A smart investor’s guide
Economic Forecasts Are Worse Than Weather Forecasts
Economic information comes from all angles in the media, constantly exposing us to endless analysis, commentary, opinion, and debate. Yet this onslaught doesn’t seem to make us any wiser as to where the economy is heading. Of the millions of people trying to read the economy, only a few are successful.
Most economic predictions are based on the wrong indicators, so there’s no chance that they will ever produce useful forecasts. Even when the right information is presented, it’s never presented in a way that’s easy for people to understand.
Making Sense of The Economy
The economic cycle is driven by cause and effect. Personal income drives consumer spending. Businesses respond to consumer spending by increasing production, which, in turn, requires greater investments in infrastructure and capital spending. Consumer spending, production, and capital spending all drive corporate profits.
Stock market performance is dependent on corporate profits; corporate profits also drive employment. And so, you see that job growth is at the very end of the food chain. Employment is a trailing economic indicator, and for this reason, it isn’t useful for making forecasts.
Redefining Economic Downturns
Market cycles have long periods, sometimes lasting years, during economic slowdowns when stocks just aren’t a good investment. In cycle after cycle, businesses always seem to get caught in periodic downturns, and by the time the leaders realize they’re in a downturn, it’s too late to do much about it.
The Fear Of Recession
There’s a traditional fear of recession (defined as two quarters or more of decline in real GDP), but ultimately, the downturn is already in the cards before a recession even hits.
Smart Economic Tracking
Too much reliance on recession as an indicator is one problem; the second problem is the standard practice of measuring the change in short-term increments—periods so short they can disguise larger trends.
The noisy, quarterly charts with wild swings of data and little context are confusing. The better solution is year-over-year charting, which makes trends much easier to spot.
Outdated Methods Of Economic Analysis
Analyzing economic data is as simple as gathering historic and current data from the internet and using Excel or similar software to assemble it all into an easy-to-read chart. Anyone can do this. It doesn’t require special skills or tools.
Econometric analyses, on the other hand, are complicated statistical analyses that economists use. But these forecasts are less useful than you’d expect. They tend to be rigid in their modeling and don’t provide a complete, dynamic picture of things.
The ROCET Formula
- The rate of change in economic tracking (ROCET) can be used as a new milepost for economic forecasting.
- Leading indicators should have a clear cause-and-effect relationship when charted together.
- Consumer spending drives the demand chain in the economy, and capital spending follows consumer spending.
- The demand cycle, which includes consumer spending, industrial production, and capital spending, affects the stock market.
- To invest successfully, it is important to follow the basic rule of buying low and selling high.
- To forecast consumer spending, various factors such as financial, fiscal, and psychological influences should be considered, and it is helpful to focus on a few key indicators that have shown causality over multiple cycles.
The Basic Trick
To get a reasonably good forecast, one has to just construct charts out of historical data and look for possible cause-and-effect relationships.
The trick is to be smart about how you chart the relationships. Changing the organization and tracking of data can be useful preparation for analyzing relationships, and the book sets forth a simple method for doing so.
The Four Stages Of Economic Downturns
At the peak, consumer spending and GDP are growing, profits are rising, and employment is hunky-dory. The stock market continues to peak, and investors are enthusiastic.
Then, things slow down a little. The economy is still growing, but the rate of growth has been reduced. Interest rates rose just a little. The stock market cools down. Soon enough, worry sets in.
Interest rates and inflation rise. The rate of growth in the GDP slows to 2 or 3%. People start predicting a recession. The stock market slumps.
Finally, the recession hits. GDP declines, profits fall, and capital spending declines.
Key Points
- There are two types of consumer spending power: personal income and personal wealth.
- Real wages, rather than changes in employment or unemployment, are more important for economic growth.
- Both employment and the economy can drive each other in a circular manner.
- Consumption should be increasing as employment bottoms out.
- The Federal Reserve Board’s actions on interest rates can impact consumer borrowing, inflation, and overall economic health, as well as affect the stock market through their impact on economic growth and price-to-earnings ratios.
The Economic Corners
Every day, we’re exposed to lots and lots of economic data. There are countless forecasters making economic predictions. Of all the people and organizations predicting the future, none are so consistently accurate as to be reliable. Nevertheless, we do need some way to interpret the trends. We need to see around corners.
Context is everything. Information needs to be juxtaposed with the information that preceded it so that we can understand the patterns in the data. Only by comparing last year’s performance to this year’s performance can we see whether we are progressing toward our goal.
The Two Big Errors
There are two big errors in traditional economic analysis. The first mistake is regarding recession as the main indication of an economic slowdown. Recession is identified by GDP, but by the time the decline has hit GDP and it reflects the slowdown, significant portions of the economy are already damaged.
The second mistake is the practice of tracking economic data from quarter to quarter and month to month. This causes a lot of noise, and there are lots of adjustments that have to be made to the data. Year-to-year tracking is better.
Recessions Vs Slowdowns
A recession, as a reminder, is defined as more than a two-quarter decline in real GDP. This measurement tends to put observers into a simplistic, dualistic headspace. If GDP is positive, then it’s good; if GDP is negative, then it’s bad.
A slowdown that doesn’t land GDP in the negatives doesn’t provoke much horror—iit’s seen as a soft slowdown, more of a minor worry if anything. But such slowdowns can cause almost as much damage as proper recessions.
