingtheir
money,andnowtheyarebeginningtoretire,”saysHarryS.DentJr.,authorofTheGreatDepressionAhead(2009).Denthasstudiedbirthtrends—alsoknownasthefertilityrateinthejargonofdemographers—andwhat’sparticularlynoticeableisthatthegenerationbornimmediatelyfollowingtheboomers,generationX,ismuchsmallerinsize.Becausethesegenerationsdifferinsize,thewaythatoverallincomewillbe
dividedamongdifferentareasoftheeconomywillchangeradicallyovertime.Forinstance,theportionofincomespentonhealthcareissettoincreaseasthebabyboomersage.Thisstudyoflikelyoverallspendingpatternsgiveseconomistsandinvestorsalikeaglimpseofthefuture.Theotherthingweknowaboutfertilityratesisthattheygodownascountries
getricher.Ormoresimply,womenintherichernationsoftheworldtendtohavefewerbabies.Thetheorybehindthisisthatthereislesseconomicincentivetohavechildreninrichercountries.Forinstance,inpoorcountrieschildrencanbeputtoworktohelpmakeends
meet.Alsowhenpeoplegrowold,morechildrenareavailabletolookaftertheirparents,ifnecessary.Thosethingsarelessofanissueinthericherstatesoftheworldwheretosomeextentlawspreventchildrenfrombeingputtoworkandwheregovernmentstypicallyprovideasocialsafetynetfortheelderly.
Thuseconomieswherepeoplearegettingricherwillseesmallerfamiliesandmorediscretionaryincomeforspendingonthingslikeeducation,automobiles,andhouses.
InvestmentStrategy
Fertilityrateshavesomeseriousimplicationsforinvestors,especiallywhenitcomestoassetallocation.Forexample,DentpointsoutthatthedemographicslookpositivefortheU.S.healthcareindustry,sothosestocksmaybeworthalookforinvestorswillingtotakearisk.Thereasoningworksasfollows:Mostpeoplespendmoreonhealthcareastheyage.Thebabyboomersarenodifferent,butbecausethereareproportionatelysomanymoreboomersthantherearepeopleinothergenerationsintheUnitedStates,healthcarebusinesseswillneedtogrowfasterthantheoveralleconomyinordertokeepupwithdemand.Thepubliclytradedhealthcarestockswillinalllikelihoodbenefitfromthis
trend.Forthatreason,demographicssuggestthatinvestorsmightwanttoconsideroverweightingtheirassetallocationtowardhealthcarestocks.Asusualtherearemanyfactorsatplay,sosavvyinvestorsshoulddotheirownresearchbeforemakinganydecisions.Dentalsoseesthedemographicbulgecausedbythebabyboomleadingtoan
increaseintheoverallsavingsrate.Thethinkingbehindthisisclear:Aspeopleheadclosertoretirement,theytendtosavemore.Thisisnothingnew;theparentsoftheboomersdidthesame.Andiftherewerenotademographicbulge,thisfactwouldhavenoeconomicimpact.Ifthatwerethecase,increasedsavingbytheboomergenerationwouldbeoffsetbymorespendingbythesubsequentcohort,generationX.Butthereisademographicbulge,sospendingbygenerationXwillnotfillthe
voidcreatedbyboomersincreasingtheirsaving.DentseestheincreaseinsavingsasdetrimentaltotheU.S.economy.High
savings,inhisview,willmeanlowergrowthforaconsiderableperiodandasluggishstockmarketforaboutadecade—throughabout2020hesays.Inourviewthenetincreaseinsavingsalsomeansmoremoneywillbe
availableforinvestment.Economistsareforevertellingpeoplethatsavingsmustequalinvestmentwhenlookedatintheaggregate.It’struethatthemoneybeinginvestedwon’tflowtothesameplacesasit
wouldifitwasspentforconsumption.Butitwillgosomewhere,andthetrickistofollowwherethatinvestmentmoneyisgoing.Todoso,you’llneedtousetheothereconomicindicators.Inparticular,checkoutdurablegoodsorderstoseeif
thereisgrowthinmachineryinvestment.
EXECSUMMARY:FERTILITYRATES
Whentolook:Thelagsonbirthdataarelongandvariabledependingonthecountry.Sograbrecentdatawheneveryoucan.
Wheretolook:FortheUnitedStatesupto1998,useHistoricalStatistics,aswedidabove.Formorerecentdata,seetheNationalCenterforHealthStatisticsatwww.cdc.gov/nchs/,especiallytheannualreportHealth,UnitedStates.Fordataonothernations,gotoNationMaster.comatwww.nationmaster.com/graph/peo_bir_rat-people-birthrate.OrcheckouttheCIAWorldFactbookatwww.cia.gov/library/publications/the-world-factbook/rankorder/2054rank.html.YoucanalsolookatHarryDent’sbook,TheGreatDepressionAhead:Howto
ProsperintheCrashFollowingtheGreatestBoominHistory.Wedon’tnecessarilybuyalltheideashepromotes,buthedoesshowhowbirthratedatacanbeusedtohelpinvestorsmakeallocationdecisions.
Whattowatchfor:Demographicchanges,especiallyfertilityrates.
Whatitmeans:Futurechangesinaggregatedemandandthedemandforspecificgoodsandservices,suchaseducationandhealthcare.
Whatstepstotake:Buyhealthcarestockswhiletheboomersageandstillhavethemoneytopay.Buyhighereducationstockswhensmallbulgesareduetoentercollege.
Risklevel:High.
Profitpossibility:$$$
Chapter29GrossDomesticProduct(GDP)perCapita
H
Coincident
OWDOWEKNOWifwearegettingricher?PercapitaGDPisoneofthebestwaystoanswerthatquestion.Orputanotherway,howmuchdoesthe
averagepersonearn/produceinacountry?ThehigherpercapitaGDPisthericherthepeopleinthatcountryare,onaverage.Despiteitsobviousimportance,thisindicatorreceivessurprisinglylittleexplanation.Here’sanexample:Forthefirsttimeinoveracentury,China’seconomyisprojectedtobebiggerthanthatofJapanin2010.DoesthatmeantheChinesepeopleareonaveragericherthantheJapanese?Yomino!(YomiistheShintowordforhell,bytheway.)China’sslightlyhighertotalincomeisdividedamongmany,manymorepeople.TheofficialestimatesfromtheCIAshowbothcountrieswitheconomiesof
about$5trillionin2009.Buthere’stherub:Japanhasonly130millionpeopletoChina’s1.3billion.SoGDPpercapitainJapanwasabouttentimesthatofChina.“Inthesamewayadoctorlistenstotheheartbeatofapatienttodetermine
theirbasichealth,aneconomistlooksatthepercapitaGDPtounderstandthehealthoftheeconomy,”saysRobertDye,senioreconomistatthePNCFinancialServicesGroupinPittsburgh.“AhighpercapitaGDPcountrywillhaveamoredevelopedeconomy.”DyesaysthatpercapitaGDPisoneofthekeydeterminantsofstandardof
living.Ingeneral,peoplewholiveincountrieswithhighpercapitaGDPtendtohavehigherstandardsofliving.Animportantcaveat,hesays,isthedistributionofincome.Isincomewidely
distributedwithmostpeopleearningclosetotheaverage?Orisincomeconcentratedinthehandsofanelitefewwhohavemassiveincomeswhiletherestofthepopulacescrapesby?Clearly,thosetwoscenariosaren’tcomparable.ThebestwaytomeasureequalityistheGinicoefficient.Atzero,allincomes
areexactlyequal.At1(or100),onedudehasitallandeveryoneelsenothing.Neitherhaseverbeenobserved,notevenincommunistcountriesorSaddamHussein’sIraq.ManycountrieswithGinicoefficientsbetween.15and.45—prettyequalincomes—exist.Thatisimportantbecausecountrieswithwidelydispersedincomes(lowerGiniscores)aremorepoliticallystableandalsoarebetterforbusinessrelativetothosewhereincomeisconcentratedinthehandsof
afew.
InvestmentStrategy
Ascountriesgetricher,thepeopleinthosecountriescanstarttoaffordmorethanjustthebasicnecessities.“Whenyouliveonadollaraday,thenyoucan’taffordmuchmorethanfood,”saysDye.“Butasyougetricheryoucanstartspendingonluxuries.”Atthatlevel,we’reprobablytalkingaboutshoes,clothes,andlightbulbs.Still,
that’showprogressstarts,oneconvenienceorcomfortatatime.Countriesbeginningtosurfupthe“rich”scalecanprovidegoodmarketsfornewproductsforagrowingconsumerculture.Again,therearecaveats:Checkoutthelegalstructureinthosecountries.In
general,agoodlegalstructureforbusinessesprotectspropertyrightsandensuresminimalcorruption.CountriesatthebottomofthepercapitaGDPladdertypicallyengageinlow
value-addedagricultureandlowvalue-addedmanufacturing.Togetuptheladdertheyneedtostartengaginginhighervalue-addedbusinesses.Watchforcountriesthatareusinggovernmentpolicytodrivethatdevelopmentprocessaspotentiallyfast-growingeconomies.Chileinthe1970sisagreatexampleasisSouthKoreainthe1960sthroughthe1990s.Ingeneral,investorsliketoinvestinfast-growingeconomieswithfriendly
legalsystems.Aswithanything,thepotentialforhighrewardscomeshandinhandwithbigrisks.Sotomitigatetheriskofinvestingdirectlyinso-calledemergingeconomies,typicallythroughlocalstocks,itcanmakesensetopicksophisticatedcompaniesthataredoingbusinessinthoseplaces.U.S.-basedmultinationalcorporationsareagoodplacetostart.
EXECSUMMARY:GROSSDOMESTICPRODUCT(GDP)PERCAPITA
Whentolook:ThefirstestimatesforGDPcomeoutat8:30a.m.ETthefinalweekofJanuary,April,July,andOctober.Amonthlaterarevisionisreleasedandamonthafterthatasecondrevision.Soneartheendofeverymonthyou’llfindsomesortofanestimateofGDP.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchGDPdata
closely.Asnewsaboutitisreleased,Journalre-portersfilebreakingnewsstoriesforpublicationonWSJ.com.Alternatively,MeasuringWorth.comhasannualdataforAmericaandthe
UnitedKingdom.ForothercountriesseeNationMaster.comortheCIAWorldFactbookatwww.CIA.gov.TheOECDprovidesdataatwww.OECD.org,andtheWorldBankwebsitesatwww.worldbank.orgarealsogoodsourcesforothercountries.
Whattowatchfor:IncreasesinrealpercapitaGDP,alowordeclininglevelofincomeinequality,andatolerableadministrationofjustice.
Whatitmeans:Rapideconomicdevelopmentmaybeintheoffing.
Whatstepstotake:Takeequitystakesinmultinationalenterpriseswithheavyexposuretotheemergingmarketor,fortheriskloving,itsdomesticcompanies.Multinationalenterprisesarethosecompanieswithextensiveoperationsacrosstheglobe—thinkPepsi,GeneralMotors,andCaterpillarasexamples.
Risklevel:Mediumtoastronomical.
Profitpossibility:$$to$$$$
Y
Chapter30Libor
Leading(SeealsoCreditAvailabilityOscillator,TedSpread)
OUMIGHTFEELTHATsometimesthebankdoesn’ttrustyou.Well,ifyouthinkthat’sbad,getthis:Sometimestheydon’teventrusteachother.
Wecanmeasuretrust(orthelackthereof)bylookingattheinterestratebankschargeeachotherforshort-term,unsecuredloans—meaningthereisnothingbackinguptheloansotherthanthegoodfaithandcreditworthinessoftheborrowingbank.Thecostinpercentagetermsforabanktoborrowmoneyundersuchtermsis
knownastheLibor,ortheLondonInter-bankOfferedRate,andit’spublisheddailybytheBritishBankers’Association(BBA).AshrafLaidi,chiefmarketstrategistatCMCMarketsinLondon,saysrising
Liborratesreflectadeclineintheavailabilityoffundsandstressesintheoverallfinancialsystem.Ormoresimply,whenLiborrises,moneyisn’tflowingasfreelybetweenthebanks.“WhentheLiborisbeingresetinLondonatelevena.m.,thatispartiallyapulseofliquidityamongstbanks,”hesays.Liboriscalculatedfortendifferentcurrencies,includingtheAmerican,
Australian,Canadian,andNewZealanddollars,Britishpoundssterling,Swissfrancs,Japaneseyen,Danishkrones,andSwedishkronas.Theratesarealsosetforvaryinglengthsofloans,fromasshortasovernightthroughaslongastwelvemonths.Inshort,it’salotofnumbers.OfficialLibordatagoesbackto1986whentheBBAhelpedtostandardizethe
measurementoftheserates.Thatwasparticularlyimportantatthetimeduetotheintroductionofathen-newfangledderivativeproductknownasaninterestrateswap.Liborhasimplicationsfarbeyondjustwhatbanksthinkofeachother.That’s
becauseLiboristhebasisforhowmuchinterestischargedformanyadjustable-rateloansmadetoconsumersandotherbusinesses,includingfloating-ratemortgages.ThatalonemakesLiborimportantbecausehousingcostsusuallyrepresentthe
biggestmonthlyexpenseformostconsumers.Whenmortgagecostsjump,peoplehavelessmoneytospendonotherthingsandatworstcanleavepeopleunabletopaytheirmortgages,andwedon’thavetotellyouthatcanspellbigtrouble.
InvestmentStrategy
Forthemostpart,Libordoeswhatinterestratesnormallydo—fallduringrecessionsandriseduringbooms.Theeconomicsofthisissimple:Demandbyconsumersandbusinessestoborrowmoneychasesupinterestratesduringtheeconomicgoodtimes.Theoppositeoccursduringaneconomicslump—fewerpeoplewanttoborrowlessmoneysointerestratesfallback.Liborisparticularlyinsightfulduringfinancialcrises.Itdroppedleadinginto
therecessionof2008aswewouldexpect,butthenitspikedduringthefinancialcrisisthatfall,astheso-calledcreditcrunchtookhold.Laidisaysthatspikesinrates,justliketheonein2008,wereasignoflackof
liquidityinthefinancialsystem.Thespikeinratesalsorepresentedariskpremium,alargepaymentdemandedofthosewithmoneytolendduringperiodsofmassiveuncertainty.Afterthepanickedatmospheresubsided,Liborfelltonewlows,indicatingthatnormalcywasreturningtothebankingsystem.
EXECSUMMARY:LIBOR
Whentolook:Daily.
Wheretolook:LibordataiseasilyfoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tabandlookunder“ConsumerMoneyRates”forLibor.Alternatively,theBritishBankers’Associationhassetupaweb-site
specificallyforthepurposeofprovidinginformationonLibor,www.bbalibor.com,whereyoucandownloadcurrentandhistoricdataonLiborratesindifferentcurrencies.ItalsohasaTwitterfeed:twitter.com/BBALIBOR.NotethattheBBAstressesthedataisforpersonaluse,notforbusinesses.Thatmaybegoodenoughforyourpurposes.Anotheravenueworthpursuing:LibordataisavailablefromEconomagic.com
atwww.economagic.com/libor.htm.
Whattowatchfor:Increases(decreases)inLiborrates.
Whatitmeans:Theeconomyisheatingup(coolingdown)orbanksare
demandingahigh-riskpremiumduetouncertainty.
Whatstepstotake:Takeappropriatecyclicalactionifthechangeappearslinkedtothebusinesscycle;scrambleforcashifaspikeisduetopanic.
Risklevel:Medium.
Profitpossibility:$$
M
Chapter31M2MoneySupply
Leading(SeealsoCreditSpreads)
2ISAMEASUREofhowmuchmoneythereisintheeconomy.Itisrelativelyeasyforyouandmetodeterminehowmuchmoneywehave(ordon’t
have),butit’smuchhardertoknowthesamefortheoveralleconomy.That’sbecauseforeconomists“money”isanebulousterm.It’snotjustbillsandcoins,butalsocanincludebankaccounts.Andthere’swhereitstartstogettrickybecausetherearemoneylikeaccountsthatworkjustlikebankaccountsatplacesthataren’tbanksandsomebankaccountsthatcan’tbeincludedforonereasonoranother.Soeconomistscameupwithdifferentmeasuresofmoney,fromverynarrow
(M0)toverybroad(M3)ones.M2isabroadmeasureofhowmuchmoneyisintheeconomy,anditincludespaperbills(notes)andcoinsaswellascheckingandsavingsaccounts.Notallbankaccountbalancesareincluded,onlythoseworthlessthan$100,000.Also,somenon–bankaccounts,likeretailmoneymarketmutualfunds,areincluded.TheFederalReservecaninfluencethesizeofM2becauseithastheabilityto
createmoneyoutofnothingandtoreturnittothatsamenothingness.TheFedperformsthismoneymagicbybuyingorsellingU.S.governmentdebt,orsimilarfinancialinstruments.WhentheFedsellsTreasuries,itdoessoforcashandbydoingsoittakesthatcashoutoftheeconomyandreducesthemoneysupply.WhentheFedbuysTreasuries,itusescashtomakethepurchase.Orinotherwordsitpumpsmoneyintotheeconomy,expandingthemoneysupply,includingM2.Typically,theFeddeliberatelyincreasesM2tospeeduptheeconomy.It
decreasesM2toslowtheeconomy.Butit’snotjusttheFedthatdetermineshow
muchmoneyisintheeconomy.Commercialbanks,likeWellsFargoandtheBankofAmerica,cancreateordestroymoney,specificallydeposits,aswell.Theydosobymakingloansandcreditingtheborrowers’checkingaccounts.Duringaneconomicexpansion,whentheeconomyisgrowing,bankersmakeloansmorefreely.Inrecessionstheyarestricteraboutmakingloans,leadingtotheadagethatabankergivesyouanumbrellawhenthesunisshining,buttakesitawayonceitrains.
