The WSJ Guide to the 50 Economic Indicators That Really Matter: From Big Macs to "Zombie Banks," the Indicators Smart Investors Watch to Beat the Market

THEWALLSTREETJOURNALGUIDETO

The50EconomicIndicatorsThatReallyMatter

FromBigMacsTo“ZombieBanks,”theIndicatorsSmartInvestorsWatchtoBeattheMarket

SimonConstableand

RobertE.Wright

Contents

CoverTitlePage

Introduction

Consumption(C)Chapter1.AutomobileSalesChapter2.ChainStoreSalesChapter3.ConsumerSentimentChapter4.ExistingHomeSalesChapter5.UnderemploymentOrSlack

Investment(I)Chapter6.Book-to-BillRatioChapter7.CopperPriceChapter8.DurableGoodsOrdersChapter9.HousingPermitsandStartsChapter10.IndustrialProductionandCapacityUtilizationChapter11.InstituteforSupplyManagement(ISM)ManufacturingSurveyChapter12.InstituteforSupplyManagement(ISM)Non-ManufacturingSurveyChapter13.JoC-ECRIIndustrialPriceIndexChapter14.LondonMetalExchangeInventoriesChapter15.PersonalSavingsRateChapter16.UnitLaborCosts

Government(G)

Chapter17.FederalGovernmentBudgetDeficitsandtheNationalDebt

NetExports(NX)Chapter18.BalticDryIndexChapter19.BigMacIndexChapter20.CurrentAccountDeficitChapter21.OilInventoriesChapter22.TankanSurveyChapter23.TicData

MultipleComponentsChapter24.BeigeBookChapter25.CrackSpreadChapter26.CreditAvailabilityOscillatorChapter27.FederalFundsRateChapter28.FertilityRatesChapter29.GrossDomesticProduct(GDP)perCapitaChapter30.LiborChapter31.M2MoneySupplyChapter32.NewHomeSalesChapter33.PhiladelphiaFed:TheAruoba-Diebold-ScottiBusinessConditionsIndexChapter34.PhiladelphiaFed:BusinessOutlookSurveyChapter35.RealInterestRatesChapter36.ShortInterestChapter37.Russell2000Chapter38.WeeklyLeadingIndexChapter39.YieldCurve

Inflation,Fear,andUncertaintyChapter40.GDPDeflator

Chapter41.GoldPriceChapter42.MiseryIndexChapter43.ProducerPriceIndexChapter44.RetailInvestmentActivityChapter45.CreditSpreads:TheRiskStructureOfInterestRatesChapter46.TedSpreadChapter47.Texas“ZombieBank”RatioChapter48.TIPSSpreadChapter49.CBOEVolatilityIndex(Vix)Chapter50.VixenIndexConclusion:PuttingItAllTogetherAppendix:UsefulEconomicIndicatorsWebsitesSelectedBibliographyAcknowledgmentsAbouttheAuthors

CopyrightAboutthePublisher

Introduction

THISBOOKISABOUTeconomicindicators.Itmustbe—itsayssoonthecover!Butit’smorethanthat.It’sabouthelpingyouprotectyourmoney.Nomatterhowmuchorhowlittlethatis,youdeservetokeepitand,withalittleluckandalotofsavvy,seeitgrow.Thebestwaytodothat,wethink,istowatchtrendsindata.Notjustafewkeymetricsfollowedbyeveryone(yes,thosetoo)butawholeslewofthem,manyofwhichmostpeoplehaveneverheardof.Wethinktoreallyhaveanedge,investorsneedtogetcreative,maybeevenalittlewacky,andlookattheeconomynotjustoutsidetheboxbutinsidethediner,thefast-foodrestaurant,andoutonthestreet.You’llseewhatwemeanbythatlateron,neartheendofthebook.AnyonewithanyinvestmentportfoliowhatsoeverknewpainwhentheGreat

