From the January 01, 2007 issue of Futures Magazine • Subscribe!

Reading economic reports

Most retail traders would be surprised at how little many professional traders on Wall Street know about economic reports. With a little work, anyone can take their knowledge to a level that many on Wall Street take years to obtain — and that some never achieve.

The frequency of economic releases makes it easy to understand economic data and how it affects the markets. The frequent releases also make it easy to spot patterns in the way the data behaves and thus draw connections from one economic indicator to the next because they are all, ultimately, intertwined.

Expert knowledge of economic reports can provide greater personal reward than theoretical academic work because it can be applied. There’s no substitute for knowledge that has application value. In this case, we are talking about making you a better investor through a greater understanding of how to use economic reports.

MONTH TO MONTH

Look closely at economic calendars from one month to the next and you’ll see that they look alike, with most economic reports released around the same date each month (see Dateline, link below).

Also notable is the large role that manufacturing-related data play in the calendar. This might surprise some, given that the U.S. economy is largely a service-oriented economy, with factory activity accounting for only around 15% of activity, and the service sector accounting for about 65%.

There are a couple of reasons for the calendar makeup. For one, the government has been slow to respond to the secular decline in the U.S. factory sector. In fact, the only major service-related economic report is the non manufacturing index released monthly by the Institute for Supply Management, a private organization. The government is failing the markets in this respect.

Second, activity in the service sector is much more difficult to measure. It’s easier, for example, to measure the monthly output of automobiles than to track the activity of landscapers, repairman, lawyers, hair and nail salons, and so on.

Most times, the focus on factory activity is appropriate because it is representative of the overall economy: the many factors that impact the factory sector also impact the service sector, for example. Still, there have been plenty of occasions when the factory sector sent misleading signals on the state of the overall economy. Nevertheless, due to the makeup of the economic calendar, the bond market is heavily influenced by the factory sector, which is why it is so important to get a grip on factory activity most of all.

NUMBERS DON’T LIE

Devising a good forecast on the economy is challenging, but the task is made easier when you let instincts and facts guide your forecasts. Many economic forecasters approach forecasting far too conservatively and rarely think outside of the box, clustering their forecasts around a safe place: the consensus. Hence, they miss making great calls. They are more comfortable knowing they will be less open to criticism if their peers are also wrong.

The conservative nature of forecasters is similar to the reticence shown by equity analysts before the equity bubble burst in 2000. Analysts stood by rosy forecasts on stocks and were reluctant to issue sell recommendations when the environment clearly called for it. In fact, less than 1% of analyst stock recommendations at that time were sells.

As a trader with your own money on the line you need to be willing to make forecasts that are sometimes far removed from the consensus. Don’t buck the trend just for the sake of doing so, but let your forecasts be dictated by numbers; numbers don’t lie. In doing so, you will find yourself delivering accurate forecasts when the crowd is wrong.

When making an economic forecast, think like a detective who is on a mission to collect as many relevant facts as possible. An example would be driving to the local shopping mall just to look at the fullness of the parking lot for clues on consumer spending. You can never have too much data when you are trying to forecast the economy, and the information age helps a great deal. Web sites by trade associations and specialized journals contain a lot of information about specific sectors of the economy.

Once you’ve assembled as many relevant facts as you can, it’s vital to let them guide your forecasts and to have conviction. You must remain open minded, but there are many situations where your forecast might seem at odds with what might be guiding other forecasters.

In the second half of 2001, for example, a forecast for weakness in the housing market was counterintuitive given that interest rates had fallen sharply, but some important numbers pointed another way. Lumber prices were near a nine-year low, mortgage applications were slipping, consumer confidence was down and home builders’ confidence was down. Despite low interest rates suggesting otherwise, housing slowed.

Similarly, when energy prices started to climb in 2003 and 2004, personal income data showed that income growth was strong enough to absorb the consumer’s increased energy costs. An astute analyst would have remained optimistic about the economic expansion and bet on Fed rate hikes into early 2006 when energy was still rising (see “Energy vs. the Fed,” above). That proved to be the right call. It is important to stand by your numbers, especially if they make a compelling case.

BE FLEXIBLE

The bond market’s focus on economic data is intense, but the specific economic reports that get the most attention vary. For example, the monthly employment report tends to be a big market mover most times, but it is often downgraded in importance and viewed as a lagging indicator. It’s therefore important to be open-minded and flexible when weighing the potential impact of a set of economic reports.

With the market’s focus on data changing frequently, you should look several steps ahead and consider the chain of events that could affect the economy and perceptions about it in the financial markets. Given how Wall Street works, looking at the present is looking in the past.

Successful investors must first identify either the economy’s key problems or its major underpinnings and then try to envision the chain of events that could alter its direction. The best way to accomplish this is to recognize that behind each economic event is a series of other events. For example, by following weekly data on mortgage applications, you can quickly drum up a view on the housing market. This is a major element in forecasting the economy and perceptions about it, especially given the intense focus on housing these days.

From there, it’s especially important to relate developments in the economy to the markets; you can’t put being right in the bank. You must apply your sense of the data to the markets in order to benefit.

METHODOLOGIES MATTER

Once you’ve got a good sense of how the economy works and you feel comfortable making economic forecasts, you can significantly enhance your forecasting ability by learning more about the survey methodology for the economic reports. This will give you an edge on other market participants who often have scant knowledge about the data.

An important premise to remember is that actual economic data can differ greatly from the reported data. Statisticians see to it that raw data are altered to smooth out seasonal fluctuations.

Consider the sale of Christmas trees, for example. Sales increase substantially in December before nose-diving in January. Statisticians attempt to “smooth,” or seasonally adjust, the fluctuations by adjusting the December data downward and the January data upward. Who, after all, wants to hear that sales rose 400% in December but fell 400% in January? By recognizing how data are altered, you can find situations where the adjustments might be too much or too little under various circumstances.

Track also how economic data are collected; specifically the survey cutoff dates because most are not at month’s end. In January, for example, a snowstorm that occurs late in the month will affect some economic reports for January but not others. Knowing the survey methodology makes it less likely you will be fooled by economic reports and you can better spot trading opportunities.

PUTTING IT TOGETHER

Few doubt that economic reports are at the root of most bond market volatility. Recognizing this is the first step to using this simple notion to your advantage.

The next step is to take advantage of the repetitiveness of the monthly releases to learn them inside and out. From there, increase your understanding of the economy and the data enough to envision the series of events that could follow different sets of economic data and how the markets might respond to the events.

Finally, get an extra edge by learning more about how economic reports are put together: the survey methodology.

Try all of these things while remembering that in the economy, everything is connected in one way or another. In the economy, there’s certainly truth to the notion that for every action there’s a reaction. As a trader, your ability to anticipate these series of reactions will separate you from the pack.

Anthony Crescenzi is a bond market strategist at Miller Tabak + Co. and author of The Money Market and The Strategic Bond Investor. He can be reached at acrescenzi@millertakak.com.

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