InvestmentStrategy
M2canhelpforecastwhethertheeconomyisabouttoexitarecessionorenterone.It’snotfoolproof,butifusedcarefullyyoucangetanideaofwhatisgoingonsoonerthanbywaitingtoseeGDPdata.Bythentheturningpointislonggone.ThetheoryisthattheeconomygrowswhentheM2growthrateincreasesbut
contractswhenM2declines.Forexample,theU.S.economywasinrecessionfromMarchuntilNovember2001.ThedatashowsthattheannualrateofM2growthslowedconsiderablyin1999,andin2000itremainedbelowthe1997–99average.M2leaptin2001,duringtherecession,predatingtheactualrecovery.Foraninvestorthat’sreallyusefultoknowbecauseittellsyouwhatisgoing
tohappenaheadoftime.Thisforesightgivesyoutimetochangeyourinvestmentstothoseareasthatdowellearlyinarecovery,whichhistoricallyhavebeengrowthstocksandsmallcompanies.However,it’snotfoolproof.“[T]hegrowthrateofbroadmoney[is]animperfectproxyfornominaldemand[orGDP],”wroteMichaelDarda,directorofresearchatGreenwich-basedtradingfirmMKMPartners,inaresearchreportin2010.Why?Becausethespeedatwhichmoneymovesaroundtheeconomy,theso-
calledvelocityofmoney,sometimesvaries.Economistsbelievethatslow-movingmoneyhaslesseconomicimpactthanfast-movingmoney.Furthertothispoint,Dardaobservesthattherecoveryoftheearly1990sandthesecondlegoftheGreatDepressionin1937sawadropinmoneyvelocity,makingM2growthlessreliableasanindicator.Hedoesnote,however,thattherewasaverytightrelationshipbetweenM2
andGDPgrowthfrom1960to1989.Aruleofthumbisthatasthecostofcorporationsborrowingmoneydeclines—relativetothatofgovernmentborrowing(theso-calledcreditspread)—thevelocityofmoneyincreases.
EXECSUMMARY:M2MONEYSUPPLY
Whentolook:EveryThursdayat4:30p.m.ETfordatafromtwoweeksprior.
Wheretolook:ForthedatagotoTheWallStreetJournalonline’s“Market
DataCenter”atwww.WSJMarkets.com.You’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“MoneySupply.”AlternativesourcesincludetheFederalReserve’smainwebsiteandtheFRED
databaseattheSt.LouisFed.
Whattowatchfor:Increases(decreases)inM2.
Whatitmeans:Theeconomyisheatingup(maybecoolingdown).
Whatstepstotake:Getintostocks(liquidassetssuchascash)becausetheeconomymaybeimproving(deteriorating).
Risklevel:Medium.
Profitpossibility:$$
T
Chapter32NewHomeSales
Leading(SeealsoExistingHomeSales,HousingStarts,andPendingHomeSales)
HEAMERICANDREAMFormanyistoowntheirownhome.Butforaluckyfewitgoesfurther:Theirdreamisbuyingabrandnewhousethatnoonehas
livedinbefore.Salesofnewhomesaren’tthelargestpartofthehousingmarket,buttheyarea
goodleadingindicatoroffutureeconomicactivity,explainsMikeLarson,arealestateanalystatJupiter,Florida–basedboutiqueWeissResearch.Newhomesnormallyaccountforaround15–25%oftotalhomesaleswiththe
remaindermadeupofexistingorpre-ownedhomes,hesays.Hepointsoutthatinthewakeofthepoppingoftherealestatebubble,thatnumberhadfallencloserto5%in2010,butheexpectsittoreboundtothenormatsomepoint.Newhomesalesactasaleadingindicatorbecausenewhousesarefrequently
purchasedbeforetheyarebuilt.Unlikewithexistinghomesales,thenewhomesalesdatameasureswhencontractsaresigned,notwhenthekeysarehandedovertothenewowners.Newsthatthousandsofnewhomesweresoldinagivenmonthsaysthatthere
willbefutureeconomicactivityasthehousesactuallygetbuilt.Workersneedtobehired,andlumber,floortiles,roofingmaterials,andelectricalwiring,tonamejustafewthings,mustbemanufactured,transported,andware-housedbeforefinallybeingusedattheactualconstructionsite.AllofthatactivityshowsupasincreasedGDP.Sorisinglevelsofnewhome
salestendtoforeshadowbettereconomictimes.Likewise,consistentlyfallingsalesofnewhomestendtoportendaweakeningeconomy.Anytypeofhome—condo,loft,orhouse—isamajorpurchasethatmany
peopleneedtoborrowtomake.Todoso,buyersneedtohaveconfidencein
theirabilitytoholddownajobandthatanyothersourcesofincomearereasonablysecure.Typically,thatmeansthatstronghomesales,newandexisting,gohandinhandwitharobustjobsmarket.
InvestmentStrategy
Theclaimthatstrongandrisingnewhomesalesactuallyaugurbettereconomictimesisborneoutintheaccompanyingchart.Ifyoulookclosely,you’llseethatnewhomesalestypicallyturndownjustbeforerecessionsstrikeandmoveupwardbeforetherecoveryoftheoveralleconomybegins.Thedatacanalsobeusedtoseewherethehousingmarketisheading.Ideally,whatyouwanttoseeinthenewhomesalesdata,whichisprovided
eachmonthbytheCensusBureau,areaffordableprices,lowinventorylevels(representedinmonthsofsupply),andlowcostsofborrowing,saysLarson.Allofthatcouldpointtogoodgrowthinhomesalesahead.Ontopofannualizedsalesfigures,thenewhomesalesdatagivesusaslewof
otherhandynuggets.Yougetthemedianandaveragehousepricesplushowmanysoldindifferentpriceranges.Also,there’sinformationontheinventoryofunsoldhomesandthenumberofmonthsofsupplythosefiguresrepresent.Asifthatweren’tenough,thereisalsoaregionalbreakdownofsales.LarsonpointstotheSouthandWestregionsasthemostimportant.Usingallofthatdatatogetherwiththeknowledgeofwheredifferenthome-
buildingcompaniesoperate(thegeographicareainwhichtheyoperateandthepricerangeofthehomestheybuild)canbeagoodwaytodecidewhetherit’sworthinvestinginthedifferenthome-builderstocks.Alternatively,forthosenotwantingtoinvestinspecificstocks,investors
mightwanttoconsiderlookingattheSPDRS&PHomebuilders(XHB)exchange-tradedfund,whichtracksabasketofhomebuilders.“Strongnewhomesalesdatawouldbegoodforcabinet-makers,tilemakers,
homebuilders,manufacturersoffaucets,andthosesellingrawwoodproductslikeWeyerhauser,”saysLarson.
EXECSUMMARY:NEWHOMESALES
Whentolook:Monthlydataismadeavailableat10:00a.m.ETaboutfourweeksafterthefact.That’saroundthe25thdayofthemonth.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchhomesales
dataclosely.Asnewsaboutitandcapacityutilizationisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“NewHomeSales.”NewhomesalescanalsobetrackedthroughtheCensusBureau,atwww.census.gov/newhomesales.
Whattowatchfor:Increases(decreases)innewhousingstarts.
Whatitmeans:Theeconomyisheatingup(coolingdown).
Whatstepstotake:Purchase(sell)home-builderstocksorETFsandthesharesofcompaniesthatsupplyhomematerialslikelumber.
Risklevel:Mediumtohigh.
Profitpossibility:$$to$$$
P
Chapter33PhiladelphiaFed:TheAruoba-Diebold-ScottiBusiness
ConditionsIndex
Coincident(SeealsoWeeklyLeadingIndex,PhiladelphiaFed:BusinessOutlookSurvey)
HILADELPHIASHOWSITSELFtobetrulythecityofbrotherlylovebygivinginvestorssomespecialkindness:aslewofeconomicindicators,publishedby
thePhiladelphiaFederalReserve,partofAmerica’smightycentralbank.Unlikemen,whichtheDeclarationofIndependencesaysareallcreatedequal,
oneindicatorfromPhillystandsoutabovetherest:theAruoba-Diebold-ScottiBusinessConditionsIndex.That’samouthfultopronounce(andspell),butyoudon’tneedtosay(orspell)ittouseit.We’llcallitADSheretosaveyouandthisbook’scopyeditorsanyfurtherconsternation.Thisindextakesinavarietyofeconomicdata,mashesitalltogether,and
comesoutwithanup-to-the-minutereadingontheeconomywithafrequencyofatleastonceaweek.Itsavescommoninvestorslikeyouandmealotofhardworktryingtograpplewiththeindividualpieces.Theinputdataincludesacompositeofquarterlyoutputdata,unemployment
indicators,industrialproduction,personalincomelesstransferpayments,andmanufacturing/tradesales,plusGDPgrowth.“WhattheADSdoesisaggregateallthisdatainastatisticallymeaningful
manner,”saysKeithSill,directorofreal-timedataresearchattheFederalReserveBankofPhiladelphia.TheeconomicwhizzesatthePhillyFeduseafiltertohelpsmooththedataso
thattheimpactoflessfrequentdata,liketheGDPgrowthfigures,blendsseamlesslywiththoseofmorefrequentindicators,likeweeklynewclaimsforunemploymentinsurance.
UnliketheotherPhillyFedindicatordiscussedinthisbook,theBusinessOutlookSurvey,theADSlooksattheentireeconomy,notjustthePhillyFed’srathertinydistrict.Additionally,becausetheADSisupdatedsofrequently—atleastonceaweekandsometimesmorefrequently—it’sareal-timereadontheeconomythatanalystsdon’thavetowaitalongtimefor,unlikethequarterlyreadonGDP.
Note:WeconstructtheADSIndexusingthelatestdataavailableasofJuly2,2010.Thisincludes(1)initialjoblessclaimsthroughtheweekendingJune26,2010,(2)payrollemploymentthroughJune2010,(3)industrialproductionthroughMay2010,(4)realpersonalincomethroughMay2010,(5)realmanufacturingandtradesalesthroughApril2010,and(6)realGDPthroughthefirstquarterof2010.LightergrayshadingindicateshistoricalNBER-designatedrecessions.Darkergrayshadingindicatestherecentrecession,designatedbytheNBERtohavestartedinDecember2007butnotyetdesignatedbytheNBERtohaveended(asofthedateofcreationofthisfigure).WeenditinJuly2009,whichappearslikelyconditionaloninformationpresentlyavailable,butweusedarkergrayasareminderthatourdatingisnotofficial.
InvestmentStrategy
ReadingtheADSiseasy.Theaveragevalueiszero.Higherthanzeroisaplusfortheeconomy.Negativefiguresareseenasdowners,economicallyspeaking.AccordingtothePhiladelphiaFederalReserve,“TheADSindexmaybeused
tocomparebusinessconditionsatdifferenttimes.Avalueof–3.0,forexample,wouldindicatebusinessconditionssignificantlyworsethanatanytimeineitherthe1990–91orthe2001recession,duringwhichtheADSindexneverdroppedbelow–2.0.”Nowthereareacoupleofwrinkleswiththisindicator.Thezeroaveragegets
recalibratedperiodically.WhatthatmeansinpracticeisthatallthehistoricalADSdatayouhaveneedstobejettisonedperiodicallyandthenewrecalibratednumbersused.SillssaysthebestwaytolookatareadingistocompareagivenADSlevelto
thatofsomepointinthepastwithasimilarreading.Becausethedataisestimatedallthewaybackto1960,therearemanybusinesscyclestolookatandcompare.Fortunatelyforthebuddingeconomicforecaster,thePhillyFedputsoutatime
serieschartoftheADSwithbarsindicatingrecessions.ThisenablesinvestorstoeasilycomparethereadingsoftheADSgoingintoandoutofpastrecessions.
EXECSUMMARY:PHILADELPHIAFED:THEARUOBA-DIEBOLD-SCOTTIBUSINESSCONDITIONSINDEX
Whentolook:Daily.
Wheretolook:DataandotherresourcesontheADSBusinessConditionsIndexareavailableforfreeatthePhillyFed’sReal-TimeDataResearchCenteratwww.phil.frb.org/research-and-data/real-time-center/.Thedatais“updatedasdataontheindex’sunderlyingcomponentsarereleased.”
Whattowatchfor:Increases(decreases)inADS.
Whatitmeans:Theeconomyisheatingup(coolingdown).
Whatstepstotake:Getinto(outof)riskierassetslikestocksorhighyield/junkbonds.
Risklevel:Medium.
Profitpossibility:$$
I
Chapter34PhiladelphiaFed:BusinessOutlookSurvey
Leading(SeealsoPhiladelphiaFed:TheAruoba-Diebold-ScottiBusinessConditions
Index)
MAGINEARATHERPLAIN-LOOKINGunopenedtuboficecream.Nowimaginewhenopeneditwasjammedfullofallthegoodiesyouknowyoulove,like
pecansandcaramel,plussomemorenibblesyounevertastedbeforebutnowloveevenmorethanyourpreviousfavorites.That’sthewaytothinkaboutthePhiladelphiaFederalReserve’sBusiness
OutlookSurvey.Forpeoplewhowanttogetintotheweedsatthemostgranularlevelpossible,thisisamust-readindicator,theclosestthingtoJapan’sTankanSurveyavailableinAmerica.(ThePhillyFedalsopublishestheAruoba-Diebold-ScottiBusinessConditionsIndex,whichsavvyinvestorsshouldkeepacloseeyeonalso.)OnthesurfacetheBOScanlookratherdrab.Itisafterallasurveyabout
manufacturinginjustonesmallareaoftheeconomy,easternPennsylvania,southernNewJersey,andallofDelaware.Butdon’tletthatfoolyouintodismissingitasirrelevant.Itsfirstbeautyissimplicityinthemetricitself,the“diffusionindex.”That’s
themetricthatmeasureshowthesurveyparticipants—manufacturersinthedistrict—feelaboutagiventopic.Theheadlineindexmeasuresanswerstothequestion:“Whatisyourevaluationofthelevelofgeneralbusinessactivity?”However,thesurveyasksnotonlyhowtheeconomyisnow,butalsohowgoodorbadwillitbeinsixmonths.Anumberoverzeroindicatesanexpansion,orgrowthinthemanufacturingsub-sectoroftheeconomy.Anumberbelowzeroindicatesacontraction.Nowherecomesthereallygoodstuff.Ontopoftheoveralldiffusionindex,
thereareaslewofsubtopicsonveryspecificpartsofthebusinessworld:neworders,shipments,unfilledorders,deliverytimes,inventories,pricespaid,pricesreceived,numberofemployees,averageworkweek,andcapitalexpenditures.“WhatcomponentIammostinterestedinissomewhatdependentonwherewe
areinthebusinesscycle,”explainsTimQuinlan,aCharlotte-basedeconomistatbankingpowerhouseWellsFargo.Forinstance,intheearlystagesofarecoveryQuinlanlooksatthe
employmentfigures.Beforehiringstartstogetgoing,thehoursworkedstarttoincrease.Quinlansaysbusinessownershavetheattitudethat“Iwillgraduallycallpeoplebacktowork,butonlyonceIhavemyfull-timestaffbackworkingasmanyhoursastheycan.”Thatmeanssustainedincreasesinhoursworkedcanbeanimportantleading
indicator,oronethatmovesaheadoftheoveralleconomy.
InvestmentStrategy
Whiletheabsolutelevelofthediffusionindexisimportant,thereadingsneedtobeusedinconjunctionwiththechangeinthelevelfromthepreviousperiod.Forinstance,adropintheindicatorfromverypositive(like26)toonlyslightlypositive(maybe3)isaworryingsign.Likewise,amovefromverynegative(–30)toonlyslightlynegative(–5)can
lookpositive,especiallyifitsignalsaturningpointintheeconomy.Theothertrickwiththisindicatoristodigintothesubindexesandlookat
whichstocksmightdowelliftheparticularindexchanges.Quinlansayshelikestolookatthenewordersmetric.“Isthatincreasingor
not?Ifitis,thenIwouldexpecttoseeacommensurateriseinbusinessspendingandthenfactoryordersandcapitalgoodsatalaterdate,”heexplains.“Inanormalbusinesscyclethatwouldeventuallymeanincreasedprofitabilityformanufacturersinthedistrict.”Ifotherindicatorspointinasimilardirectionitmightmakesensetotrackdownstocksofcompaniesinthedistrictwithaviewtoinvesting.Quinlancautionsthatasgreatasthesurveyis,itisameasureofsentimentand
not“harddata.”Thesix-monthoutlookisalsolessreliablethanthecurrentdata,hesays.Still,sentimentismuchofwhatdrivesthebusinessworld.Andifsentimentis
weak,it’sunlikelytoaugurarobusteconomy.
EXECSUMMARY:PHILADELPHIAFED:BUSINESSOUTLOOKSURVEY
Whentolook:NoonETonthethirdThursdayofthemonth.
Wheretolook:GotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“PhiladelphiaFed.”Alternatively,forthefullreportgodirectlytothePhiladelphiaFederalReserve,whichpublishestheBusinessOutlookSurveyeachmonthandmakesitavailableatwww.phil.frb.org/research-and-data/regional-economy/business-
outlook-survey/.
Whattowatchfor:Increases(decreases)inthediffusionindex.
Whatitmeans:Theeconomyisheatingup(coolingdown).
Whatstepstotake:Buy(sell)riskierassetslikestocksandhighyieldcorporatedebtandgetoutof(into)saferinvestmentslikegovernmentbondsandcash.Forthemoreadventurous,exploitinformationinoneormoreofthe
subindexestopickoutpossiblemovesinspecificindustriesorsectors.
Risklevel:Mediumtohigh.
Profitpossibility:$$to$$$
F
Chapter35RealInterestRates
(Leading)
EDWATCHING,ORTRYINGtoworkoutthepolicystanceoftheFederalReserve,hashistoricallybeenamind-numbingexperience.Listeningtotestimony
fromitsgovernorsandvariouschiefsgivesnewmeaningtothedescriptionofeconomicsasa“dismalscience.”Itdoesn’tnecessarilyneedtobethatway.Wecanlearnalotaboutwhatthe
Fedistryingtodobylookingatso-calledrealinterestrates.That’sactuallybothquitesimpletodoandquiterevealingatthesametime.“It’sagoodmeasureoftheaccommodativenatureofmonetarypolicy,”says
GuyLeBas,chieffixedincomestrategistatinvestmentbankingfirmJanneyMontgomeryScottinPhiladelphia.Toworkouttherealinterestrateyouadjustthestated,ornominal,interestrate
forthewitheringeffectsofinflation.(Realinterestrate=nominalinterestrateminusinflation.)Or,inotherwords,whatgoodsandserviceswillthemoneyyouinvestingovernmentsecuritiesbuyyouwhenyougetbacktheprincipalplusinterest?Ifitwon’tbuyyouasmuchasitwouldnow,thentherealinterestrateissaid
tobenegative.Ifitwillbuyyoumoreinthefuture,thentherealinterestrateispositive.Sowhat?Well,thesimplefactofknowingwhetherrealinterestratesare
positiveornegativetellsyoualotaboutthepolicyoftheFederalReserve.Specifically,ittellsuswhethertheFedhasanaccommodatingpolicyorarestrictivepolicy.Accommodativepolicyiswhenrealinterestratesarenegativeandis
conducivetospeedingupeconomicgrowth.Restrictivepolicy,whenrealratesarepositive,tendstoslowdowngrowthintheeconomy.