CreditCrunchhurledstockmarketsintoturmoilin2008andinto2009.Investorslargeandsmallwatchedwhiletheirwealthshrankbytheday,andsometimesevenbythehour.Thisbookisaboutyounotlettingthathappenagain.Toachievethatwe’ll

showyouhowtheeconomicindicatorswe’vechosencanhelpyouseetheturnsintheeconomybeforetheyhappen.Withthatprescienceyoucanthenmakechangestoyourinvestmentsaheadoftimeandavoidthesufferingyouprobablyfeltduringthepastcoupleofyears.Protectingone’snestegginthiswayiscrucialtoinvestingsuccess.Afterall,

whatisthesenseofbeatingthemarketforfive,ten,ortwentyyearsonlytohavethemarketbeatyousenselessinafinancialcrash?Andaftertheuglinessisover,willyouhavetheforesightandthegutstojumpbackinwhilethegettingisstillgood?Thefinancialcrisisof2008–9anditsaftermathsuggestthatmostinvestorswereinsufficientlynimblebecausetheywerelookingatwhattheeconomywasratherthanwhatitwouldbecome.Whilecollectivelytheseinvestorslosttrillionsofdollars,theproblemisthat

manyappeartobenowiserabouttheeconomyorinvestingthantheywerebeforethecrisis.Theyseemdestinedtoplayittoosafewhentheyshouldbemakingriskytrades,andmakingriskyinvestmentswhentheyshouldbeplaying

itsafe.Inessencetheywillbuyhighthenselllow,andtheneventuallybuybackhighagain.Thatistheexactoppositeofaprofitableinvestmentstrategy.Suchanunhappyoutlookforinvestorswillremainthesame—unless,thatis,

theydigestthelessonsofthisbook,whichaimstoteachinvestorshowtoinvestacrossthebusinesscycle,notjustwhenpricesarerising.Inotherwords,thisbookintendstoprovideinvestorswithsophisticatedwaysofthinkingabouttheeconomy,nottoleadthembythenosetospecificinvestments.Youknowtheparableabouthowgivingamanafishonlyfeedshimforaday,butteachinghimhowtofishfeedshimforalifetime?Thesamegoesforinvesting.

UsetheClues

Discerningtheeconomy’sdirection—whetheritwillsoar,plummet,orstagnate—maysounddifficult,anditcertainlyisn’teasy,buttheeconomycan’thelpbutconstantlyprovidestatisticalcluesaboutitshealth.Thosecluescanbeseenusingeconomicindicators.Some,calledleadingindicators,pointtowheretheeconomyisheading.Others,calledcoincident,providecluesaboutitscurrentposition.Yetothers,so-calledlaggingindicators,telluswheretheeconomyhasbeen.Leadingindicatorsprovidethemostobviousbasisforprofit-makingideas,butconcurrentandlaggingindicatorsareimportant,too.Incaseyouhaven’tsensedityet,atthepointsatwhichwediscussspecific

investmentstrategiesandnotjustsimpleeconomics,wethinkmostlyaboutintermediateandlong-terminvesting,notdaytrading,foreignexchangedealing,derivativesswapping,orotherformsofshort-termspeculation.Thatsortofstuffisbestlefttotechnicalanalysts,computers,andlargesophisticatedplayers.Whowecanhelparepeoplewhowanttouseeconomicdataandindicatorsto

discernwhatisactuallygoingtohappentotheeconomynextmonthornextyearandinvestaccordinglynowtoreapgainslater.Ifyoulookaroundenoughbookstores,you’reboundtoencounterotherbooks

oneconomicindicators,includingonethatpurportstounlocktheirsecretcluesandatleastonethatexplicitlyaimstohelppeoplewithbelow-averageintelligenceunderstandsomeofthemostcomplexconceptsknowntohumanity.Wemakeneitherclaim.Thisbookiscertainlynotfornovices,butatthesame

timeyoudon’thavetoalreadyhaveaPhDineconomicstounderstandit.Italsocontainsno“secrets.”Theinformationcontainedinthisbook,thoughoftenobscuretosomepeople,

ismostlyreadilyavailable.Allwehavedoneistofind,compile,andexplainitinwhatwehopereaderswillfindasuccinctandentertainingway.Wealsobelievethatpeoplehavetodoatleastsomeresearchandforecasting

ontheirown.Awet-behind-the-earsbeginnercan’ttellthedifferencebetweenatrueexpert,aquack,andaknave.Soitisimportanttodevelopsomeexpertiseofyourown.

