Understanding Economic Reports

[Top Step Trader 10]

Understanding Economic Reports

 

Gregg Killpack (Gregg K) of TopStepTrader.com

 

Economic reports can be confusing. They are couched in professional jargon and technical information that can be difficult to understand. How do you know what they really mean?

 

At their most basic level, economic reports help to answer the big question: Is the economy growing or not? If so, how fast is it growing? Or if not, how fast is it contracting? Each report or indicator is like one piece of a jigsaw puzzle indicating what the future may hold for the economy.

 

The economy is a broad financial system where consumers and companies are linked and interwoven together. If that system is growing, then more money is available for all companies to potentially increase sales, from small business to IBM and Microsoft. Economic reports, data, and news imply how much money may be flowing into that system and at what rate. They show signs of growth (or the lack thereof) or in other reports, headwinds to that growth.

 

For example, Initial Jobless Claims is a report for how many new people filed for unemployment benefits. If fewer people are applying for unemployment, presumably they have found a job, an indication that the economy is improving. If the number of people applying for benefits has dropped significantly compared to what it had been or compared to what was expected – that indicates a strongly improving economy; markets may jump at that news. However, if the number comes out in-line with what it had been and what was expected, the markets are probably already priced in-line with expectations and won’t move much.

 

To us as traders, economic data is critical information because how fast the economy is growing is key to the valuation of markets, including stock and futures markets. For example, a stock’s price is based on where the future financial performance of the underlying company is expected to be. No one knows for sure where it will be, so expectations are important. They represent our best guess about an unknown future of the company’s financial performance. As the company releases financial data about how well it actually did, that information is compared with what was expected, and the market responds accordingly.

 

When an economic report comes out, we receive new information about whether the released data is in line with previous expectations about future economic growth for the whole system – the U.S. economy. Instead of looking at the future prospects of a company or a single market, these reports can affect all companies and all markets; they are systematic reports that can affect the entire economy. When companies are growing, their stock prices rise. They will also demand more raw materials; therefore equities and commodities markets tend to rise and fall together, generally speaking.

 

The 1st Key

 

The first key to understanding economic reports is to know how big an effect the data to be released can have on the economy and hence the markets. Reports and indicators that have large, systematic effects can have huge, instantaneous effects in markets. Others may have little or no effect.

 

A change in interest rates set by the Federal Reserve has a tremendous, system-wide impact to speed up or slow down the economy and can instantly cause markets to shoot up like a rocket, or fall off a cliff. A rate change will increase or decrease interest expenses on debt for every company in the country. Most of the time the Federal Reserve doesn’t surprise the markets and expectations are built into the prices of the markets, but when the Fed does anything unexpected, the markets move – and fast.

 

For example, on October 15, 1998, the Federal Reserve ordered a surprise rate cut of 0.25% to help with the bailout of Long-Term Capital Management, a highly leveraged hedge fund that had lost billions of dollars. In response, the market soared. The Dow Jones Industrial Average climbed more than 25% over the next year and a half. It wasn’t just that the Federal Reserve lowered rates – 0.25% isn’t a huge move – it was the unexpected move that Mr. Greenspan and company were easing rates to stimulate the economy… and might continue to do so if needed to aid in the crisis.

 

The 2nd Key

 

Another key to understanding economic reports and indicators means knowing whether the indicator is leading, coincident, or lagging. Economic indicators are like driving in your car: some look forward, some look back, and some are like looking out the side window, showing where you are now.

 

Leading indicators are like looking through the front windshield to see where you’re going as you drive. Coincident indicators are like looking out the side window and lagging indicators show where you have been. The problem comes when you look at all three images and don’t know which is forward, sideways, or backwards. Trying to drive while only looking at the rear view mirror would be difficult at best; only looking out the side window would not be much better. More confusing still would be trying to drive while looking at all three and not know which was forward, side, and behind.

 

As traders or investors, leading indicators are the most important to us because we need to anticipate future prices in order to profit. We want to find the earliest and most reliable information that we can find and notice the co-incident indicators to confirm what the leading indicators are telling us. That will help us enter positions at the right time – when markets are about to make a move and in which direction. Stock and commodities prices anticipate corporate profits, so we want to find economic indicators that rise before corporate profits. Lagging indicators aren’t going to help us as traders; we can already see that on the price charts.

 

Leading indicators include Hourly Earnings, Consumer Spending, and the Consumer Price Index or CPI.

 

Average Hourly Wages show the wages that employees earn. Many employees will spend all they make, so as this number goes up there is more money being spent and the economy grows.

 

Consumer Spending, known officially as Personal Consumption Expenditures or PCE, is similar to hourly wages. As consumers spend more, the economy improves soon after. Corporate profits tend to follow average hourly wages and consumer spending, both up and down.

 

The Consumer Price Index or CPI is a broad measure of inflation. It breaks down inflation into many different categories that give a solid understanding of where inflation is coming from – if it is across the board or just a temporary reading in one sector.

 

The CPI is a huge danger signal to warn against coming bear markets. When inflation gets too high, the Federal Reserve raises interest rates. All companies with debt are forced to pay higher rates, cutting directly into profits, not to mention consumers. When the Fed continues to raise rates, a bear market is sure to follow.

 

One of the best coincident indicators is GDP or Gross Domestic Product for the most recent quarter. That is the ultimate report of how well the economy has done without showing where it is heading. Watching the trend for GDP helps us in our analysis of the future direction of the economy.

 

The most important Lagging Indicator is Unemployment – it is important to ignore. The Unemployment rate is one of the most commonly reported indicators on the evening news. Most people look at it (especially if they are among the unemployed) and think that is where the economy is headed, but that is incorrect. The truth is that companies hire after their financial situations improve, but by then stock prices have already climbed to reflect this rise in profits. As of this writing, the stock market has been in a bull market for 2 ½ years while the national unemployment rate has not improved much over the same period. This is clear proof that unemployment is a lagging indicator.

 

Learn how much effect your economic reports have and keep an eye on the leading indicators to see the big picture. This will help you drive the vehicle of your trades to where you want to go.

 

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