Thelowerrealinterestratesare,themoreborrowerswanttoborrow,bolsteringtheconsumptionandinvestmentcomponentsoftheeconomy.Asrealinterestratesincrease,peoplewanttoborrowless,andthathurtsinvestmentandconsumption.
InvestmentStrategy
Realinterestratesriseduringexpansionsandfallduringrecessions,largelyduetochangesindemandformoney.Realinterestratestypicallyfallbeforearecoveryasnominalinterestratesstayflatandinflationexpectationsrise.Therehavebeenacoupleoftimesinhistorywhenacentralbankloweringthe
costofborrowinghadlittleeffectonstimulatingtheeconomy:forexample,theUnitedStatesduringtheGreatDepressionandJapanduringitsGreatStagnation(1990–present).Thereasonissimple:Peopleexpecteddeflation,orafallinthegeneralpricesforgoodsandservices.Thatmeant“realinterestrates”remainedhigh,toohighforaneconomicrecovery.Realinterestrateshaveimplicationsforinvestorsalso.“Intheory,ifreal
interestratesarenegative,nomatterwhatyouthrowyourmoneyintoyoushouldmakeaprofit,”saysJanney’sLeBas.“Thetheorybreaksfromrealityinthatshort-termmarketvolatilitycanalwaysbeatoutaprofit.”LeBaspointstocommoditiesingeneralandindustrialmetalsinparticularas
assetsthatdowellduringtimesofnegativerealinterestrates.Hesuggestsavoidingthestocksofmetalscompanies,asthatexposesinvestorstostockmarketrisk.Conversely,hesays,whenrealinterestratesarehigh,that’sagoodtimeto
lookatthebondmarket.HealsonotesthatithasbeendecadessincerealinterestrateswerehighintheUnitedStates.Oneotherimportanttip:LeBassaystherearemanywaystocalculatereal
interestrateswithmuchoftheproblemcenteredonhowtomeasureinflation.LeBasfavorsthePersonalConsumptionExpenditure(PCE)deflatorusedinthecalculationofgrossdomesticproduct,asittakesintoaccountthechangingpreferencesofconsumers.“CPI[ConsumerPriceIndex]assumesthatsomeonewhoboughtabasketof
goodsayearagowillbuythesamebasketofgoodstoday,”hesays.“That’snotnecessarilythecase:IfBriepricesrise,theymaygowithStiltoninstead.”
EXECSUMMARY:REALINTERESTRATES
Whentolook:Daily,orasnewdataoneitherinterestratesorinflationcomes
out.
Wheretolook:Tocalculatethisindicatoryou’llneedtolookfortwopiecesofdata.Takeanominalinterestrateseriesandsubtractameasureofinflation,beitCPI,PPI,theGDPPCEdeflator,orsomeothermeasure.ThedataforinflationandnominalinterestratescanbefoundatTheWallStreetJournalonline’s“MarketDataCenter.”You’llfindthedatacenteratwww.WSJMarkets.com.Inflationdatawillbefoundwithinthe“Calendars&Economy”section,whereasinterestrateinformationwillbewithinthe“Bonds,Rates&CreditMarkets”section.OrfindthenecessarydataatFRED,whichalsohasdataonTIPSorTreasury
Inflation-ProtectedSecurities.Undernormalmarketconditions,TIPScanserveasadirectmeasureofinflationexpectations.Seehttp://research.stlouisfed.org/fred2/categories/82.However,underabnormalconditions,likeduringtheGreatCreditCrunchof2008–9,thevalueofTIPSdeclinedsomuchthattheindicationofinflationexpectationswaserroneous.
Whattowatchfor:Increases(decreases)inrealinterestrates.
Whatitmeans:Theeconomywillshrink(grow)inthenearfuture.
Whatstepstotake:Buyhardassetswhenrealinterestratesarenegative,butbewareshort-termfluctuations.Buybondswhenrealinterestratesarepositiveasnominalinterestrateswillprobablymovelower,sparkingabullmarketforbonds.
Risklevel:Mediumtohigh.
Profitpossibility:$$to$$$
Chapter36ShortInterest
B
Leading
ETTINGAGAINSTACOMPANYseemsun-American.Weareafterallanationofoptimists.Still,wecanlearnsomethingfromthenaysayers,notablythose
whobetagainstthestocksofpubliclytradedcompanies.Theseso-calledshortsellersmakemoneywhenstocksgodowninpriceandwecanusetheiractivityasaninvestmentindicator.Shortsellersbetagainstapubliclytradedcompanybysellingstockthatthey
haveborrowed.Theshortsellerprofitsifthepriceofthesharesgoesdownbeforehehastoreturntheborrowedstock.It’sjustsellhighandbuylow,insteadofbuylowandsellhigh.Thetotalamountofstocksoldshortofaparticularcompanyisknownasshort
interest.Tobeabsolutelyprecise,shortinterestisaninvestmentindicator,notaneconomicone,butitisincludedherebecausethetwoareverycloselyrelated.Also,it’sworthnotingthatthisbookisaboutindicatorsandhowtousethemtomakemoney.Inthatregard,thisonefitsthebill.Sellingsharesshortattractsamassiveamountofnegativepublicity.Perhaps
notsurprisingly,managersofpubliclytradedfirmsoftendisliketheircompanies’sharesbeingshorted.Occasionally,thegovernmenttemporarilybansshortingcertaintypesofstock,suchaswithsomebanks/financialsharesduringtheheightofthefinancialcrisisin2008.Despitethebadpublicity,theinformationthatshortsellersgiveusisvery
useful.That’sbecauseshortinterestisacontraryindicator.Inthesimplestterms,whenmanysharesofastockhavebeensoldshortit’sbullishforthestockprice.Thenumberofsharessoldshortrepresentsa“well”ofpotentialbuyingpower.
Thereason:Shortscan’tstayshortforever.Eventuallyshortsellersmustreturnthesharestheyborrowedandsold.Thereareacoupleoffinancialreasonsforthis.Whenyousellsharesshortyoumustpayinterestforborrowingthemplusthevalueofthedividendsduethelender.Inaddition,ifthepriceofthestockgoesup,thenthebrokerthatlentthesharesmayaskforcollateraltocoveranylosses.Suchralliessometimesforceshortsellerswhocan’tposttheextracollateralto
buybackstockto“cover”theshortposition.Thatextrabuyingcansendthestockevenhigher.Insimpleterms,highshortinterestcanbeabullishsignfora
stock.
InvestmentStrategy
Onaverage,stockpriceshavetrendedupwardoverlongperiods,soindiscriminatelyshortingsharesislikelynotawinningstrategy.Successfulshortsellersmustlookforspecificreasonsforaspecificsharetodecline,astheydidwithLehmanBrothersin2008.Butquitefrequentlyshortsellersarewrong.Andwhentheyare,savvy
investorscanprofit.Thetrickistofindastocknotonlywithrelativelyhighshortinterest,butthat
isalsoawell-runandattractivelyvaluedcompany,saysAdolfoRueda,atechnicalanalystatWJBCapitalGroupinNewYork.“Thattellsmesomeonehasthefundamentalsincorrect.”Thebestwaytogaugewhetherastockhasalotofshortinterestistolookat
howmanydaysitwouldtaketocoverthenetshortpositionbasedonrecenttradingvolumeinthestock.Theresultingfigureisknownastheshortinterestratio.Ashortinterestratioof2meansitwouldtakeasmanysharesasweretradedintwodaystocompletelybuybackallthesharessoldshort.Asatechnicalanalyst,Ruedalooksatpatternsinstockpricechartsto
determinewhethertobuyastock.Heusestheshortinterestdatatoaugmentsuchanalysis.“Ifinditbettertolookforthegoodchartsorthosewithpositivetrend,andthenbackintoitbylookingattheshortinterestdata,”hesays.Or,inotherwords,whenhefindsachartwithbullishtrendsandonethathasalotofshortinterest,heconsidersbuyingthestock.Thesameapproachwouldworkforsomeonewhoanalyzesacompanyby
readingfinancialstatements.Ruedasaysit’sprobablynotsmarttodrawtoomanyconclusionsfromlookingatshortinterestinexchange-tradedfundslikethosethattrackmajorstockmarketindices,suchastheSPDRS&P500(SPY)ETF.TheproblemisthatsomemoneymanagersusesuchETFsforsophisticated
hedgingactivitythatsometimeshaslittletodowithwhethertheyexpectaspecificindextodeclineornot.3
“Itkindaskewsthedata,”Ruedasays.
EXECSUMMARY:SHORTINTEREST
Whentolook:Eachbusinessday.
Wheretolook:SomeusefuldataonshortinterestisfoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“U.S.Stocks”tabandlookfor“Quarterly/MonthlySnapshots,”whereyouwillfindalistofthebiggestshortpositions.Inaddition,majorexchangesliketheNYSEandNASDAQpublishshort
interestreports.DailyFinance.comalsoprovidesshortinterestdata,includingtheshortinterestratio,asdoeshttp://shortsqueeze.com/.
Whattowatchfor:Increasesintheshortinterestratioofacompanywithgoodmanagementandsolidfundamentalsorabullishtechnicaltrend.
Whatitmeans:Shortsellersmayhavebittenoffmorethantheycanchew.
Whatstepstotake:Buythecompany’ssharesandhopethattheshortswillbidupthepricewhenthey“cover,”orbuysharestoreturnthemtothelender.
Risklevel:Astronomical.
Profitpossibility:$$$$
I
Chapter37Russell2000
Leading(SeealsoRiskStructureofInterestRates)
FYOULIVEINAmerica,chancesareyouworkforasmallcompany.Smallbusinessesfuelmostjobcreation,buttheyaremoreriskythanlarger
enterprises.It’sthatextrariskandinvestorattitudetowarditthatcanhelpuslearnalot
aboutthebroadereconomy.Trytoenvisionasmallboatontheoceannexttoalargewarship.Wavesknockthesmallervesselhitherandthitherwhilethelargervesselremainsstable.Thesameistrueofcompaniesgettingknockedaboutbyeconomicshocks.Investorsknowinvestinginsmallercompaniesisriskierthaninvestingin
largerones.Buttheyalsoknowthatsmallercompaniesbenefitmuchmorefromfairereconomicconditionsthanbigonesdo,justassmallerboatsbenefitmorefromcalmerseasthanlargerships.That’swheretheRussell2000comesin:Ithelpsusmeasureinvestorrisk
appetite,andfromthatwecaninferhowtheeconomyisdoing.Specifically,theRussell2000(RUT)Indextrackstwothousandsmallerpubliclytradedstocks.Theindexitselfistheoneagainstwhichmostmutualfundmanagersspecializinginsmallcapitalization(smallcap)stocksarebenchmarked.What“capitalization”meansis:“Howmuchisthiscompanyworth?”It
specificallyreferstothedollarvalueofallofacompany’soutstandingstockatitscurrentstockprice.That’stheeasybit.Whatcountsas“small”isabitofamovingtargetthatchangesovertime.For
themostpart,thinkaboutcompaniesworthlessthan$1billion.TheaveragemarketcapofcompaniesintheRussell2000wasaround$400millioninmid-2010,accordingtoRussellInvestments’website.Orputanotherway,the
averagefirmintheindexisaso-calledsmallcapworthlessthanhalfabilliondollars—prettysmallpotatoesthesedays.Thatcompareswithover$170billionforGeneralElectriconthesamedate,
forinstance.Clearly,theRussell2000stocksaretinyincomparison.Sowhatcanwelearnbylookingatthisindex?“Ifthebroaderindiceslikethe
S&P500(GSPC)aremeanderingalongandthesmallcapsareup,thenyoumightbeseeingriskappetitereturn,”saysBarryRitholtz,CEOofNewYork–basedassetmanagementfirmFusionIQ,andauthorofBailoutNation.Thegoodnewsaboutanincreaseininvestorappetiteforriskyassetsisitcan
presageeconomicexpansion.Ifthemoveismatchedintherealeconomy,withbusinessesbuyingnewmachineryandequipment,thensmallcompanieswilltendtodowell.
InvestmentStrategy
Theproblemwithanyindexisthatmarketscansometimesbevolatile.Twentieth-centuryeconomistJohnMaynardKeynesputitwell:“Marketscanremainirrationallongerthanyoucanremainsolvent.”ForthatreasonRitholtzsaysit’simportantnottojumptoerroneous
conclusions.Forinstance,hesayswhentheRussell2000jumpedinlate2009andearly2010,thequickrisemayhavebeenduetogreaterriskappetite,butitalsomayhavebeenbecausetheindexhadbeensobadlypummeledearlierintheyear.Stocksareoftenobservedtobouncebacksomewhatfollowingalongperiodof
falling.Somecallthisa“technicalbounce,”othersa“deadcatbounce.”Sometimesithaslittletodowithchangesintherealeconomyorinvestorexpectations.Ritholtzsaysthatmarketindicescanbelikeaninkblottestwherewhatisseen
isopentoavastarrayofinterpretations.Forthatreasonhesuggestsguardingagainst“seeing”anythingthatisn’treallytherebutthatperhapsyou’dliketheretobe.Inotherwords,cometodatawithanopenmind,notapreconceivednotionthatyouarehell-benton“proving”nomatterwhat.Goodquestionstoaskyourself:Isthereanotherreasonableexplanationforthe
phenomenonI’mseeing?Dootherpiecesofdatasupporttheconclusion?ThissortofskepticismworksnotonlywhenlookingattheRussellbutalsomanyoftheotherindicatorsinthisbook.ForthosewantingtoinvestintheRussell2000,probablytheeasiestwayof
doingsoisthroughtheiSharesRussell2000IndexFund(IWM)exchange-tradedfund,whichtracksthevalueoftheindex.
EXECSUMMARY:RUSSELL2000
Whentolook:Continuously.
Wheretolook:FordataontheRussell2000,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“U.S.Stocks”tabandlookunder“OtherU.S.Indexes.”
Inaddition,dataontheRussell2000tradingpricescanbefoundatYahoo!Financeatwww.finance.yahoo.com.DetailsoftheindexitselfcanbefoundonRussellInvestments’websiteatwww.Russell.com.
Whattowatchfor:Increases(decreases)intheRussell2000.
Whatitmeans:Theappetiteforriskmaybegrowing(shrinking)duetoinvestorexpectationsabouteconomictrends.
Whatstepstotake:Ifyouthinkthefirstupward(downward)movementsintheindexrepresentachangeinsentimentratherthanatechnicaldeadcatbounce(minorcorrection),buy(sell)aRussellETF.
Risklevel:High.
Profitpossibility:$$$xs
H
Chapter38WeeklyLeadingIndex
Leading(SeealsoJoCECRIIndustrialPriceIndex)
ERE’SATALLORDER:Developametrictogivearelativelyaccuratereadonthefuturestateoftheentireeconomy.Makeit“see”notjustonemonthdown
theroad,butasfaraseightmonths.Anditneedstobetimelytoo,sothatthereistimetotakeevasiveactionbeforethecrash.That’smoreorlesswhattheManhattan-basedEconomicCycleResearch
InstitutetriedtodowhenitdevelopedtheWeeklyLeadingIndex(WLI)inthe1980s.ThepeopleatECRIbasicallyspendalldayeverydayfiguringoutthewhatandwhyofbusinesscycles.“[TheWLIis]basicallythesequeltotheoriginalleadingindicatoridea,which
cameintobeinginthe1960s,”saysLakshmanAchuthan,managingdirectoratECRI,referringtotheConferenceBoard’smuch-admiredleadingeconomicindicator(LEI).AchuthansaystheinputsthatmakeuptheWLIincludemeasuresofthe
moneysupply,theJoCECRIIndustrialPriceIndex,measuresofhousingactivity,jobsandlabormarketindicators,equityprices,andsomebondmarketprices.Inacoupleofkeyways,ECRItriedtoimproveontheoriginalLEI,justlike
automobileengineersimproveduponHenryFord’sclassicModelT:First,theWLI’sdatacomesoutweekly,notmonthly—soit’smoretimely.Inaddition,allbutoneofthenumbersthatmakeuptheWLInevergetrevised.“Revisionsmakeahandyexcuseforforecasters,”saysAchuthan.“So,we
removedthatexcusefromourselves.”
InvestmentStrategy
Thebigproblemwithmanyeconomists’forecastsisthattheytellyou,“Ontheonehandthis,ontheotherhandthat,”saysAchuthan.Thisambivalencemakesitdifficulttoknowwhateconomistsarereallysaying,
iftheyaresayinganythingusefulatall.Therefore,theWLIwasdesignedasaone-armedeconomist.Asheexplains,“Itgivesyouadirectionalcallontheeconomiccyclewithoutsayingontheonehandthis,butontheother...”ThetrickisnotinreadingtheWLI,butratherininterpretingit.Somepeople
managetomisreadtheWLIandthengetitwrongwhentheycalltheendorbeginningofarecession.Achuthansaysthesemisinterpretationsoftenhappenbecausewhat’sneeded,andnotalwaysused,isadisciplinedapproachtothemetric.ECRIclaimsnevertohavemadeabadcallonarecessionendingor
beginning.Aswithitsotherindicators,liketheJoCECRIIndustrialPriceIndexcoveredearlierinthisbook,ECRIusestheso-calledthree-P’sapproachwherebymovementsintheindexthatcatchtheirattentionarepronounced(bigmovement),persistent(lastsliketheEnergizerBunny),andpervasive(basedonnumerousinputs,notjustafew).It’sthelastelementthattripsupmanyforecasters.Forinstance,followingthe
spectaculardropinthestockmarketin1987theWLIdropped,butthemovewasn’tpervasive,becausestockswerereallytheonlyelementoftheWLItomove.SoECRIcoollyandcorrectlyshiedoffcallingarecessiondespitethewidespreadfearinthemarkets.Otherforecastersweren’tsolevelheaded.If,ontheotherhand,thereisaturn
intheWLIgrowthratethatsatisfiesthethreeP’s,thenarecession(ortheendofone)canbeexpectedseventoeightmonthslater.“TheWLIisveryunemotional[and]itdoesn’tgetcaughtupinthenarrativeof
theday,”Achuthansays.It’simportanttonotethattheWLIisameasureofwhat’sgoingtohappenfor
theentireeconomywhereastheJoCECRIIndustrialPriceIndexspecificallyfocusesinontheindustrialsectorandperhapsforthatreasonisbettersuitedtogaugingthehealthofmanufacturing.