TheFantastic50

Whenwedecidedtoputtogetheralistofindicatorstohelpreadersunderstandwhatwasgoingonintheeconomywewantedtodeveloponethatcoveredtheentireeconomy.Wealsodecidedtoexcludesomeofthebigindicatorsthatyou’velikelyheardof.Soyouwon’tfindtheCPI(theConsumerPriceIndexmeasureofpriceinflation)inourlistbecauseeventhosewithjustacasualinterestintheeconomyhaveheardofthatcommonmeasureofinflation.Knowingwhateveryoneelseknowswillnotputyouaheadofthepack.Insteadyouneedtolookbeyondtheobvious.That’swhyourlistismostly

welloffthebeatentrack.Theindicatorsincludedcanhelpyouunderstandwhereinflation(andnotjustconsumerprices),GDP(grossdomesticproduct,themeasureoftheentireoutputofgoodsandservicesintheeconomy),and(un)employmentaregoingnext—butbeforetheygothere.Iffiftysoundsdaunting,keepinmindthattheeconomyisashape-shifting

beastbestexaminedfrommanyanglesandmultipleperspectives.Someperspectivesaremoreimportantthanothers,butallhelptoprovideamorenuancedandtexturedportraitofthebusinesscycle.Andyoureallydoneedasophisticatedportraitoftheeconomybecausethereisnoone-size-fits-allindicator.Manyindicatorsmovewildlyupanddownfrommonthtomonthforrandom

reasons,suchasafreakstormoraflukeorder.Moreover,duetopressuretoputnumbersoutquickly,manyindicatorsaremerelyguesstimatesthatwillberevisedlater,sometimesdrastically.Finally,manyindicators,likehousesales,havetobeseasonallyadjusted.Adjustmenttechniques,however,arefarfromfoolproofandmayover-orundercompensateforseasonalfluctuations.Analyzingaselectionofcarefullychosenindicatorsisabetterwayofsorting

outwhat’sknownas“statisticalnoise.”Theintuitionbehindourviewthatmanyindicatorsshouldbeconsultedissimple:themoreindicatorsthatpointinthesamedirection,themorelikelytheyarepointingtoarealeconomicphenomenonandnotarandomorseasonalchange.Weconsidertheindicatorswechosetobethebestbasedonfoursimplecriteria:

1.Timeliness:Iftheinformationisstalebeforeitisavailable,whybother?2.Accuracy:Ifthedataisunreliableorisfrequentlyrevised,whybother?

3.Exoticness:Ifmostinvestorsalreadyknowanduseit,whybother?4.Degreeoflinkagetotherealeconomyorthepracticalworldofinvesting:Ifitdoesn’ttelluswherethingsaregoing,wheretheeconomyisnow,orwhereithasbeen,whybother?

Havingspentacombinedperiodofoverhalfacenturyengrossedineconomicsandeconomichistory,wehadagoodsenseofwheretostart.Butthatalonewasn’tenough.Likeanyoneelsewearepronetohumanerror.Soweaskedcolleagues—journalists,financialmarketprofessionals,andacademics—toseewhattheythoughtofourlist.Wetooknoteoftheircommentsandmadethenecessarymodifications.Wearegratefulfortheinput.Onethingwenoteaboutourselectionprocess:Evenamongthepeoplewe

know—peoplewhospendallday,everyday,thinkingabouteconomicsandinvesting—noonewaspreviouslyawareofeveryoneoftheFantastic50.That’sright.Itseemedtherewasasurpriseforeveryone—aChristmascomeearlyforeconomistsifyoulike.Inshort,ifyouwanttoknowwheretheeconomyhasbeen,whereitis,and

whereitisheaded,starthere!

HowThisBookWorks

WedescribeourFantastic50inastandardizedfour-partformat.Section1providesashortdescriptionandsection2atimeseriesgraphorotherillustration.Section3iscalled“InvestmentStrategy”andprovidestipsonhowtousetheindicator.Finally,section4brieflysummarizestheindicator’skeyaspectsandprovidesashortdiscussionofwheretogetthedata.ThemostfamousequationinphysicsisEinstein’sE=MC2.Theequivalentfor

macroeconomicsisGDP=C+I+G+NX.ThisequationrepresentsthecomponentsofGDP,themostwidelyacceptedmeasureofeconomicactivityintheeconomy.Moreplainly,ittellsushowmuchstufftheeconomyproducedinagivenquarteroryear.Withthatequationinmindwearrangedourindicatorsalphabeticallywithin

thosebroadcategoriesofconsumption(C),businessinvestment(I),1government(G),andnetexports(NX).Thosecomponentsencompasseverythingthathappensinaneconomy,andwehaveindicatorsforeachone.Wealsoputtogetheranadditionalcategoryforindicatorsthatpoint

