The most important
driver of investment return is a company’s earnings growth which tends to
follow the business cycle. For this reason, it is important for investors to
keep track of the current state of the economy and anticipate future changes in
order to make informed investment decisions. Ultimately, the health of the
economy impacts all businesses.
Modern investment
society is largely focused on the analysis of economic data. Investors, in
general, spend ample time trying to read, analyse and discuss economic data,
with the hope of gaining insight that will provide them with the ability to
forecast the market and choose the right assets, sectors and companies to
invest in. In the digital age, information is everywhere. Having access to all
this information is empowering but at the same time can be very confusing and
overwhelming for the general investor. Thus, the question is, does all this
economic news and data so often reported on, discussed and analysed by market
participants, have any real value when making investment decisions? The answer
in most cases is no, not really.
Economic indicators are
generally categorised as leading, lagging, or coincident, depending on whether
the indicated change in economic activity will happen in the future, has
already happened, or is currently underway. Investors must attempt to stay away
from much noise, low impact economic data. Most economic data indicators have
very little predictive power and valuable time should not be spent
over-analysing them. The attention and publicity that economic data receive are
disproportionately high. Firstly, this is because many economic variables are
reported on and secondly, there are many different market participants
(analysts and economists) who would find this data as useful information to
pass on to clients.
The below pointers will
assist in guiding you as an investor, as you may be inundated with economic
data passing through your multiple device screens and e-mail inboxes weekly.
- Ignore data which has a
frequency inappropriate to your investment horizon: Looking at
high-frequency data if you are a long-term investor is a waste of time. Do
not spend time looking at monetary policy commentary on interest rates or
short-term predictions of exchange rates as they are often
inconsequential. Look to invest in companies that will do well regardless
of the economic cycle.
- Ignore most backward-looking
data: Backward-looking
data, often also called lagging economic indicators such as balance of
trade and unemployment rate, etc. These indicators signal a change in the
economy, usually after the change has taken place. They are not very
useful in predicting future economic outcomes but are used as signals for
conforming to the ongoing scenario. Often investors themselves can get
more insight by “kicking tyres” and by talking to connections in various
industries, as these individuals are at the coal face of the economy and
are often the first to notice when things change on ground level. Their
qualitative feedback can thus be valuable for identifying turning points
in the economy ahead of the data.
- Ignore most forward-looking
data: Leading
economic indicators such as consumer confidence, the Purchasing Managers
Index and the stock and housing market can give investors an indication of
the direction the economy is moving towards, laying the foundation for
an investment strategy that
will fit future market conditions. Leading indicators are meant to predict
changes in the economy, but they are not always accurate and often face
trade-offs between accuracy, precision, and lead time in predicting future
events. However, looking at several leading indicators in conjunction with
other types of data can help provide information about the future health
of an economy.
Also, these
macro-economic forecasts are often weak, therefore, be sceptical of them. They
seldom forecast an economic turning point as economists are particularly prone
to herding and the economic consensus is frequently wrong.
Some key points to note
are the following: Firstly, forecasts are always too high. Secondly, forecasts
tend to lag reality, and thirdly, the following is key, analyst forecasts do
not forecast, they trail. They are reactive, lagging what is actually happening
by a significant amount of time because most forecasts are extrapolations of
the most recent past. Forecasting is intrinsically very difficult, and the
results are therefore usually poor.
Since many reported
economic data has limited use and forecasts are only partially correct the
question then is, what economic indicators are worth looking at?
- Business cycle and the
yield curve: Investors
should track the business cycle because the earnings of listed companies
and hence the overall market follow it. The business cycle refers to the
upswings and downswings the economy undergoes over a period. One business
cycle includes both an upswing and a downswing. An indicator of the
business cycle, given that it relates to aggregate economic activity, is
often Gross Domestic Product (GDP). Turning points in the market earnings
growth coincide very closely with turning points in GDP growth. Therefore,
if we forecast GDP growth, we will be able to tell what market earnings
will do. However, earnings growth in fact leads to GDP growth. The
market’s earnings growth is a better predictor of GDP growth than vice
versa. The yield curve is a good predictor of GDP growth and one can use
it to forecast market earnings growth directly. Other data such as vehicle
sales, retail sales, mining, and manufacturing data can also be useful and
can be read in conjunction with the outcomes of the yield curve.
- Inflation: A very
important economic variable. Interest rates affect all investments, their
valuations, and their attractiveness in comparison to each other. Interest
rates and financial markets tend to move in opposite directions, but
interest rates change only in response to changes in inflation. Inflation
and inflation expectations are thus important indicators to monitor as
their movements and outlook directly affect asset prices.
In summary, most
economic indicators and their market predicting ability are relatively limited
and one should reduce their use in your investment-making decisions. The
majority of economic data gives insight into what has already happened in the
economy as opposed to what will happen. Furthermore, refrain from using
economic forecasts to attempt to predict future scenarios for the economy. We
cannot predict the economy any better than we can predict the stock market. As
a long-term investor, you should limit your time spent on high-frequency data
and short-term forecasts. Buy stocks that will do well irrespective of the
economic cycle and refrain from continuously over-analysing a vast variety of
economic indicators.
Source: moneyweb