EXECSUMMARY:WEEKLYLEADINGINDEX
Whentolook:Weeklyat10:30a.m.ET.
Wheretolook:TheECRIWLIdataispostedfreeonwww.businesscycle.com.ItalsoprobablypaystoscourthepressfornuggetsinordertogetECRI’scallsonwhethertheeconomyisgoingtoboomorflop.
Whattowatchfor:Increases(decreases)intheWLIthatarepronounced,persistent,andpervasive.
Whatitmeans:Theeconomyisheatingup(coolingdown).
Whatstepstotake:IfYodawerehere,hewouldsaysomethinglike:“WhentheWLIgoesdown,riskyassetsyoushouldsell.LetTheForceguideyoutothesafetyofbondsanddefensivestocks.WhentheWLIrises,asmustiteventually,riskyassetsyoushouldbuy.LukeSkywalkerhaveyouseenrecently?”
Risklevel:Medium.
Profitpossibility:$$
Chapter39YieldCurve
E
Leading
VENFORECONOMISTS,MONITORINGtheU.S.governmentsecuritiesmarketcanbelikewatchingpaintdry.Still,forthosewiththepatiencetodoso,itcan
yieldbigprofits.Butfirstyouneedtoknowwhattolookforandwhatitmeans.Whattowatch
isthedifferencebetweentheyieldsonlong-termgovernmentsecurities(ten-yearbonds,a.k.a.ten-yearT-note)andtheyieldsonshort-termones(thethree-monthTreasurybill).Monitoringthedifferenceinratesisknownaswatchingtheyieldcurve,andit
canhelpidentifyturningpointsintheeconomy,suchasthebeginningofarecession.(Aplotoftheyieldsofmorethantwomaturitiesofgovernmentsecuritiesproducesacurveonachart.)Whenthedifferenceinyieldsisnegative—inotherwords,whentheyieldontheten-yearTreasurynoteislowerthantheyieldonthethree-monthT-bill—thechanceofarecessionfourquarterslaterrisesdramatically.Evenmoreinterestingly,thehighertheT-billrateisabovetheten-yearT-noteratethegreateristhelikelihoodofarecession.“Itisoneofthebetterindicatorsoutthere,”saysAnthonyCrescenzi,strategist
andportfoliomanageratNewportBeach,California–basedbond-fundgiantPimco.Hepointstoaclassic1995NationalBureauofEconomicResearch(NBER)studybyArturoEstrellaandFredericMishkinthatdetailedhowthedifferencebetweentheten-yearnoteandthethree-monthbillwashighlycorrelatedwitheconomicactivityoneyearinthefuture.Whyisthisindicatorsopowerful?Onesimplewaytothinkaboutitisthatthe
long-terminterestrate(theten-yearT-note)isacumulativebetonwheretheshort-termratewillbe,explainsCrescenzi.Inotherwords,theten-yearrateistheone-yearratetentimes.Afallingten-yearratethensuggeststhatshort-termrateswillbeheading
south.Why?LikelybecausetheFederalReserve,theU.S.CentralBank,willlowerratesinresponsetoweakeconomicconditions.“Onecouldsayabouttheyieldcurvethatit’sthecombinedjudgmentof
millionsofinvestorsaroundtheworld,”saysCrescenzi.“Theexpectationsofinvestorsareembeddedinthoseyieldsacrossthecurve.”
InvestmentStrategy
MishkinandEstrella’spaperlaysoutarelationshipthatwe’vereplicatedhereshowingtheincreasingprobabilityofaU.S.recessionthemorenegativethedifferencebetweentheten-yearT-noteandthethree-monthT-billis.Notably,whentheyieldcurveissimplyflat—thedifferenceinratesis
approximatelyzero—thechanceofarecessiononeyearlateris25%,oroneinfour.Thechancesofaslumprisetoapproximately70%whenthespreadwidenstominus1.5percentagepoints.Bestofall,becauseit’ssoforwardlooking,investorshaveplentyoftimetoact
ontheinformation.Specifically,ifyouspyarecessiononthehorizon,thenonestrategyistostartlookingtomoveawayfromso-calledriskyassetstowardlessriskyones,saysCrescenzi.Inthiscase,investorsshouldstayawayfromjunk-rateddebtinvestments(so-
calledhighyield)infavorofhigh-qualitybondsorgovernmentsecuritiesthatwillriseinvalueasinterestratesfall.Lookalsotoavoidsharesofcompaniesthatareseenaseconomically
sensitive,likehomebuildersandretailers.Instead,Crescenzisuggests,buydefensivestockslikethosethatsellconsumerstaplesorcatertobudget-consciousconsumers.
EXECSUMMARY:YIELDCURVE
Whentolook:Continuously.
Wheretolook:TheWallStreetJournalpublishestheyieldcurvedaily,inclassicchartformat.DataonyieldsofdifferentmaturitiesofTreasurysecuritiescanbefoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tab.Alternatively,youcanfindthedataintheFREDdatabaseattheSt.LouisFed.TheMishkinpaperisavailableallovertheWeb.Here’soneplacetograbit:
http://ideas.repec.org/p/nbr/nberwo/5279.html.4
Whattowatchfor:Increases(decreases)inthespreadbetweenlong-andshort-
termTreasuries.
Whatitmeans:Theeconomyisheatingup(coolingdown).Thehighertheshort-terminterestraterisesoverthelong-termone,themorelikelytheeconomyisheadedintorecession.
Whatstepstotake:Appropriatecyclicalinvestments,e.g.,buyhigh-qualitybondsandconsumerstaplesandavoidhigh-risksecuritieswhenitlooksliketheeconomyiscoolingdown.
Risklevel:Medium.
Profitpossibility:$$
Inflation,Fear,andUncertainty
OURREMAININGELEVENINDICATORSarearguablythemostimportantofallbecausetheypointtothepossibleapproachofthethreehorsemenoftheapocalypse.Well,theinvestmentapocalypseanyway.Theyareinflation,fear,anduncertainty.Often,theyareabsolutelycrucialtoseeingimpendingrecessionsbefore
theinvestingherddoesbecausetheycanpresagemajordownticksintheGDPcomponentsofconsumption,investment,government,imports,exports,andthecombinationindicators(C,I,G,andNX).Wheninflation,fear,oruncertaintyreartheiruglyheads,arapidresponsecansaveinvestorsabundleandgreatlyrewardtheboldandthebrave.
I
Chapter40GDPDeflator
Coincident(SeealsoProducerPriceIndex,BigMacIndex)
NFLATIONMATTERSBECAUSEit’slikeasilenttax.Ingoodtimesitslowlyeatsawayatthepurchasingpowerofyourmoneyorcash.Inbadtimesithasa
voraciousappetiteandquicklyrenderspapermoneyworthless.Thissilenttaxhurtsthosewhocanleastaffordit:thepoorandthoseonfixed
incomes.UndoubtedlyitcontributedtostrifebetweentheworldwarsinGermanywhenpeopleneededwheel-barrowsfullofcashtobuybasicfoods.Becauseoftheseconsequences,economists,politicians,andthepublictakenoteofit.Therearemanymeasuresofinflation,andnotoneofthemisperfect.Butthe
GDPdeflatorhassignificantmerits,accordingtoMichaelWoolfolk,managingdirectorandforeignexchangestrategistatBankofNewYorkMellon.TheGDPdeflatortellsushowmuchthepricesofgoodsandservicesrose
duringagivenmeasurementperiod.It’susedto“deflatetheGDP”figuresandtellushowmuchtheeconomygrewin“real”terms.Forthatreasonweseeitcomeoutonceperquarteralongwithdetailsofhowmuchtheeconomygrew.TheGDPdeflatorhasanadvantageoverthemorewidelyrecognizedCPI
(ConsumerPriceIndex).Ittellsuswhatpricesdidforallgoodsandservicesacrosstheeconomy,whereastheCPIlooksonlyatarelativelysmallbasketofgoods.Thatgenerallyfixedbasketcanleadtodistortionsinmeasurementofinflation.WoolfolkalsopointstothefactthatU.S.CPI(ConsumerPriceIndex,which
tracksthechangingpriceofabasketofgoodsandservices)isn’treallycomparableacrossnationalboundaries.“TheGDPdeflatoristhemostbroad-basedmeasureofinflationandarguably
itisthemostcomparabletoinflationmeasuresinothercountries,”hesays,notingthatCPIcalculationsindifferentcountriestendtousetotallydifferentmetrics.
InvestmentStrategy
WoolfolkusestheGDPdeflatortohelpanalyzethecurrencymarkets.That’sgenerallyconsideredtobeaprettytallorderascurrencymarketsaregenerallyconsideredtoberatheropaque.Ontopofthat,governmentshavebeenknowntointerveneincurrencymarkets,throwingoffotherwisesoundeconomicanalysis.However,Woolfolkgetsahandleononepartoftheproblem—thatofthe
economicanalysis—bytryingtoadjusthisforecastsfordifferencesinrelativeinflationlevels.Thedifferencebetweentheratesofinflationtellsushowmuchfasterthespendingpowerofonecurrencyisdepreciatingrelativetotheother.Ifallelsestaysthesame,thenthatmeansthecountrywiththehigherinflationshouldseethevalueofitscurrencyfallrelativetothecurrencyofthelower-inflationcountry.HeusesanexampleoftheJapaneseyenandtheU.S.dollar.IftheUnited
Stateshasinflationof3%andJapanzero,anot-unfamiliarsituationformuchofrecenthistory,thenWoolfolkadjustshiscurrencyprojectionsbythedifference.Soaprojectionofonehundredyentothedollarwouldbereducedtoninety-sevenyeninthisexample.Aswithmanyoftheindicators,however,theGDPdeflatorhasitsdrawbacks,
too.Notably,itonlycomesoutquarterly.TheConsumerPriceIndexandtheProducerPriceIndexarebothpublishedmonthly.Separately,ifusingthisdataforcurrencytrading,it’sworthnotingthatthe
currencymarketsaredominatedbyhugeplayersincludingcentralbanks(liketheBankofEngland)andmassivecommercialbankslikeCitigroup.Thatmeanssmallinvestorsoftenstandtolosewheninvestinginthem.Becautiousbeforedippingatoeintothecurrencymarkets!
EXECSUMMARY:GDPDEFLATOR
Whentolook:At8:30a.m.ET,thethirdorfourthweekofthemonth.ThedatacomesoutintandemwithGDP.Therearethreeestimatesgiventoeachquarter’sdata.
Wheretolook:TogettheGDPdeflatordata,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,
you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“GDP.”TheGDPdeflatoristhesamethingastheGDPpriceindex.Alternatively,theFREDdatabasepublishestheGDPdeflator,asdoesthe
BureauofEconomicAnalysisatwww.bea.gov.It’salsoeasytogetdatafromthefree“Investor”sectionofthewebsiteBriefing.com.
Whattowatchfor:Changesinrelativeinflationratesbetweentwocountries.
Whatitmeans:Thecurrencyofthecountryexperiencingmoreinflationwilleventuallydepreciatevis-à-vistheother.
Whatstepstotake:Buythecurrencyexperiencingrelativelylessinflationandsitouttheshort-termfluctuationsandgovernmentinterventionsthatregularlyrockforeignexchangemarkets.
Risklevel:Astronomical.
Profitpossibility:$$$$
Chapter41GoldPrice
Y
Leading
OU’VeHEARDOFTHEgoldenrule—whoeverhasthegoldmakestherules.It’strite—ratherlikesaying,bericher.Whatisn’tsotrivialisthefactthatgold
canbeusedasameasuringstickofsentiment.Broadlyspeaking,goldisahighlysensitivebarometerofallthingsdodgyeconomically,financially,andgeopolitically.Whentheeconomyisrobust,thefinancialsystemissound,andtheworldis
notinvolvedinmajorupheaval,investorsdon’ttendtobuygold,andpricesforthemetaltendtoremainsubdued.Duringthe1980sand1990s,forexample,mostinvestorsshunnedgold,
preferringotherinvestments.Asaresult,goldremainedinabearmarketforthetwodecadesfrom1980through1999,duringwhichthepricefellfromapeakof$850toalowaround$250anounce.Thatalsocoincidedwithgreattimeseconomically:highgrowth,lowinflation,andnoprolongedwars.Contrastthatwiththedecadestarting2001.Duringthattimegoldpriceshave
morethanquintupledfromaround$260anouncetoover$1,300bylate2010.Thatcoincidedwiththeburstingofthetechbubble,theriseandfallofaspeculativemaniainU.S.realestate,thenearcripplingoftheworldbankingsystem,andthedrawn-outinvolvementbytheUnitedStatesintwomajorwars:IraqandAfghanistan.OntopofthattheU.S.governmentisborrowingunsustainableamountsofmoney,raisingthethreatofinflation.That’swheregoldstepsinasaviableinvestment.Themetalhasbeenshown
tobeastoreofvalueovertheverylongterm,whilepapermoneyinvariablylosesmuchofitsvaluewithinmeredecadesifnotmorequickly.VeterangoldinvestorGeorgeGeropointsoutthatinthe1930sakiloofgoldwouldbuyyouanicefour-doorcar;itwillstilldoexactlythesamethingtoday.That’sdespitethefactthatadollar,oranyothercurrency,willbuyyouatinyfractionofwhatitoncedid.
InvestmentStrategy
Thekeytousinggoldasasentimentindicatoriswatchinginvestmentdemandforthemetal.Abouttwo-thirdsofthegoldproducedintheworldgoesintomakingjewelry.Butwhatismostcorrelatedwithsurgesinthegoldpriceishowmuchgoldinvestorsaresockingaway.JeffChristian,headofNewYork–basedcommoditiesconsultingfirmCPM
Group,notesthatthegoldpricetendstodowellwheninvestmentdemandisover20millionouncesayear.“Wearestillusingthatrubric,”saysChristian.Thebigdifferencenowisthat
investorsaresnappingupevengreaterquantitiesandlooksettocontinuedoingso,hesays.Sohowdoyouusethisinformationtomakesomemoney?Youcouldtryto
followthesmartmoneyandinvestingoldwheninvestorsarebuyinglotsofthemetal.However,thatmightbebetterlefttoprofessionalslikeChristianbecausethegoldmarketismurkytosaytheleast.Whatyoucando,though,isusegoldasportfolioinsurance,orinsurance
againsteconomiccatastrophes.“Myviewhasalwaysbeenthataportionofyourportfolioshouldbedesignedtoprotectagainstdisasters,”saysChristian,whohasbeenactivelywatchingthegoldmarketsincethemid-1970s.“Butmostofyourportfolioshouldbedesignedtobenefitfrommoreprobableeconomicscenarios.”Orputanotherway,putapercentageofyourportfoliointogold.Thepriceof
goldhasbeenshowntobeuncorrelatedwiththepricesofotherassets,andthatlackofcorrelationmeansthatitreducestheswingsintheoverallvalueofaninvestmentportfolio.Iftheworsthappens,thenthevalueofthegoldwilllikelyappreciate.Iftheworstdoesn’thappen,thentheotherinvestmentswilldowell.Mostprofessionalsthinkputting5–15%ofyourtotalportfoliointogoldisappropriate.Thereareafewmethodsofbuyinggold.ThesimplestistheSPDRGold
Sharesexchange-tradedfund(GLD),whichisboughtjustlikestocks.Youcanalsobuyphysicalgoldintheformofcoins.Butmakecertaintopurchaseonlybullioncoins,thosewhosevalueisdeterminedbythegoldcontentandnotbyfinishorrarity.PopularcoinsincludeAmericanEagles,SouthAfricanKrugerrands,andCanadianMapleLeafs.
EXECSUMMARY:GOLDPRICE
Whentolook:Goldistradedmostbusinessdays.
Wheretolook:Forgoldprices,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Commodities&Futures”sectionandlookforgoldunderthemetalssection.Inaddition,WorldGoldCouncilhasawealthofinformationonallthingsgold
atGold.org.Itsponsorsthelargestgoldexchange-tradedfund,theSPDRGoldShares,andprovidesdailyinformationonhowmuchgoldisheldbythefund.TheWorldGoldCouncilworkscloselywithLondon-basedconsultingfirm
GFMSLtd.topublishresearch.CPMalsopublishesbooksongold,whichcontainhard-to-obtainhistoricaldataaswellasmarketcommentary.TheLondonBullionMarketAssociation,LBMA.org.uk,dominatesthetrade
ingoldandpublishesareferencepriceknownasthe“fix.”Thepriceisn’trigged.ThefixismuchlikethesettlementpriceonU.S.futuresexchanges.AlsocheckoutKitco.com,thewebsiteoftheMontreal-basedgolddealer.
Whattowatchfor:Changesinpricesandquantitiesindicatingthatsupplyand/ordemandforgoldisshifting.
Whatitmeans:Whendemandforgoldincreases,investorsfearinflation,eveneconomicimplosion,orgeopoliticalinstability.
Whatstepstotake:Buy(short)goldonthefirsthintofinflationorcatastrophe,man-madeornatural(signsoflong-termpricelevelandfinancialsystemstability).
Risklevel:High.
Profitpossibility:$$$
Chapter42MiseryIndex
W
CoincidenttoLeading
HENTHEECONOMICSGODSaresmiling,weseeourpaychecksgetfatterandthegoodswebuygetcheaper.Don’tlaugh.It’sbeenknowntohappen.But
sometimeswegettheopposite.Weseeourpaychecksdisappear(loseourjobs)andthecostsofeverythingweneedtobuyskyrockets(inflation).That’seconomicmisery.Wecan’tbesurebecausehe’snotalivetoask,buteconomicandsocialmisery
werelikelyattheforefrontofeconomistArthurOkun’smindwhenhedevelopedtheMiseryIndex(MI).Likesomanybrilliantideas,theMIissimple.Itjustaddstheunemploymentratetogetherwiththeinflationrate.Thehigherthefigure,themoremiserysocietyhastodealwith.“TheMiseryIndexcapturesthepainthroughouttheeconomy,”saysPeter
Rodriguez,professorofeconomicsattheDardenBusinessSchool,UniversityofVirginia.“It’smostacuteamongthelowestrungsontheeconomicladder.”ItmakessensethattheMIwasdevelopedinthe1970s,whenforthefirsttime
sincethe1860sthegovernment’s(orthegoldstandard’s)tightholdoninflationcameunstuck,explainsRodriguez.DuringthatsamedreadfuldecadecamelevelsofunemploymentnotseensincetheGreatDepressionofthe1930s.Undertheeconomictheoriesprevailingintheseventies,highinflationandhighunemploymentwereincompatible;theformerwouldautomaticallycreatejobsandthelatterwouldnaturallykeeppricesdown.However,thetheorieswerewrong.“Thisphenomenonofhighunemploymentandrisinginflationwasanewthing
altogetherandwehadthe‘dismalscience’turningintothe‘miserablescience,’”saysRodriguez.AsimilarindexinventedbyeconomistRobertBarro,theBarroMiseryIndex,alsousesinflationandunemploymentbutaddsinothervariablestoo.
