Successful investing in a volatile global market involves more than just watching the stock market. Savvy investors need to be aware of changes to, and the direction of, the broader economy.
“Understanding the momentum (of financial markets) will give you insight into what is happening within a given asset class and help you weigh each asset class’s relative merits,” says Jack Ablin, Chief Investment Officer at Harris Private Bank in Chicago. “But you must go further and develop of set of metrics that will alert you to economic changes that will affect those asset classes.”
Generally, stock markets rise when the economy is growing and decline when it isn’t. The reason is corporate profits. When the economy is doing well, companies tend to make money, which drives up their stock prices.
Unfortunately, the economy, like the weather, changes and moves in cycles -- often referred to as economic expansion, contraction, peak and trough.
“My goal as an investor is to use economic metrics to figure out what stage we are at in that cycle and thus what investments offer the best opportunities,” Ablin says in his book, Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace.
The most crucial economic metric, Ablin contends, is the yield curve, which is calculated by plotting the yields on Treasury securities with maturities ranging from 30 days to 30 years.
“One of the best things to do is to track what happens to the yields on both the two and 10-year Treasury notes. If the latter is higher than the two-year yield, the economy is expanding, If the 10-year yield is lower than the two-year yield, it’s an economic contraction.”
When the yield on 10-year T bills is higher than on two year notes, the Dow Jones Industrial Average has returned an average of 11.4 per cent over the following 12 months.
The Composite Leading Indicator is another forward-looking barometer of economic performance that investors should watch.
It is a composite or weighted average of 10 components specifically chosen to track emerging changes in the direction of key sectors of the economy. They turn before the economy does, often because they capture changes in the volume of work early in the production process.
For example, ground-breaking on a new housing start precedes most of the actual building of the house, while most factories do not start production until receiving a new order.
By combining these key indicators for household spending, manufacturing, exports and financial markets, the overall composite index provides an early indication about impending changes in the course of the economy.
There are a number of other, less technical indicators, such as unemployment, retail and home sales, inflation and Gross Domestic Product, that investors can watch for signs of economic movement and change.
“When people don’t have jobs they tend not to spend money,” says Patricia Lovett-Reid, Senior Vice-President of TD Waterhouse.
“Retail sales account for a big part of the economy, and when consumers are spending money almost all sectors of the economy are touched.”
Investors also should watch foreign and emerging markets such as China, India and Brazil for economic changes and possible investment opportunities.
“If the business cycle (domestically) has peaked and is beginning to contract, the next logical step is to look abroad in search of a region where the economy is expanding as measured by its general business activity, such as growth in corporate profits and gross domestic product,” Ablin says.
“The economy, like a giant oil tanker, changes direction only slowly and after giving lots of warning,” Ablin adds. “If you’re watching the right indicators, you’ll get enough advance notice of a change in direction to begin planning changes in your investment portfolio.”
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors. He can be contacted at boggsyourmoney@rogers.com.