We’re at a unique time in history right now. Amid the housing and financial crisis of 2008 and its aftermath, bank bailouts and extraordinary actions by the Federal Reserve became commonplace. Many would agree that the easy money policies of the Fed have driven the prices of many asset classes up with less than typical consideration to inherent value. We’re still waiting to see how the reining in of the good times and the reversal of quantitative easing will ultimately impact markets.
While it is impossible to have a crystal ball into the future that will predict how all these factors will unfold, one thing remains certain. We’re all in some way at the whim of market forces and in times of uncertainty it pays to have a strategy in place. And now’s the time to ask… have you given ample thought to what your strategy will be should we face a market correction or worse?
If not, know that there is still time to get your plan of action in place. For exactly how long no one can say. However, each day brings an opportunity to learn new ideas that combined will contribute to your wealth of knowledge.
The Economy and the Market
As you try to make sense of the current market environment, one of the best places to start is with the economy. You may already know that the stock market broadly follows the economy, especially after accounting for short-term volatility. But you may not realize a very key distinction – the market follows where it believes the economy is headed, not where it has been.
Every month, dozens of numbers and statistics are released that purport to tell a story of the health of the economy. While each news release may make for good news, not all of these statistics will actually help you determine how to plan your investing activities in the short and medium term.
Some of these economic reports actually tell you very little about where the economy is headed. In fact, a whole class of macro factors, so called trailing indicators, is designed to review past performance. While these may be useful for economists to do their research, the majority actually can create confusion and churn in the markets.
Generally speaking, for an economic indicator to have predictive value it must be current, have a clear relationship to future economic performance and lastly, discount current values with respect to future expectations.
Trailing versus Leading Indicators – Which Are Better?
There are a handful of trailing indicators that are of value when trying to understand market movement. The reason they have an impact is because traders and investors realize two things: i. that the Fed determines its monetary policy, in part, based on the recent performance of the economy, and, ii. that the current and future direction of monetary policy impacts the movements of markets.
Leading indicators, in contrast, work as early warning signals of economic activity. They tend to be input oriented (production of goods that will create value downstream) and they are generally harder to measure. However, these data are deemed to be pulling the economy and therefore give an indication of where the economy is headed.
Copious research has been done to determine which numbers have real predictive value for future stock market values. You wouldn’t necessarily know which numbers merit careful consideration from the coverage in the financial media because they must report on every number. However, there are only a few macroeconomic factors that may have real relevance for you if you are trying to get a sense of where the market is headed.
The Key Factors to Watch Right Now
As with so many things in life, the 80/20 rule applies. In this time of information overload, it’s helpful to focus on the most meaningful factors so you can be nimble in your response to changing market conditions.
So what are these eight key factors? The table below shows a list of the top leading and trailing macroeconomic indicators along with those that researchers from top universities found to have actual predictive value.
It is beyond the scope of this blog post to explain the intricate relationships between these eight key indicators and stock market movement, but each is vital to track to have advance warning should a market correction be imminent. Careful consideration of these eight (Unemployment Rate, CPI, Balance of Trade, Housing Market, M1/M2, PPI, PMI, and Consumer Credit) will give you an edge over the typical retail investor by providing a peek into where the economy is and by proxy, where markets are headed.