InvestmentStrategy
“Forthemostpartthisisaveryblue-collarindex,”saysRodriguez.However,thatisnottosaythatthosehigheruptheladderdon’tfeelsomethingalso,headds.Becauseofthewayeconomicpainisfelt,wecanusetheMiseryIndexasa
crudemetrictohelpreadtheelectoraltealeaves.Ormoresimplyput,whentheMiseryIndexishighandrising,thenyoucanexpectthegeneralpopulacetobehoppingmad.Andsometimestheyhopmadlytothepollingplace,wheretheytakeouttheir
frustrationsonincumbents,aswhentheyoustedDemocraticpresidentJimmyCarter.WhenCartertookoffice,theMiseryIndexwasafairlyelevated12.7,butclosetothelowofhisone-termpresidency.Itjumpedtotherecordhigh(ofanypresidency)ofabout22inJune1980.Needlesstosay,CarterlosttoRonaldReaganinaRepublicanlandslide.ThosepresidentswhosomehowmanagedtoseetheMiseryIndexdroporstay
relativelyflattendedtomakeitthroughtwoterms—GeorgeW.BushandBillClintonaretwoexamples.“Eitherthepresidentmustimprovetheoveralleconomicconditionsorhe
won’tgetasecondchance,”saysRodriguez.TheMiseryIndexalsotellsushowwelltheFederalReserveisdoing.
RodriguezpointsouttheFed,unlikeothercentralbanks,hasadoublemandateoflowinflationandlowunemployment.SothehighertheMiseryIndex,theworsethejobtheFedisdoing.WhatinvestorscandowiththeMIisatricky,contextualquestion.Theymight
usetheMItopredict“gridlock”inWashington,whichmightbebullishforstocks.Ortheymightuseittohelpreadtheinterestratetealeaves.TheFedisprettyindependentfromthepoliticalprocess,butitisnotcompletelyimmuneasitenjoysnoconstitutionalprotection.
EXECSUMMARY:MISERYINDEX
Whentolook:Wheneverinflationorunemploymentrateschange.
Wheretolook:YoucangetthecomponentsoftheMiseryIndex—theunemploymentrateandtheCPIinflationrate—yourselfbygoingtoTheWallStreetJournalonline’s“MarketDataCenter”www.WSJMarkets.com.ThesamedataisalsoavailableattheBureauofLaborStatisticswebsite,
www.bls.gov.Alternatively,youcangetyourdataalreadydownloadedalongwithdetailsof
whowasintheWhiteHouseatthattimeatwww.MiseryIndex.us/.
Whattowatchfor:Arising(falling)MiseryIndex.
Whatitmeans:Incumbentpoliticiansareindeepdoo-doo(haveitmadeintheshade)andFedbashingwillbeontherise(decline).
Whatstepstotake:Lookforchanges(thestatusquo)inWashingtonandattheFed.
Risklevel:ThatdependsonwhatyoudowiththeMI.Ifyoubetamillionbucksevenmoneyonthenextpresidentialelectionwe’dconsiderthatprettyrisky.Ifyouusetheindexinconjunctionwiththeotherforty-ninediscussedinthisbooktoplacesmallbets,thenwe’dsaythatitisprettylow.
Profitpossibility:$to$$$$
I
Chapter43ProducerPriceIndex
LeadingintoRecessions,CoincidentintoExpansions(SeealsoGDPDeflator,GoldPrices,TIPSSpreads)
NFLATIONISN’TBORNINthesupermarket.Ratherstoresinherititasthepricesofgoodstheybuyfromtheirsuppliersrise.That’swhylookingatthepricesof
thethingsthatproducerssellgivesusaspecialwindowintowhereconsumerpricesmightbegoing.ForthatwegototheaptlynamedProducerPriceIndexorPPI.ThePPIisameasureofinflationthatismuchlessfamousthanitscousin,the
CPIorConsumerPriceIndex.InsteadofmeasuringhowmuchabasketofgoodsandservicescostsindividualconsumersastheCPIdoes,thePPImeasureshowmuchdomesticproducersreceivefortheiroutputsor,lookedatfromtheotherside,howmuchretailerspayforthegoodstheysell.“PPItellsusaboutbusinesscosts,”saysPeterRodriguez,professorofeconomicsattheDardenBusinessSchool,UniversityofVirginia.“Whentheeconomyadjusts,someofthefirstindicationsofthatchangewillbeseeninproducers’prices.”Inrecessionarytimesproducersareunderstresstosurvive,sotheywilllower
theircostsandcutpricesorwages.Also,inordertokeeptheircustomershappytheywilloftentrytocushionpriceincreasesfromthefinalconsumers.Butwhentimesaregood,pricesgetpassedontoconsumersimmediately.
InvestmentStrategy
ThePPIincludesanumberofdifferentcomponentsincludingtwoveryvolatileelements:foodandenergy.Thatinstabilitymakeslookingattheoverallfigurerathertrickyforeconomistsandinvestors.Sotomakethingseasiertheystripoutthefoodandenergypricesandlookattheso-calledcorerate.Theideahereisthatit’seasiertospottrendswhenthereislessvolatilityintheindex.AndtrendsaretherealkeywiththePPI.Rodriguezsays,“Lookfor
multimonthtrends.”Morespecificallyhesaysit’sworthlookingatthe“highestfrequencymovingaverages,”likeanaverageofthelastthreeorfivemonths.Whenyouplotthoseaverages,thenyoucanlookfortrendswithinthoseaverages.Specificallytrythis:Overtimetakeanaverageofthepriorthreemonths
annualizedPPIrateandplotitonachart.Theseso-calledrollingaveragesironoutthevolatilityinthemonth-to-monthdata.Ifyoucanseeacleartrend,thenyoucanstarttodrawconclusions.Forinstance,iftheaverageinflationforthepriorthreemonthsrisesfrom1%
to2%,then3%overtheperiodofJune,July,andAugust,thenthereisclearlyatrendofrisinginflation.Whereasifthethree-monthmovingaveragewas4%inonemonthfollowedbyadeclineof2%andthenariseof1%,itwouldbehardtoarguethatinflationisbecomingaproblem.Anupwardtrendcouldmeaninflationattheretaillevelcomingdownthe
road.Oriftheeconomyisweakitcouldmeantheprofitmarginsofretailersandproducersalikewillbesqueezed.Fallingpricesaretrickiertoanalyze.Theymightfallduetoaweakeconomy
oritmightbebecauseofefficiencygainsatthemanufacturinglevel,saysRodriguez.RodriguezsaysTreasuryInflation-ProtectedSecurities(TIPS)areagoodway
tobeatinflationrelativetoregularbonds.Regularbondspayinterestandprincipalonlyonthe“nominal”facevalueofthesecurityratherthanthespendingpoweroftheoriginalbond.IfTIPSdon’tappeal,hesaysyoumightchoosetoholdyourassetsinaless
inflationarycurrency.Healsopointstogoldasauseful,albeitvolatile,hedge.
EXECSUMMARY:PRODUCERPRICEINDEX
Whentolook:At8:30a.m.ETaroundthemiddleofthemonth.
Wheretolook:EditorsandwritersatTheWallStreetJournalwatchthePPIclosely.Asnewsaboutitisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatayouarelookingfor,gotoTheWallStreetJournalonline’s
“MarketDataCenter”atwww.WSJMarkets.com.You’llneedtolookunderthe“Calendars&Economy”tabfor“U.S.EconomicEvents”andfind“ProducerPriceIndex.”Alternatively,youcouldgotothesource:theBureauofLaborStatistics,
whichcomputesthePPI.Seewww.bls.gov/pPI/.HistoricaldataisavailableontheFREDdatabaseathttp://research.stlouisfed.org/fred2/series/PPIACO?cid=31.Briefing.comalsohastheinformationreadilyavailableinitsfree“Investor”
sectiononitswebsite.
Whattowatchfor:Unexpectedincreases(decreases)inthecorePPIthree-orfive-monthmovingaverage.
Whatitmeans:Inflationmaybeabouttogowild(remaintame).
Whatstepstotake:Getinto(outof)inflationhedgeslikeTIPS,gold,orlessinflationarycurrencies.
Risklevel:High.
Profitpossibility:$$$
S
Chapter44RetailInvestmentActivity
LeadingintoRecessions,LaggingduringRecoveries
OMEPEOPLEAREJUSTbornunlucky—sounluckyinfactthattheydojusttheoppositeofwhattheyshouldatexactlythewrongtime.Suckers?Maybe.But
inthebusinessofinvesting,thosepeoplehaveaname:retailinvestors.Economistsandinvestorscanlearnalotbywatchingagroupthathas
historicallymadeverypoordecisionswhenputtingtheirownmoneytowork.Specifically,we’retalkingaboutthe“littleguy.”Whenthelittleguysinvestinanyassetclassinabigway,beitstocksorhouses,theeasyprofitsareusuallyalmostover.“Itendtothinkthatretailinvestorswillhearaboutthingswhenit’stoolate,”
saysPeterWelgoss,researchanalystatFinancialResearchCorporation(FRC)inBoston,Massachusetts.“It’soneofthosethingsthathasplaguedsmallinvestorsforalongtime.”FRCcollectsandcollatesdataoninvestmentsinmutualfunds,aproduct
favoredbymostsmallinvestors.Wecangetahandleonwhattheretailinvestorisdoingbyusingthatdataandthenincertaincasesdoingtheexactopposite.Why?Becausethelittleguystendtodotheoppositeofwhatthesavvy
institutionalinvestordoes.Smallinvestorstendtobuyatornearthehighpointsforthemarket,usuallywhenthe“smart”moneyisbailing.Likewiseretailinvestorstendtosellwhenmarketpricesareatorneartheirlows,whenperhapstheyshouldbebuying.“Thatmightjustbeahumannaturepanicbuttoneffect,”explainsWelgoss.
InvestmentStrategy
FRCtrackshowmuchmoneyinvestorsplowintomutualfundseachmonthbyusingsophisticatedtechniquestoestimatehowmuchmoneyeitherflowedintooroutofaparticularfund.FRC’smutualfunddataisimportantbecauseitisolateswhatretailinvestors
aredoing.Professionalinvestorstendnottoinvestinmutualfunds.Insteadtheymightuseexchange-tradedfundsforstockmarketinvestments,orbuyindividualbondsinthefixedincomemarket.Richindividualsalsotendnottobuymutualfunds.Insteadtheyemploymoneymanagerstotailoraportfoliospecificallyfortheirneeds.Ofcoursethereareexceptionstotheserules.Butingeneraltheyholdtrue
enoughforustousetheflowsofmoneyintoandoutofmutualfundsasaproxyforretailinvestorsentiment.Becausethemutualfundsaretypicallycategorizedbythetypeofassetthey
investin—stocks,bonds,cash,preciousmetals,domesticorinternational—wecanseewhichcategoriesoffundssawthebiggestinflowandwhichsawthebiggestoutflow.Thatmeansyoucanseewhichassettypessmallinvestorswentcrazyforandwhichtheyfled.Ifwecombinethatwithinformationabouttheperformanceofcertainassets,
wecangetanideaofwhetheranassettypeiseitherenteringabubbleorwhetheritisunfairlybeingdumped.Forinstance,ifreturnsonbondfundshavebeenhealthyandyouseeretail
investorspilinginathistoricallyhighlevels,thenitmightbeworthevaluatingwhetheritmakessensetofollowtheherdortogoinadifferentdirection.Sometimestheflowofmoneyintoaparticularfundistheresultofan
advertisingcampaignthathaslittletodowithconsumersentimentforaparticularasset.So,asalways,youneedtodocarefulresearch.
EXECSUMMARY:RETAILINVESTMENTACTIVITY
Whentolook:Catchascatchcan.
Wheretolook:FRCdoesn’tprovidethefundsflowdatatojustanyone.You
havetobeabigcorporation.However,theirpressreleasesaboutthemonthlyfundsflowdatatendtogetwrittenupinthebusinessmediaandsodetailsofthefundsflowsareavailableontheWebforthosewillingtodigalittlebit.Inaddition,dataonmostmutualfundsisprovidedbyMorning-star,andit
shouldbepossibletoestimate(roughly)whattheflowsarebylookingattheassetsundermanagementandseeingthedifferenceinvaluebetweenmeasurementperiods.(You’llneedtomakeslightadjustmentstoaccountfortheunderlyingperformanceofthefund.)
Whattowatchfor:Changesinretailinvestorsentimentasmeasuredbyinvestmentflowsinto(outof)differenttypesofmutualfunds.Morespecifically,lookforrecordflowsoffundsinto(oroutof)differentassetclasses.
Whatitmeans:Arecordoutflow(inflow)offundsfromacertainassetcouldsignalthattheendofabear(bull)marketisnear.
Whatstepstotake:Buywhenthe“littleguy”sellsandsellwhenhebuys,especiallywhenthatistheoppositeofwhatprofessionalinvestorsaredoing.
Risklevel:Medium.
Profitpossibility:$$
T
Chapter45CreditSpreads:TheRiskStructureofInterestRates
Leading(SeealsoTedSpread)
AKINGRISKSISATtheheartofAmerican-stylecapitalism.Thatdoesn’tmeanyoushouldtakeinsane,swashbucklingriskslikethosetakenbynuttythrill
seekersorberserkwarriors.Rather,itistakingrisksforaprofitthatisthetrueessenceofgoodbusiness.NowhereisthismorequantifiablethaninthebondmarketwherebigpubliclytradedcompaniesgotoborrowmoneybysellingIOUs.Insimpleterms,riskiercompaniespaymoretoborrowmoneythanlessrisky
ones.Itmakessense.Youwouldn’tlendtoariskiercompanyifyou’dmakethesamemoneylendingtoasaferone.You’dwantmorereturnfortheincreasedrisk.Thisdifferenceinthecostofborrowingiscalledthecreditspread.Itis
measuredinmanyways,butherewefocusonthedifferencebetweentheinterestratespaidontheabsolutehighestgradeoftradeddebt(thatratedAAA)andthatofagradeslightlybetterthanjunkbonds(ratedBBB).(Ostensibly,specializedratingagenciesratedebtbasedonthecreditworthinessoftheborrower.)Thesizeofthiscreditspreadalsochangesovertime,narrowingaheadofan
economicrecoveryandthenwideningbeforeaneconomicslowdown.Theeconomicsbehindthischangingrelationshipisquitesimple,andthey’realsobehindthepredictivequalitiesofthisindicator.“Capitalbeingputtoworkmakestheworldgoround,economically
speaking,”saysDavidRanson,headofresearchattheBeverlyFarms,Massachusetts–basedeconomicsconsultingfirmH.C.Wainwright&Co.EconomicsInc.Asthecreditspreadswiden,itmeansinvestorsarepricinginahigherlevelofrisk.Thatincreasedperceptionofrisktendstoslowtheflowof
capitalthroughtheeconomy.Withoutenoughcapital,economicgrowthischokedoff.“ThisiswhathappenedinOctober2008,”whenspreadswidenedandcapital
stoppedflowing,saysRanson.“Hence,yougotarecession.”Thegoodnewsisthatthesamethinghappensinreverse.Whencreditspreads
narrow,it’sanindicationthatcapitalisflowingmorefreelythroughtheeconomy.Bydoingsoitfuelseconomicgrowth.
InvestmentStrategy
Ransonhasstudiedthewaycreditspreadstendtomoveinrelationtotheeconomyallthewaybackto1949.Onaverage,whenevercreditspreadswidenornarrowdramaticallytheeconomyrespondsinamajorway.Broadlyspeaking,amajornarrowinginthespreadresultsinstrongeconomicgrowthshortlythereafter.Awideningofthecreditspreadslowsgrowthdown.Specifically,whathefoundwasthatwhencreditspreadsnarrowbymorethan
3.5percentagepoints(forexample,thedifferenceinborrowingcostsbetweenhigh-qualityborrowersandlower-qualityonesdecreasingfrom6.5%peryearto3%),theneconomicgrowthinthatsamequartertendstojumpbymorethan5%onaverage.Butmoreimportant,threetosixmonthslatereconomicgrowthexplodes,with
annualizedgrowthratesexceeding6%.Incaseyouareinanydoubt,thatcountsassmoking-hotgrowthforarichcountryliketheUnitedStates.RansoncorrectlypredictedthebounceintheU.S.economyinthefourthquarterof2009followingthedramaticnarrowingofcreditspreads—aninsightthatwasnotobvioustomosteconomicobserversatthetime.Hisstudyalsofoundthatawideningofcreditspreadsby3.5percentagepointstendstoleadtoadropineconomicoutputbyabout1.4%inthatsamequarterandalsothreemonthslater.Sohowdoyoumakethisknowledgeworkforyou?Theanswerissimple:You
choosetobuycertainassetclassesthatwilllikelydowellintheapproachingeconomicscenario.Ascreditspreadswidendramatically,it’ssafetoassumethataneconomic
slowdownwillfollowrelativelyshortlythereafter.“Attheonsetofrecession,seekouttheinvestmentsthatoffersafetyratherthanriskinanyform,orcyclicality,”saysRanson.Specifically,hesaysfavorsovereignorgovernmentdebtsuchasU.S.Treasury
bonds—aswellasgoldasasafe-havenasset—andavoidcommoditiesandequitiesofanytype.(Ransonexcludesgoldfromhisdefinitionofcommodities.Insteadhe,likesomeothers,seesitasitsownspecialassetclass.)U.S.TreasuriescanbepurchaseddirectlyfromtheU.S.governmentat
TreasuryDirect.gov.SmallinvestorscangetexposuretothepriceofgoldbullionbyconsideringtheSPDRGoldSharesexchange-tradedfund(GLD),whichholdsbarsofgold.Ascreditspreadsnarrow,itsignalsthattheeconomyis
comingoutofarecession.Sotheoppositeinvestmentadviceapplies.Investorsshould“embracerisk,”saysRanson.Also,emergingmarketsstockscanbegoodtooastheytendtobehavelike
hybridscombiningcommoditiesexposureandequityrisks.Manyemergingmarketscompaniesareengagedincommoditybusinesseslikeminingandagriculture.