simultaneouslytomultipleGDPcomponents.Ontopofthatweincludedafinalcategoryforindicatorsthatpointtoinflation,fear,and/oruncertainty.Whilethiswayoforganizingthematerialwillbeintuitivetoanyonewhohastakenbasiccoursesineconomics,italsomeansthatthebookbeginswithsomeofthemoretechnicalindicators.Thoseinterestedinthesexierchaptersshouldnotfret,however,astheendingisspicierandcanbeskippedtoatanytimewithafewflicksofthethumbandforefingerorclicksonthecomputerkeyboard.TheFantastic50isnotalinearnarrativethatmustbeencounteredpagebypagebutratherawebthatcanbeexploredatwill.Aspartofourresearchforeachindicator,weinterviewedseasoned

professionalswhoareintimatewithhowdifferentstatisticsreflectchangesintheunderlyingeconomy.Youwillfindquotesandexplanationsfromthemtogiveyouthebenefitoftheirwisdomandtohelpgiveyouathree-dimensional,texturedviewoftheeconomyingeneralandinvestinginparticular.Asyouwillsee,wecastournetwideinthisendeavor.WehavealsoembeddedourFantastic50withafewhelpful“apps.”Forfaster

reference,eachindicatorisclearlylabeledasleading,coincident,lagging,orsomecombinationthereof.Cross-referencestorelatedorsimilarindicatorsare

prominentlydisplayedtoo.Finally,attheendofeachindicatoryou’llfindan“ExecSummary”boxthatconciselyreviewssevenofitsmostimportantattributes:

•Whentolookforthedata.•Wheretolookforthedata.•Whattowatchforinthedata.•Whatthatmeansintermsoftheoutlookfortheeconomyoraparticularsector.•Whattodotomakeyourselfsomemoneyortopreventyourselffromlosingsome:Someoftheadviceisveryspecific,likewhatinvestmentdecisionstomakeunderwhatcircumstances.Someofitismoregeneric.Inthesimplestterms,makesaferinvestmentswhentheeconomyisgoingintoarecessionandriskieroneswhenitiscomingoutofaslump.We’vealsoaddedamoretechnicalnoteatthebottomofthispagetohelpexplainotheraspectsfurther.2

•Riskleveloftheinvestmentstrategysuggestedabove.•Profitpotentialofassumingtherisksdescribedabove,whereeach$representsupto10%annualreturn:Riskandrewardareofcoursepositivelycorrelated—thehighertheriskassumed,thehigherthepotentialreward.Pleasenoteweusedtheword“potential”intheprevioussentence.Thehigherthepossiblepayoff,thelesslikelyitbecomes.Butyouknewthat(wehope!).

Isitreallynecessarytolearnaboutandtrackallfiftyoftheseindicatorsinordertothriveasaninvestor?No,youcouldgetreally,reallyluckyandstumbleontothenextGoogle,atechstockthatmadeearlyinvestorsrich.OfcourseyouarejustaslikelytobuythenextEnronorLehmanBrothers—bothnow-defunctfirmsthatwereoncebigplayersinfinancialmarkets.Insimpleterms,themoredatayoutrackthebetteranintuitivefeelyouwillhaveforwhatisreallygoingonintheeconomy.Atfirstitmayseemconfusingoryoumayfeelyouarelearninglessandless.Butprettysoonyou’llstartseeingthebigpictureandthatwillhelpyouinvestbetter.You’rehuman,soyou’llstillmakemistakesthatwillcostyoumoney.

However,ifyouusetheknowledgecontainedinthisbook,suchlosseswilllikelybesmallerandmorequicklyreversed.Additionally,ifyoulearntolistentotheeconomy’srhythmsyoucanpickappropriateassetsectorsbeforemostotherinvestors,givingyouadistinctadvantage.Theindicatorsexplainedinthefollowingpageswillhelpyoutomaximizeexposureintherightplacesandminimizeitinthewrongones,soreadonandneverstopstudying.

Consumption(C)

THISSECTIONDETAILSFIVEindicatorsofconsumption,acategorythatincludespersonalexpendituresondurablegoodssuchascars,furniture,andappliances;nondurablegoodssuchasfood,clothing,andfuel;andservicessuchashealthcare,transportation,education,andrecreation.Thesedays,consumptionconstitutesabout70%oftheU.S.economy,

makingitacategoryyoucan’tignore.Monitoringtheindicatorsinthissectionofthebookwillkeepyourfingeronthepulseofthishugecomponentofeconomicactivity.