EXECSUMMARY:CREDITSPREADS—THERISKSTRUCTUREOFINTERESTRATES
Whentolook:Eachbusinessday.
Wheretolook:TheWallStreetJournalonline’s“MarketDataCenter”hassomeinformationoncorporatedebtyields.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tabandlookforthe“MostActives”incorporatebonds.OtherinterestratedataforcorporatebondsiswidelyavailableontheInternet.
Foreasilysearchedanddownloadedhistoricaldata,oftengoingbackdecades,ourfavoritesiteistheFREDdatabaseathttp://research.stlouisfed.org/fred2/.Also,privateconsultingfirmslikeH.C.Wainwright&Co.Economicscompilesuchdata.
Whattowatchfor:Narrowing(widening)creditspreads.
Whatitmeans:Theeconomyisgoingtogrow(shrink)thatquarterandthenext.
Whatstepstotake:Buystocksandcommodities(buyshort-termbondsandgold,orkeepholdingsincash).
Risklevel:Medium.
Profitpossibility:$$
F
Chapter46TedSpread
Leading(SeealsoLibor,CreditAvailabilityOscillator)
OLLOWINGTHEGREATCREDITCrunchof2008,itbecamereally,reallyfashionabletohatebanks.However,thereisprobablyamoreprofitableway
toexpressyouranger.That’stofigureouthowbanksfeelaboutmakingloansandthenmakingakilling.Despiteallthebrouhahaandthehating,lendingbybanksiskeytoeconomic
growth.It’sactuallyquiteeasytotellhowbankerscollectivelyfeelaboutlendingbylookingathowtheypricetheriskthatloanswon’tbepaidback.Specifically,thequestionishowmuchmoredothebankspaytolendtoeach
otherthanthegovernmentpaystoborrow?TheU.S.governmentisconsideredtohavezeroriskthatitwon’tpayitsloansback.(Itcantaxandprintmoneyatwill,afterall.)Soanyinterestratechargedoverthegovernment’srateisameasureofcreditrisk.Wecaneasilyanswerthequestionofhowmuchmorebanksneedtopaythan
doesthegovernmentbycalculatingtheTedSpread,thedifferencebetweentheyieldonT-billsandLibor,therateatwhichbankslendtoeachother.“Itrepresentstheoxygenlevelinthefinancialmarkets,”saysDavid
Rosenberg,chiefeconomistandstrategistatToronto-basedwealthmanagementcompanyGluskinSheff.“Itassesseshowconfidentthecommercialbanksareinlendingtooneanother.”Anarrowspreadindicatesconfidence.Awidespread,lessconfidence.Areally
widespread,pandemonium.Thismattersbecausehowmuchbankslendandwhatpricetheychargeto
borrowmoneyhasamajorimpactontheeconomy.Typically,morelendingleadstoeconomicgrowth.Lesslendingleadstoaslowdownorevenarecession.
“Invariablywhathappensinthefinancialarenaendsupintherealsideoftheeconomy,”Rosenbergsays.
InvestmentStrategy
WhentheTedSpreadwidens,theoverallamountoflendingintheeconomycontracts,andthatultimatelyleadsto“avisibleslowingineconomicgrowth,”explainsRosenberg.Likewise,whentheTedSpreadnarrows,itisasignthatlendingisresuming.Orputanotherway,theappetitefortakingonriskierloansbybanksisincreasing.TheTedSpreadwidenedin1987,1990,1998,2000,2008,and2010.
Recessionsdidnotfollowin1987or1998,buttheydidin1990,2000,and2008.SoariseinTedclearlysuggeststhataperiodofslowereconomicgrowthmay
beintheoffing,but,aswheninterpretingotherindicators,it’simportanttolookforasustainedtrendandcorroboratingevidencebeforeacting.Ingeneral,lowerappetiteforlendingbybanksisnotauspiciousforthe
economy,anditdoeschangetherisk-rewardratioinfavorofmakingmorecautiousinvestmentdecisions.“Whenyoustartnoticingthisindicatoriswidening,it’susuallyasigntostep
tothesidelinesandincrementallytakeriskoffthetable,”saysRosenberg.Solooktoinvestinrelativelylow-riskassetslikegovernmentorhigh-rated
corporatebonds.Ifyouwanttostayinstocks,lookatcompaniesthatspecializeinconsumerstapleslikemanufacturersandretailersofsoap,toothpaste,andshampoo.But“don’tdoanythingwholehog,”hewarns,meaningmakechangestoa
portfolioofinvestmentsinsmallincrements.Andthat’sparticularlypertinentgiventhattheTedSpreadcannarrowquickly,indicatingthatthebanksonceagainfeelbetteraboutlending.
EXECSUMMARY:TEDSPREAD
Whentolook:Continuously.
Wheretolook:YoucancalculateyourownTedSpreadbylookingupLiborratesandsubtractingtheT-billrates.Tobeexactyouneedthree-monthT-billratesandthree-monthLiborrates.YoucanfindboththeseratesinTheWallStreetJournalonline’s“MarketData
Center”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tab.Alternatively,forU.S.Treasuryyields,seetheFREDdatabase.ForLibor,look
atthewebsiteoftheBritishBankers’Associationatwww.bbalibor.com/bba.
Whattowatchfor:Increases(decreases)inTedspreads,thedifferencebetweenTreasuryyieldsandLibor.
Whatitmeans:Bankswillbelendingless(more)inthenearfuture,slowing(stimulating)theeconomy.
Whatstepstotake:Appropriatecyclicalinvestment,i.e.,loweringexposureincrementallytoriskierassetslikestocksasTedspreadswiden.
Risklevel:Medium.
Profitpossibility:$$
Chapter47Texas“ZombieBank”Ratio
W
Leading
HENTHEDEFINITIVEMOVIEoftheGreatCreditCrunchof2008ismade,itshouldbegiventhesubheading“AttackoftheKillerZombieBanks.”
Zombies,youmayrecall,aretheundead,neitherdeadnoralive.Torturedbythisunnaturalstateofbeing,theywreakhavocamongthelivinguntildestroyed.Thezombiebanksaresimilar.Theycausehavoctoo.Neitheraliveenoughto
makeloans,nordeadenoughtodieorgettakenover,theylingeranddragontheeconomy.Howdoyouknowifyourbankisazombiebank?Youusetheso-calledTexas
Ratio.Itwasinventedintheearly1980sbyGerardCassidyandhiscolleaguesatRBCCapitalMarkets.Inthesimplesttermsitcomparestheratioofbadassetsatabanktoits
availablecapital.Thatavailablecapitalisacushionagainstthefirmgoingbust.“IcoveredtheTexasbanksinthe1980sandwhatIlearnedfromthemwasthat
whentheirTexasRatiobrokethrough100%theywentbust,”saysCassidy,who’sstillwithRBCCapitalMarkets—nowinPortland,Maine—asabankequityanalyst.Thesimplereasonthatthe100%figureissoimportantisthatatthatpointthebank’sreservesorcapitaliswipedoutbymountingbaddebts.TheTexasRatiocanbealittletrickytocalculate.Thebadassetspart,or
numerator,containsthetotalbookvalueofallnonperformingassetsonthebank’sbooks.Thatincludesrealestatethebankhasrepossessed(whichsometimesgoesbythemonikerOREO,orotherrealestateowned)aswellasloansthatareindefaultorarebeingrestructured.Inshort,itincludesthingsthataregoingtocostthebankmoney,saysCassidy.Thedenominatoristhevalueofthebank’sequityorbookvalue,plusits
reservesagainstloanlosses.Intangiblepartsofthebank’sequity,likegoodwill,areexcluded.Thewaytothinkaboutthedenominator(thebank’stangiblecapital)islikethesandbagsonthetopofariverbankthatprotectpeoplelivingnearbyfromextraordinaryfloods,explainsCassidy.Orintheparlanceoffinance,thebank’scapitalisthedefenseagainstbad
loanswipingouteverything.It’slikethelastlineofdefenseagainstanattackoftheundead.BankswithahigherlevelofbaddebtsandahighTexasRatioaresometimesrescuedbystrongerbanks.However,sometimestheyjustlimpalong
likezombies.
InvestmentStrategy
“AbankwithaTexasRatioover100%isindirestraits,”saysCassidy.“It’slikedrivingacarwiththetachometerintheredzone,”hesays.“Ifyoukeepdoingthat,eventuallythecarwillblowuponyou.”ThebiggestproblemmostpeoplehavewhentryingtousetheTexasRatiois
thattheyforgettotakeoutintangibleequity—suchasgoodwill,tradesecrets,copyrights,patents,andtrademarks—fromthedenominator,saysCassidy.“Whenyouseeabankhavingtroubles,thengoodwillandintangiblesareusuallyworthless,”hesays.
EXECSUMMARY:TEXAS“ZOMBIEBANK”RATIO
Whentolook:Daily.
Wheretolook:TheFederalDepositInsuranceCorporation(FDIC)hasthenecessarydatatocalculateyourownTexasRatiosforeachbankatwww.fdic.gov/bank/statistical/.SomedatacanalsobegleanedfromtheOfficeoftheComptrolleroftheCurrencyatwww.occ.treas.gov/pubinf.htm.Alternatively,forbanksthathavepubliclytradedstock,aninvestorcanglean
informationfromthequarterlyearningsreleaseknownasthe10Q,ortheannualreleaseknownasthe10K.
Whattowatchfor:Increases(decreases)intheTexasRatio(nonperformingassets/tangiblecapital).
Whatitmeans:Thebankorbankingsectorismore(less)likelytofail.
Whatstepstotake:Sell(buy)thebankorsectorespeciallyastheratioapproachesthezombielandof100%.
Risklevel:Medium.
Profitpossibility:$$
T
Chapter48TIPSSpread
Leading(SeealsoPCEDeflator,RealInterestRate)
HEWORDSOFWALLStreetforecastersareoftencheap.Sowhenyoureallywanttoknowwhatpeoplearethinkingaboutthefutureyoushouldwatch
whattheydo,notwhattheysay.Morespecifically,bylookingattheactionsofinvestorsintwodifferentparts
oftheU.S.governmentbondmarket,wecancalculateexpectationsoffutureinflation.Wederivetheanswernotbywhatpeoplesay,butratherbyhowmuchtheaverageinvestoriswillingtopayforthebondsinquestion.Thetwotypesofbondstocomparearegovernment-issuedinflation-indexed
securities,commonlyknownasTIPS,andstandardtermdebtsoldbytheU.S.Treasury.TIPSstandsforTreasuryInflationProtectedSecurities,atypeofbondthatcompensatesinvestorswheninflationincreases.Withregularbonds,bycontrast,holdersarehurtasinflationrisesbecausethepurchasingpowerofthenominallyfixedinterestpaymentsandtheprincipaldeclinesovertime.TreasuriestypicallyofferahighernominalinterestratethanTIPSdo.Inother
words,theypromisetopaymoredollarsofinterestperonehundreddollarsinvested.ButtheactualinterestpaymentoftheTIPSisadjustedinthefuturefortheeffectsofinflation.Thedifferencebetweentheyieldsofthetwotypesofsecuritiesistheexpectedfuturerateofinflationatthatpointintime.It’sknownastheTIPSspread,ortheTIPSbreakeven.Here’sanexample:Iften-yearTreasuriesareyielding4%andTIPS1%,then
thefutureinflationrateisexpectedtobe3%ayearforthenexttenyears.Thedifference,orspread,betweentheyieldschangeseverydaybasedonchangesinthepricesofthetwotypesofbond.Investorstendtoputalotofweightonthismetricbecauseitgivestheman
insightintobondmarketinvestors’inflationexpectations.Unlikeinsomemarkets,tradingingovernmentbondsisalmostentirelycarriedoutbysophisticatedinvestorswhotendtoactrationally.(That’squiteunlikethestockmarket,whichhasasizableportionofretailinvestorswhohaveactedquiteirrationallyattimes.)
InvestmentStrategy
TheTIPSspreadmattersbecauseittellsyouwhatlevelofinflationaverysavvypartofthemarketisexpecting.Expectationsarekeywithinflationbecausetheycanbeself-fulfilling.Ifyou
andeveryonearoundyouthinkpricesofgoodsandservicesaregoingtorise,thenpriceshaveaworrisometendencytodoso.Becauseofthisself-fulfillingproblemwithinflationexpectations,theFedkeepsacloseeyeonthispartofthebondmarket.Accordingly,wecanalsogetareadonwhentheFederalReservemight
changethecostofborrowing,explainsbondmarketveteranandheadofNewJersey–basedresearchoutfitMartaontheMarkets,T.J.Marta.“Twopercentseemstobethedividinglinebetweenhikingandeasing,”explainsMarta.Whathemeansisthatwheninflationexpectationsareabove2%ayear,theFedwilllikelyraisethecostofborrowing.Inthiscase,long-termbondsmaybeinforarally,hesays.“ThatisseenastheFedbringinginflationundercontrolandsoyieldscomedown[andpricesofbondsgoup],”hesays.Whenexpectationsareforinflationlowerthan2%ayear,theFedwilllikely
notraiseshort-terminterestrates.Asaresult,theshort-termcostofborrowingwillstaylowandthattendstobegoodforcommodities,explainsMarta.Healsosaysequitiescandowellinthatscenariotoo.Martapointsout,however,thattheTIPSspreadsometimestemporarilyjumps
above2%,so,aswithallindicators,it’simportanttoseethatasustainabletrenddevelopsbeforeleapingintoaction.
EXECSUMMARY:TIPSSPREAD
Whentolook:Daily.
Wheretolook:DataonTIPSyieldsandTreasuryyieldsareavailableinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”section.Alternatively,theFREDdatabasehasyieldsonbothTIPSandregular
Treasuries.TheU.S.Treasury’swebsite,www.treasurydirect.gov/,alsohas
informationonTIPS.
Whattowatchfor:Sustainedinflationexpectationsgreaterthan(lessthan)2%asmeasuredbytheTIPSspread.
Whatitmeans:TheFedwilllikelyraise(notraise)interestrates.
Whatstepstotake:Appropriatecyclicalinvestments.Forexample,whentheTIPSspreadpointstomonetarypolicytighteningbytheFed,considerbuyinglessriskyassets,likehighgradecorporatebonds,andsellingriskierones,likestocks.
Risklevel:Medium.
Profitpossibility:$$$
Chapter49CBOEVolatilityIndex(VIX)
D
Leading
OGS,THEYSAY,CANsmellfear.Well,youcantoo,inanentirelyobjectivemanner.That’simportantbecausefearandgreedarewhatdrivetheactionon
WallStreet.Whilewecan’tmeasuregreedverywell—it’sjusttoosubjective—wecaneasilymeasurefear.It’sdoneusingtheVIX,ortheCBOEVolatilityIndex:ThehighertheVIX,the
greaterthelevelofanxietyamonginvestors.Ifevertherewasa“tell”onWallStreet,thisisit.Inthesimplestterms,theVIXmeasuresthecosttobuyprotectionagainstthe
broadstockmarketfalling.Themoreinvestorsarewillingtopayforthis“insurance,”themoreanxioustheyareoverall.Sowhileitstillwon’tletyouseethroughthetoughemotionalshellofaninvestmentbanker,itwillgiveyouanideaofhowscaredtheyareasagroup.TheVIXisarelativemeasureofthecostofbuyingoptionsontheS&P500
Index,themostpopularbroadmeasureoftheU.S.stockmarket.TradedontheChicagoBoardOptionsExchange,theseoptions5actlikeinsuranceprotectionfromunforeseenstockmarketcrasheslikein1929,1987,or2008.Themoreuncertaininvestorsfeelaboutfutureevents,themoretheyarewillingtopayforthatinsurance,sotheybidupthepriceoftheoptions.Thetheoreticalvalueofoptionsismostfrequentlydeterminedusingthe
Black-Scholesformula,namedafterthetwocannyeconomistswhoinventeditinthe1970s.Theformulausesanumberofdifferentinputs,includinginterestrates,lengthoftheoptioncontract,therelativepricesoftheindex,andlastbutnotleast,volatility.Thekeythingtoknowisthatatanypointintimeeveryvariableexceptvolatilityisalreadydetermined.Traderslookatthemarketpriceoftheoptionandsolveforthevolatilityvariable.Theycalltheresult“impliedvolatility.”That’spreciselywhattheVIXis:impliedvolatility.
InvestmentStrategy
Someoneelse’sfearcanhelpyoumakemoneyonWallStreet.Butfirstyouneedtoavoidsomehighlyriskystrategies.Mostnotably,someinvestorsusechangesintheleveloftheVIXtobuyorsell
options.Thatmayworkforthem,butbeforeyoutryit,considerthis:“Buyingoptionsisawaytoloselotsofmoneyreally,reallyquickly.”That’swhatoneveteraninvestoradvisedoneoftheauthors.Thisisespeciallysoforthenoviceinvestor,soifthat’syou,avoidoptions.Ofcoursethatdoesn’tmeantheVIXisuseless.Ontopofjustageneralsense
ofcollectiveanxietyonWallStreet,therearewaystosnagsomeprofits.JamesAltucher,managingdirectorofNewYork–basedalternativeasset
managementfirmFormulaCapital,sayshe’sfoundagenerallywinningtradeusingtheVIXasanindicator.“WhentheVIXspikesupover20%inaday,it’softenaverygoodtimetobuy
themarket,regardlessofwhetherweareinabullorbearmarket,”hesays,notingthatsuchajumpintheVIXistypicalofagutreactiontofallingstocks.However,thereisfrequentlyabouncebackinstocksthenextday.Specifically,hesays,afterthe20%spikeintheVIX“buySPYthenext
morningandsellattheendofthatday’strading.”Theso-calledSPYistheSPDRS&P500(SPY)exchange-tradedfund,which
tracksthevalueofthewidelyfollowedS&P500Indexof500leadingpubliclytradedcompanies.Theresultisanaveragegainof0.97%,basedonAltucher’sanalysisofdata
goingbackto1993throughmid-2010.The20%-plusjumpintheVIXhappenedonlythirtytimes,butthesuggestedtradewouldhavebeenprofitableintwenty-twocasesor73%ofthetime.Theaveragereturnofnearly1%is“enormous”foraone-daytrade,says
Altucher.It’sroughlyequivalenttoover200%inannualizedreturns.Henotesthattransactionscosts,ataboutonecentashare,areminimalwiththistrade,andthatthedayswhenthetradedidn’twinsawonlymodestlosses.“Inthepastseventeenyears,doingthesystemdescribedabovebutholdingfor
amonthinsteadofadaywould’veresultedinanaveragereturnof–0.64%pertrade,”hesays,notingtheworstyearwas2008.Excludingthedatafrom2008,
themonthlongtradewouldhaveseenprofitsonaverage.
EXECSUMMARY:CBOEVOLATILITYINDEX(VIX)
Whentolook:Continuously.
Wheretolook:DataontheVIXisavailableatthemainpageofTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,lookfor“CBOEVolatilityVIX.”Alternatively,dataontheVIXcanbefoundatYahoo!Financeat
www.finance.yahoo.comandtheChicagoBoardOptionsExchangeatwww.cboe.org.
Whattowatchfor:AnupwarddailyspikeintheVIXof20%ormore.
Whatitmeans:Theremaybeexcessfearinthemarket,makingitripeforabounce.
Whatstepstotake:BuyabroadmarketETFlikeSPYthemorningafterthespikeandsellitattheendofthatsameday.
Risklevel:Astronomical.
Profitpossibility:$$$$
Chapter50VixenIndex
T
Coincident
HEVIXENISOTHERWISEknownastheHotWaitressIndex.Theideaisthatwhenthewaitressesatyourlocaleateriesandbarslooksmokinghot,thenit’s
asurefireguaranteethattheeconomyisinthedoldrums.Thisindicatorfirstcametolightin2009inthedepthsoftheeconomiccrisis
whenHugoLindgren,theneditorialdirectorforNewYorkmagazine,wroteapieceaboutitforhismagazine.Apparentlythiswasn’tjustadesperateattemptto“fillspace”insidetheadvert-heavyglossypublication.Believeitornot,thereissomeseriouseconomictheorybehindthisindex,and
itallrelatestoemploymentopportunities.“There’reawholelotofbusinessesthatareinterestedinhiringattractive
people,”saysLindgren.“That’strueforbothmenandwomen.”ButLindgrenpointsoutthatbeautifulwomenarevaluedmorebybusinesses
thanattractivemen.That’swhythisiscalledtheVixen,andnottheStud,indicator.Ingeneral,employers—particularlythoseintheserviceeconomy—generally
placeapremiumongood-lookingpeople.That’snotjustinrunwaymodeling,butalsoforallmannerofsocial/commercialevents.AcompanyinNewYorkcalledBarCandy,forexample,specializesinprovidingattractivebartendersforfancyevents.Whentheeconomybooms,“beautifulpeople”snagthesebetter-paidgigs.
Theydon’ttendtoworkatthelocalgreasyspoon.Butasthingsgetroughintheeconomyandthewell-paidjobsdryup,theymaytaketheregularrestaurantpositions.Sonexttimeyounoticethatthewaitstaffatyourlocaldinerisdrop-dead
gorgeous,thenyoucanrightfullysuspectthattheeconomyisincrisismode.EitherthatoryouarelivinginLosAngeles.
InvestmentStrategy
It’salittletrickytoapplythisindicator.That’sbecauseyourviewofwhatisattractiveisunlikelytobeexactlythesameasanyoneelse’s.Forthatreasonyouhavetocollectyourdatayourself,notfromothers.Andyoushouldtrytoensurethatyouareinthesamestateofmindeachtime.Togetanaccuratereadonthisindicatorsomeseriousstudyisinorder.Yep,
yourhomeworkassignmentistocheckoutthewaitstaffatyourlocaleatery.Onetripwillnotsuffice.You’llneedtotakenotesandtodosoeachtimeyouvisittheeaterybecause
thekeytothisindicatorisestablishingatrend.Itisnotreallyabouttheabsolutelevelofcuteness.Forinstance,isthebeautyofthewaitressesimprovingovertime?Ifitis,then
perhapsthatmarksasignthattheeconomyissouring.If,ontheotherhand,thelocalcoffeeshopsarestaffedbythehideousandunattractive,thenyoucanbesurethingsarelookingup.It’sworthnotingthatoneofthereasonsLindgrenwrotehispiecewasto
promptpeopletothinkforthemselves.“Itwasafunstorytowriteasameanstohelpotherscomeupwiththeirown
indexes,”saysLindgren.Orinotherwords,don’trelysolelyonthedataprovidedbygovernmentagencies.Insteadwould-beforecastersshouldcomeupwiththeirownideas.FormerFederalReservechairmanAlanGreenspanissaidtofavorwatchingscrapmetalpricesandunderwearsales,saysLindgren.Meanwhile,otherpeoplesaythetimeittakesyoutohailacabonaNewYork
Citystreetisafairindicationofhowstrappedconsumersarefeeling.The“taxiindicator”hasalotofmerit.That’sbecausethenumberofcabsonthestreetisbasicallyfixed.Whatisn’tfixedisthedemandforthosecabs.Thespendingontaxiswaxesandwaneswiththerelativestrengthoftheeconomy.Aspeoplehailmorecabs,therearelessfreeonesavailableforyousoittakes
youlongertocatchone.Inshort,ifyoucanconsistentlygetacabinstantlyatrushhourinMidtownManhattan,thentheeconomymustsuck.Likewise,ifyoucan’tgetoneeasilyevenintheoff-peakhours,thenthingsmustbelookingup.Andifyourunintoastringofattractivecabbies,headforthehills!
EXECSUMMARY:VIXENINDEX
Whentolook:Wheneveryouvisitarestaurant.Wheretolook:BecauseTheWallStreetJournalisafamilypublicationyou
won’tfindtoomanyhotwaitressesinitspages.Thatmeansyouarekindofonyourownwiththisindicator.Butifyouhavereadthisfarinthisbook,youarewellonyourwaytobeingabletoactonyourown.Youmightbereadingthisinacoffeeshoprightnow.Ifso,makenoteoftheattractivenessofthestaff.Writeitdown(maybeevenonthispage)alongwiththelocationandthedateandthendothesameagainandagainandagain.Prettysoonyou’llhaveenoughdatatoworkwith.ButmorethanjustdevelopingtheVixen,doasHugoLindgrensuggestsand
thinkofyourownindicators.Trythemout.Iftheywork,keepusingthem.Ifnot,discardthem.Butmostofallhavefunandnever,evermakebigmoneydecisionsonthebasisofanyoneindicator,nomatterhowattractiveitmayseem.
Whattowatchfor:Anincreaseintheattractivenessoflocalwaitstaff.
Whatitmeans:Well-paidjobswherebeautyisrequiredarescarce.Theeconomyissofterthanthepuddingyoujustordered.
Whatstepstotake:Askthehotwaitressout,thenbuydefensivestockslikeutilities,foodretailers,andpharmaceuticalcompanies.
Risklevel:Astronomical.
Profitpossibility:$$$$
I
ConclusionPuttingItAlltogether
FYOU’VEREADANDthenrereadourFantastic50,youarenowinapositiontostartputtingitalltogether.Asyoudothat,rememberthateconomic
forecastingismoreartthanscience.Farmore!Hereareafewtips,innoparticularorder:First,bemorethanalittlewaryofmathematicalmodelsbecausetheygivea
falsesenseofprecisionandhencesecurity.Sayingtheeconomywillgrow2.3422674%nextyearisanabsurdstatement.Bewaryofanyonewhosaysotherwise.Likewise,numbersfromofficialsourcescangiveafalsesenseofaccuracy.
Whenthegovernmentsaystheunemploymentrateis9.6%,rememberthatitisanestimatedfigurebasedonasmallsampleofhouseholds.Bettertosayit’sbroadly10%.Betterstilltonotewhetherit’sfallingorrisingmonthtomonth.That’sfarmoretelling.Insteadoflookingforexactnessinnumbers,looktogainexperienceand
improvejudgmentbyunderstandingsomebasicmodelsofeconomiccausation.Theyarefarsuperior,andfarmoreflexiblethanjustfigures.WeoutlinedsomebasicideasintheindividualeconomicchaptersoftheFantastic50.Still,whileyoulookatthosemodels,rememberthatforecastingisamoving
target.Statisticalrelationshipsbetweenvariablesthatheldlastdecade,lastyear,orevenlastweekmaynolongerringtrue.Thatiswhydataimmersion,thoughitwillstrikemanyasredundant,issoimportant.Andthatisalsowhywepackedmultipleindicatorsintothesectionscoveringthedifferentpartsoftheeconomy(withoneexception:thegovernment,wherewefeltonewassufficient).Afterall,considerthis:SayX,Y,andZalltraditionallymoveinlockstepand
typicallyprecedeA.YoumightconcludethatyoucanjusttrackXandforgetaboutYandZ.Butthenyou’llmissastructuralchangeintheeconomicbeastthatmakesYalonepresageAwhileXandZheadoffintheoppositedirection.Aninvestorintunewithallthreeseries,bycontrast,willnotetheanomalyand
treadcautiously.Thatwayyoudon’tloseyourshirt.FormerFederalReserve
chairmanAlanGreenspanwasanadvocateofimmersion,poringoverreamsandreamsofdatabeforemakingthepredictionsuponwhichhebasedU.S.monetarypolicy.Hedidn’talwaysgetitrightbuthehadafarbetterrecordthanmost!Asinformationflowsfaster,therearepressurestoforecastevermorequickly
andaccurately.Ifyouarefeelingthatpressure,youmaybetemptedtoconcentrateonafewbroadindicatorsratherthanthefiftywespecify.Don’t!Why?Becausedoingsowillgiveyoumajorproblems.Thebroaderan
economicindicatoris,thelessaccurateitis.Orputanotherway,metricsthatlookatoveralleconomicactivitytendtobecrudeatmeasuring.Thatinsightisjustanapplicationoftherisk-returntradeoffwellknowntoinvestors.Aquickreadofindicatorsusedtomakeinvestmentdecisionssometimesmayworkbutoftenwillbackfire.Attheotherextreme,youcouldwaituntiltheNBERcompletesitsextensive
(butbackward-looking)evaluationofmanydifferentmeasuresoftheeconomythatdefinewhenthebusinesscyclestartsandfinishes.Theproblemwithdoingso:You’llmisstheboateverytime.That’sbecausebythetimeNBERcallsarecessionorexpansiontheactualeventislonggone—solonggonethatit’salmostahistoricalevent!Bythattimetherelevantinvestmentopportunitiesarehistorytoo.Whatyouneedtodoislookatavarietyofindicatorsthatcoveralltheareasof
theeconomyandlearntomakedecisionsoninvestmentswhilethereisstillsomeuncertainty.Indeed,youmaybeaheadofthepackcomparedtothosewhohaven’tstudiedtheFantastic50andmayhearfromfriendsthattheeconomyisgreatwhenyouseemultiplesignsthatit’sheadingforaslump.Learnthroughexperiencetotrustyourjudgment.
ChoosingIndicatorsWisely
Beforeusinganyindicator,itiscruciallyimportanttounderstandthedifferencebetweencyclicalandstructuralchanges.Cyclicaliswhathappensduringthebusinesscycle—recessionfollowedbyexpansionandthenrecessionagain.Structuralchangeshappenwhenthingsfundamentallychangeintheeconomy,liketheadventoftheautomobileintheearlytwentiethcentury.ArecentexamplehappenedintheUnitedKingdom.Thenumberofitems
mailedinBritainwaslonganeconomicindicator.Whentheeconomygrewbriskly,therewasmoreneedtousethepostforadvertising,magazinesubscriptions,contracts,checks,etc.,sotheRoyalMail’svolumeincreasedcommensurately.Startingaround1999–2000,however,useofthemailservicedroppedevenwhileBritain’seconomyexpanded.DuringtheGreatRecession,thevolumeoflettersdroppedmanytimesfasterthantherateofeconomicactivity.TousetheRoyalMail’sdeclineasanindicatoroftheimminentdemiseoftheBritisheconomywasfalse.Thesteepdeclineinpostalvolumehasmoretodowithtechnology(e-mail,websites,electronicsignatures,etc.)thanwiththelevelofeconomicactivityinBritain.Similarly,aswementionedearlierinthebook,investorsoncebelievedthat
whatwasgoodforGeneralMotorswasgoodforAmerica,andviceversa.IfGM’searningswerepoor,they’dtakethatasasignofaneconomicdownturn.Thatmighthavemadesenseinthe1950s.ButovertimethecorrelationbetweenGM’sfortunesandthoseofthenationhavegrownweaker.Today,aninvestormightevenseesaggingGMsalesasasignofastrongereconomytocome,ifonlythegovernmentwouldlettheonce-behemothcompanyfail,thusallowinghundredsofmoreinnovativecompaniestospringforthfromthenutrients(engineers,robots,unusedfactories,etc.)providedbyitsgiant,rottingcorpse.Atthetimeofthiswriting,GMwaspartiallygovernmentowned,followingamassivebailout.That’ssomethingtheauthorsthinknevershouldhavehappened.Someforecastersusethenumberofpatentsgrantedannuallyasameasureof
economicactivity.Butit’strickytousethatfigurebecauseitmaybebothacoincidentindicator(thatdutifullyfellduringtheGreatDepressionandthe1970s)andafarsightedleadingindicatorthatmeasuresfutureproductivitygrowth.Patentsgrantedtoday,inotherwords,willallowustoproducemoretomorrow.Peoplespendgoodtimeandmoneyinventingstuffandprotectingit
withapatent,sotheymustexpectittobevaluable.Right?Right!However,inmanyplaces,includingtheUnitedStates,obtainingand
maintainingapatentisprettycheapintheschemeofthings.So,whilewemightstipulatethatallpatentshavepositiveexpectedvalue(expectedprofitsexceedthecostsofpatenting),allpatentsarenotequallyimportant.Thedifferenceineconomicimpact,bothinprofitsandinspillovereffects,betweenthefirstcomputerchipandthefirstholywaterdispenser,forexample,wasundoubtedlyhuge.Butit’shardtotellhowmuchmore.Qualitymattersherebigtime,inotherwords,butit’strickytomeasureaheadoftime.Evenmoretroubling,thenumberofpatentsgrantedisfarfromaclean
measureduetochangesinpatentofficerulesandefficiency.Some,most,orevenalloftheapparentfalloffinpatentingactivityinthe1970s,forexample,wasduetoasmallerpercentageofpatentapplicationsbeingacceptedandalongbacklogofcasesawaitingreviewduetogovernmentstaffcuts.Anotherclassicerrorinforecastingistosimplygobytheideathatifan
expansionorarecessionlastslongerthanaverage,thenaturningpointisimminent.Thereisnoreasonwhyarecessioncan’tlasthalfacentury—justasksomebodyfromCubaorNorthKorea—andnoreasonwhyanexpansioncan’tlastmuchlongerthan“average,”whichofcoursewillbehighlysensitivetostartandenddates.AccordingtotheNBER,forexample,theaverageexpansionsince1854hasbeenthirty-eightmonths,yetsevenexpansionssincethenhavelastedfiftyormoremonths,i.e.,afullyearormorepasttheaveragedate.Investorsalsoneedtobecarefulthattheydon’treadtoomuchintocomplex
indicatorslikethenumberofMexicanscomingillegallytotheUnitedStatesforwork(evenifthatfigureispossibletomeasure).AstheComedyCentralTVcartoonseriesSouthParkshowedbrilliantlyinits2004episode“Goobacks,”thelevelofMexicanimmigrationisafunctionoftherelativehealthoftheMexicanandU.S.economies,notsolelyabarometeroftheAmericaneconomy.Sowhiletheestimatednumberofimmigrantsin2009waswelloffitspeakofover1.5millionin2000,immigrationactuallybegantoslidein2005–6,wellbeforetheGreatRecession.ItwasnotthatpotentialMexicanimmigrantswereparticularlyprescientandfore-sawthefinancialcrisis;itwasthattheMexicaneconomyimprovedvis-à-vistheU.S.economyatthattimeandcontinuedtodosothrough2009.Thefinancialmarketsareforwardlooking,soinvestorsneedtobetoo.The
earlybirddoesn’tnecessarilygetthewormasitmightmisshoursofsleeponly
toarriveinthewrong,wormlessplace.Likeabove-marketreturns,wormsareelusivecreaturesthatdonotoftenappearinthesameplacetwice,atleastonsuccessivedays,soitisthesmartbird,thepredictiveone,thatwillgetthewormanddosowithminimalcost.Likewiseforinvestors,youmustbesomewhatanticipatoryinordertoprofit.
OurMagicBullets
InadditiontotellingyoualittleabouttheFantastic50indicators,wehavetriedtoestablishthefollowingpoints:
•Successfulinvestingmeansmakingandkeepingabove-marketreturnsateachstageofthebusinesscycle.•Investorsmustcorrectlyforecastthebusinesscyclebeforetheycanknowwhichtypesofspecificinvestments(bonds,equities,commodities,realestate)arelikelytogeneratesuperiorreturns.•Investingisnotaone-offevent.Itisalearningprocess,alifetimecommitmenttounderstandingtheeconomyinallitsgloriouscomplexity.•Forecasting,likeinvestmentmoregenerally,ismoreartthanscience.Correctreasoningandbig-picturepresciencetrumpquantitativeandmathematicalprecisionbasedondubiousassumptions.•Yourcapacitytoaccuratelypredictstemsfromacombinationofsoundhistoricaltrenddataandamodelthatcorrectlyidentifiescausalagentsratherthanmerestatisticalcorrelations.•Economicindicatorsmaylead,coincidewith,orlagactualeconomicconditions,asmeasuredbypercapitaoutputorGDP,whichisthesumofconsumption,investment,governmentexpenditures,andnetexports(C+I+G+NX).•Themoreindicatorsaninvestortracks,thebetterfeelfortheeconomyshewilldevelopandthemoreconfidentshecanbethatchangesinthebusinesscycleareintheoffing.•Thefiftyindicatorsdescribedinthisbookarethebestbecausetheyarethemosttimely,accurate,andrelevanttotherealeconomyandalsorelativelyunknown.•Whilelaggingandcoincidentindicatorsareimportanttofollowinordertounderstandtheeconomyinallitscomplexity,leadingindicatorsarethemostimportanttoinvestors.•Occasionally,though,thecomponentpiecesofacoincidentindicator
aretimelyandprovideaglimpseofthefutureandcanthereforebeasusefulasleadingindicators.
Readingabookexplainingtheseeconomicindicators—andhowyoucanprofitusingthem—onceisonething.Actuallyapplyingitisquiteanother.Sohowdoyouputthisknowledgeintopractice?Whatyouneedisaplantoreallymasterthematerial.First,startbysetting
asideaperiodeachdaytostudyjustacoupleoftheindicators.Thebestwaytochoosewhichonestostudyandwhenistomarkacalendarwheneachnewsetofdataoneachindicatoriscomingout.Mostoftheindicatorshavespecificandpredictablereleasedatesandtimes.CurrentreleasedatesarelistedinourExecSummaries.TheWallStreetJournalhasacalendaronline:http://online.wsj.com/mdc/public/page/2_3063-economicCalendar.html?mod=topnav_2_3000.Also,Briefing.commaintainsacalendarofeconomicdatareleasedatesandtimesatwww.briefing.com/Investor/Public/Calendars/EconomicCalendar.htm.BecausemostdatacomesoutinthemorningNewYorktime,wesuggest
dedicatingsometimetheeveningbeforeitistobereleasedtorereadthechapterontheindicator(s)inquestion.Whenyou’vereadandrereadthechapter,alsoreadthefinancialpress.Therearefrequentlyarticlesthatoutlinewhatinvestorsareexpectingfromthenewdataandwhatitmightmeanifvariousscenariosoccur.Inthemorninggetupearlytoseewhatthedatasays.Alsoatthattimeitwill
payofftoreadwhatthefinancialpressactuallysaysaboutthenewdata.Mostdaysofthemonth(therearetwenty-twoworkdaysinanaveragemonth)havesomeeconomicdatareported.Soyoucouldsetupastudycalendararoundthatschedule.Thatsaid,someoftheindicatorswefeaturedareprivatelypublished(e.g.,the
CreditAvailabilityOscillator)ordon’thaveregularreleasedates(VIX,Vixen,TexasRatio,etc.).Thismakeslifeatadtrickier.Butthisiswhereyourregularperusalofthebusinesspresswillpayback.You’lldevelopwaystofindtheinformationyouneedtofollowthoseindicators.Wheneveryoucomeacrosstheinformationyouneedforthesenonpublicorqualitativeindicatorsrereadtherelevantchapters.Followthatstudyscheduleofreadingthechapterthenightbeforeandthen
analyzingtheactualdatathenextdayforatleasttwomonths.Atthattimeyou
maybereadytostartkeepinganinvestingdiary.Thisiswhereyoumake“papertrades.”Inotherwords,you“buyandsell”
assetsbasedonwhatyouarelearningabouttheeconomy.Buthere’sthekey:Thetradesareonlyonpaper.Noactualmoneyshouldbeusedatthisstage.Theideahereistotryouttheknowledgeyouarelearningbutinasafeandcost-freeway.Foreaseofcalculation,useclosingpricesofthesecuritiesorassetsyou“buy”and“sell”foryourphantom“account.”Usethispaperaccountforatleastsixmonths,possiblylonger.Whenyoufeel
ready,startmakinginvestmentswithrealmoney.Atfirstyoushouldbecautiousbecauseyouwillundoubtedlystillmakemistakes.However,byusingtheknowledgeyou’vegainedinthisbookandinyourstudies,theseinvestingmisstepswillhopefullybefewerandlessdamagingthanbefore.Andthatcanleadtosomethingallinvestorsarelookingfor:biggerprofitsandlessstress.
AppendixUsefulEconomicIndicatorsWebsites
GENERAL
Briefing.com:www.briefing.comhasafree“Investor”sectionandaneconomiccalendar.
CONSUMPTION
BureauofLaborStatistics:www.BLS.govhasaplethoraofinformationaboutunemployment,efficiency,andthemakeupoftheU.S.work-force,aswellasproducerpricesandlotsofotherdata.
BureauofTransportation:www.bts.gov/publications/national_transportation_statistics/Statisticshasdetailsofcarsales.
ConferenceBoard:www.conference-board.orgprovidesdetailsonconsumersentiment.
RedbookResearchandChainStoreAge:www.chainstoreage.com/industrydata/monthlysales.aspx?menuid=471andwww.redbookresearch.comhavedataonretailsales.
INVESTMENT
EconomicCycleResearchInstitute(ECRI):www.businesscycle.comhasdataontheWLIandtheJoC-ECRIIPI,plusotherindicesandmetrics.
InstituteforSupplyManagement:www.ism.wshasdataontheISMManufacturingSurveyaswellastheISMNon-ManufacturingSurvey.
Kitco:www.Kitco.com,www.kitcometals.com,www.kitcosilver.comprovidedeepresourcesformetalsmarketwatchers.
LondonMetalExchange:www.lme.co.ukhasdetailsofbasemetalspricesaswellasregularreportingonmetalsinventories.
NationalAssociationofRealtors:www.realtor.orghasaslewofdataavailableonthehousingmarket.
NewYorkMercantileExchange(partoftheCMEGroup):www.cmegroup.comprovidesdataonenergyandmetals.
SemiconductorIndustryAssociation:www.SIA.orghasdetailsofthebook-to-billratio.
WorldBureauofMetalsStatistics:www.world-bureau.comhasdetailsoftheglobalmetalsmarkets.
GOVERNMENT
U.S.Treasury:www.treasury.govhasloadsofinformationontheeconomyandtaxes.
WhiteHouse:www.whitehouse.govpublishesdataonthegovernment.
NETEXPORTS
BalticExchange:www.balticexchange.comfortheoceangoingfreightrates.
BankofJapan:www.boj.or.jp/en/fortheTankanSurveyandotherJapan-specificdata.
CentralIntelligenceAgency:www.cia.govhasbasiceconomicdataonmostcountries.
Economist:www.economist.comprovidesdetailsontheBigMacIndexandothereconomicdata.
EnergyInformationAdministration:www.eia.govprovidesdetailsonoilinventories.
InternationalMonetaryFund:www.imf.orghasinformationonalmostallcountriesintheworld.
OrganizationofEconomicCooperationandDevelopment:www.oecd.orghasdataontheworld’srichcountries.
WorldBank:www.worldbank.orghasdataonover1,200economicindicators,fromagriculturetoeducationandtheenvironmenttohealth,forovertwohundrednations.
MULTIPLECOMPONENTS
BritishBankers’Association:www.bbalibor.comforLiborquotes.
BureauofEconomicAnalysis:www.bea.govmaintainsdataonincome,spending,andsavingsaswellasmanyotherdata.
CensusBureau:www.census.govhasinformationondurablegoodsorders,thehousingmarket,andnumerousothereconomicindicators.CentersforDiseaseControl:www.cdc.govprovidesdemographicdata.
FederalReserve:www.federalreserve.govhasdataandresearchreportsonaslewofthingsincludingindustrialproduction,aswellasthefamedBeigeBook.
DailyFinance:www.dailyfinance.comhasdataonshortinterest.
FREDdatabaseattheSt.LouisFed:http://research.stlouisfed.org/fred2/providestimeseriesdataonovertwothousandnationaleconomicvariables,includingbanking,business,prices,employment,exchangerates,output,interestrates,monetaryaggregates,andinternationaltransactions.
OfficeoftheComptrolleroftheCurrency:www.occ.gov/pubinf.htmhasthedataforanalyzingbanks.
PhiladelphiaFed:www.phil.frb.orghasdataontheAruoba-Diebold-Scotti
BusinessConditionsIndexanditsBusinessOutlookSurvey.
TheWallStreetJournal:www.wsj.comhasmassesofnewsandanalysisplusahandy-dandydatacenter.
Yahoo!Finance:finance.yahoo.comhastimeseriesdataonstocks,indices,andexchange-tradedfunds.
INFLATION,FEAR,ANDUNCERTAINTYChicagoBoardOptionsExchange:www.cboe.orghasdataontheVIX.
FederalDepositInsuranceCorporation(FDIC):www.fdic.gov/bank/statistical/hasdataneededtocalculatetheTexasRatio.
LondonBullionMarketAssociation:lbma.org.ukhashistoricaldataongoldandsilverprices.
MiseryIndex:www.miseryindex.ushasdataoninflationandunemploymentthatitcombinesintotheMiseryIndex.
SelectedBibliography
Axilrod,Stephen.InsidetheFed:MonetaryPolicyandItsManagement,MartinthroughGreenspantoBernanke.Cambridge:MITPress,2009.Baumohl,Bernard.TheSecretsofEconomicIndicators:HiddenCluestoFutureEconomicTrendsandInvestmentOpportunities,2nded.Philadelphia:WhartonSchoolPublishing,2008.Birchenhall,Chris,HansJessen,DeniseOsborn,andPaulSimpson.“PredictingU.S.Business-CycleRegimes,”JournalofBusinessandEconomicStatistics17(July1999):313–23.Boldin,Michael.“DatingTurningPointsinEconomicCycles,”JournalofBusiness67(January1994):97–131.Bordo,Michael.“TheLimitsofEconomicForecasting,”CatoJournal12(Spring/Summer1992):44–48.Fleckenstein,WilliamA.andFrederickSheehan.Greenspan’sBubbles:TheAgeofIgnoranceattheFederalReserve.NewYork:McGrawHill,2008.Friedman,Walter.“TheHarvardEconomicServiceandtheProblemsofForecasting,”HistoryofPoliticalEconomy41(2009):57–88.Griliches,Zvi.“PatentStatisticsasEconomicIndicators:ASurvey,”JournalofEconomicLiterature28(December1990):1661–707.Kaufman,Henry.OnMoneyandMarkets:AWallStreetMemoir.NewYork:McGrawHill,2000.McCloskey,Deirdre.“TheArtofForecasting:FromAncienttoModernTimes,”CatoJournal12(Spring/Summer1992):23–43.Rogers,R.Mark.TheCompleteIdiot’sGuidetoEconomicIndicators.NewYork:Alpha,2009.Stock,JamesandMarkWatson.“NewIndexesofCoincidentandLeadingEconomicIndicators,”NBERMacroeconomicsAnnual4(1989):351–94.Wright,RobertE.Fubarnomics:ALighthearted,SeriousLookatAmerica’sEconomicIlls.Buffalo:Prometheus,2010.
Wright,RobertE.andVincenzoQuadrini.MoneyandBanking.Irvington,N.Y.:FlatWorldKnowledge:2009.www.flatworldknowledge.com/printed-book/1634.
Acknowledgments
Nobookcanbecompletedorevenattemptedwithoutthehelpofmanyothers.Inadditiontoallthepeoplequotedinthisbook,thereweremany,manyothers.Inparticular,webothhighlightRoeD’AngeloandMattInmanfortheir
patienceandperseveranceduringtheeditingprocess.Weneversaidwewereeasy!Inaddition,Mr.ConstablesaysthanksdearlytoCourtneyLuttermanwithout
whosemoralsupportthiswouldnothavebeenpossible.ThanksarealsoduetoAlanMurrayandRickStineformakingawholehostofthingspossibleatDowJones.OthersnotablefortheirencouragementinthisprojectincludeNealLipschutz,BrettArends,JulieIannuzzi,ShawnBender,BobBruner,andKenEades.Dr.WrightthanksDavidBackus,MichaelDarda,JanReid,MarkStickle,and
RichardSylla.Finally,weapologizeinadvanceforanyomissions.Youknowwhoyouareevenifweforgottomentionyou!
AbouttheAuthors
SIMONCONSTABLEishostoftheNewsHublivewebshow,whichairsweekdaysat4:00p.m.ETontheWallStreetJournalDigitalNetwork.Healsomakesstand-alonevideosforWSJ.com,MarketWatch,andBarrons.com.HehaswrittenforTheWallStreetJournal,WSJ.com,DowJonesNews-wires,MarketWatch.com,TheStreet.com,theNewYorkPost,theNewYorkSun,andtheSouthChinaMorningPost.HeisalsoafrequentguestonFoxNews,BBC,andABCTV;afill-inhostfortheJohnBatchelorShowonWABCRadio;andwaspreviouslyaseniorcorrespondentforTheStreet.comTV.ConstableholdsanMBAfromtheDardenSchoolofBusinessatthe
UniversityofVirginia.HealsoworkedonWallStreetasanadvisertotopmanagementatsomeofAmerica’smostprestigiouscompanies.HelivesinNewYorkCity.
ROBERTE.WRIGHT(PhDinHistoryfromtheStateUniversityofNewYork–Buffalo,1997)istheNefFamilyChairofPoliticalEconomyandtheDirectoroftheThomasWillingInstitutefortheStudyofFinancialMarkets,Institutions,andRegulationsatAugustanaCollegeinSiouxFalls,SouthDakota.Hehasauthoredorcoauthoredfourteenbookswithleadinguniversitypressesandcommercialpublishers.HehasalsowrittenforBarron’s,theChronicleofHigherEducation,theLosAngelesTimes,McKinseyQuarterly,andotherprominentpublicationsandhasappearedonNPR,C-SPAN,FoxNews,theBBC,BNN,MSNBC,variouslocalTVnewsstations,andadozennationallysyndicatedradioprograms.WrightalsositsontheeditorialboardoftheMuseumofAmericanFinance’sFinancialHistorymagazine.
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AuthorphotoofSimonConstablecourtesyofTheWallStreetJournal
AuthorphotoofRobertE.WrightbySamStern
Copyright
THEWALLSTREETJOURNALGUIDETOTHE50ECONOMICINDICATORSTHATREALLYMATTER.Copyright©2011byDowJonesandCompany.AllrightsreservedunderInternationalandPan-AmericanCopyrightConventions.Bypaymentoftherequiredfees,youhavebeengrantedthenonexclusive,nontransferablerighttoaccessandreadthetextofthise-bookon-screen.Nopartofthistextmaybereproduced,transmitted,downloaded,decompiled,reverse-engineered,orstoredinorintroducedintoanyinformationstorageandretrievalsystem,inanyformorbyanymeans,whetherelectronicormechanical,nowknownorhereinafterinvented,withouttheexpresswrittenpermissionofHarperCollinse-books.
IllustrationsthroughoutthisbookareusedcourtesyofTheWallStreetJournal.
FIRSTEDITION
LibraryofCongressCataloging-in-PublicationDataConstable,Simon,1968–TheWallStreetJournalguidetothe50economicindicatorsthatreallymatter:fromBigMacsto“zombiebanks,”theindicatorssmart
investorswatchtobeatthemarket/bySimonConstableandRobertE.Wright.—1sted.
p.cm.Includesbibliographicalreferences.ISBN-13:978-0-06-200138-2(pbk.)ISBN-10:0-06-200138-8(pbk.)1.Portfoliomanagement.2.Economicindicators.3.Businessforecasting.I.Wright,RobertE.(RobertEric),1969-II.Title.III.Title:Guidetothe50economicindicatorsthatreallymatter.HG4529.5.C6582011339.3—dc22
2010052579
EPubEdition©2011ISBN:97800620497731112131415OV/RRD10987654321
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1Readersshouldnotconfuse“investment”with“businessinvestment.”Businessinvestmentinvolvesbuyingnewmachineryorbuildingnewfactories.Insomecontexts,investmentsareanysumsofmoneyinvestedinfinancialorotherassetsinthehopeofeconomicgain.Buyingequitiesinasecondarymarketisanexampleoffinancialinvestmentnotbusinessinvestment,forexample,becauseitdoesnotrepresentnewnetinvestmentintheeconomy,justachangeofowners.Throughoutthebook,wewilltrytoclearlydifferentiatebetweenthetypeofinvestmentthatreadersmightmakefromthebusinessinvestment(I)usedbyeconomistsinGDPcalculations.
2Ifyouthinknominalinterestratesareheadeddownward—astheytypicallymoveduringarecession—buybonds,becausetheywillincreaseinprice.(Nominalinterestratesandbondpricesareinverselyrelated.Ifyoudidn’tknowthatorotherwisefeelthatyourbasicbackgroundisalittleshaky,readWrightandQuadrini’sMoneyandBankingtextbookfirst.It’sfreeatwww.flatworldknowledge.com/printed-book/1634.Alsoavailablefree,ontheThomasWillingInstitute’swebsite,www.augie.edu/thomaswilling,isanextensiveglossaryoffinancialterms.)Ifyouthinknominalinterestratesareheadedupwardduetoaneconomicexpansionorbecauseinflationisheadedskyward,short(mostsimplysell,orborrowsomebonds,sellthemhigh,andbuymoreofthembackatlowerprices,asdescribedintheshortinterestentrybelow)bonds,becausetheywillbehithard.Usethenewcashtobuygold,realestate,andotherassetsexpectedtoappreciateinlinewith(orbetteryet,fasterthan)thepricesofothergoods.Iftheeconomylookstoheatupwithoutinflationarypressures,pro-cyclicalstocksinthefinancial,industrial,andconstructionsectorsareagoodbet.Whenrecessionlooms,bycontrast,defensivestockslikefoodandutilitiesareprobablythewaytogo.Andifpanicorcrisisappearsimminent,Treasurieswilllikelysoar,justastheydidinSeptember2008.
3Forinstance,afundmanagerwhoexpects,say,abankstocktooutperformitspeergroupmaysellshortanETFthatholdsabroadbasketofbankstocksandthenusetheproceedsoftheshortsaletobuythestockthatisexpectedtooutperform.Thatwayeveniftheentiregroup—includingthefavoredstock—dropsinpricebutthefavoredstockstilldoesbetter,themoneymanagerwillhavemadeaprofit.
4WhileMishkinandEstrellagetmuchofthecreditformodernyieldcurvetheory,Duke’sCamHarveypresagedtheirefforts.Ifyouwanttodelvedeeperintothepredictivepowersofyieldcurvesanddon’tmindalittlemathematics,checkoutCam’s1986UniversityofChicagodissertation“RecoveringExpectationsofConsumptionGrowthfromanEquilibriumModeloftheTermStructureofInterestRates,”his1988JournalofFinancialEconomicsarticle,“TheRealTermStructureandConsumptionGrowth,”orotherworkavailableatwww.duke.edu/~charvey/research_term_structure.htm.
5Optionsarefixed-termcontractsthatgivethepurchaserofthecontracttherighttobuy(orsell,dependingonthecontract)theindexatapredeterminedprice.Profitsorlossesaremadefromthedifferencebetweenthecontractpriceandthemarketpriceoftheindexattheexpirationoftheoptioncontract.