B

Chapter1AutomobileSales

LeadingintoRecessions,CoincidentwithLaggingRecoveries(SeealsoISMManufacturingSurvey)

ACKIN1953THEheadofGM,CharlesWilson,saidthat“whatwasgoodforthecountrywasgoodforGeneralMotorsandviceversa.”It’sstilltruethatcars

(GM’sorotherwise)countwhenitcomestotheeconomy,especiallyforthemanufacturingsector.Justthinkaboutallthethingsthatareneededtomakeacarortruck:steel

sheetforbodypanels,paint,glassforwind-shieldsandlights,copperforelectricalwiring,rubberfortires,plastic,fabric,andpossiblyleatherforinteriors.WhatitallmeansisthatwhenthebigcarcompanieslikeFordMotor,Toyota,GeneralMotors,Chrysler,Honda,andHyundaiaremakingandsellingcars,thenbusinessesinalotofancillaryindustriesareworkinghardtoo.“Thisisnotanicheindicator,”saysCampbellHarvey,professoroffinanceat

DukeUniversity’sFuquaSchoolofBusiness.“Theautoindustryisinterconnectedwithsomuchelsethatbywatchingitsmovementsyougetsomeviewoftheoverallhealthoftheeconomy.”Formostpeople,thecostofacarortruckislarge—amajorpurchasesecond

onlytothecostofbuyingahouseorapartment.Anewcarthatcoststhirtythousanddollars(notanunreasonablepriceatthetimeofwritingin2010)wouldbealargechunkofmanyfolks’pretaxannualincome,andgreaterthanayear’spayforsome.Asaresult,manypeopleborrowmoneytobuycarsandtrucks.Whentheydo,ittellsussomethingabouthowconfidenttheyfeelabouttheireconomicandfinancialfuture.“Theyarenotgoingtogooutandbuyacariftheythinkthereisreasonablechancethey’llgetlaidoff,”explainsHarvey.

InvestmentStrategy

Carsalesareadecentleadingindicatorofimpendingrecessionsaspeopletendtobackoffbuyingcarswhentheydon’tfeelconfidentabouttheirjobs.Comingoutofarecession,carsalestendtolagbecausemostpeoplewaituntiltheeconomyhasclearlyturnedupwardbeforemakingsuchamajorpurchase.Asshownintheaccompanyingchart,salesofnewautosslowedbeforethe

2000–1downturn.Theypickedupalittleduringthemid-decadeboombeforedroppingdramaticallyin2007astheeconomybegantoshowsignsofweakness.Oneofthekeyswithautomobilesalesistofocusonsalesandleasesofnew

carsbecause,intheend,theydrivetheotherpartsoftheeconomy.Thesaleofausedcardoesn’tactuallymeananynewmaterialswereused,althoughit’sstillagoodsignthatpeoplewanttobuyanothervehicle.Thatsaid,whenparsingtheautomobilesalesdatayouneedtolookfortrends.“Trytodetectaclearmomentum,apositiveornegativetrend,”saysHarvey.

“Takealookatwherewearerelativetorecenthistoryandseeifthereisanyconsistency.”Ifthereisaconsistentdecreaseinsales,thenwearelikelyseeingtheeconomy

headintoaperiodofweakness,hesays.Likewise,ifthetrendishigher,thentheeconomymaybeimproving.Harveyalsonotesthatthefactthatsomanypeopleborrowtobuycarscanactuallydisturbthesalestrendsabit.Duringeconomicslowdownsinterestratestendtofall,thusmakingborrowers’carpaymentsmuchlower,sometimesdramaticallyso.Thataddedaffordabilitycansometimesdrivesalesupatadbetterthanexpectedwhentheeconomyisweak.Whenautomobilesaleslookliketheyaresignalingaslowdownorrecession,it

makessensetoavoidinvestinginassetsusuallysensitivetotheeconomiccycle.Inotherwords,shunstocksinfavorofgovernmentsecuritiesandhigh-qualitycorporatebonds.

EXECSUMMARY:AUTOMOBILESALES

Whentolook:Autosalesfiguresarereleasedonthefirstbusinessdayofeachmonth.Thedatacoversthepreviousmonth’ssales.

Wheretolook:ReportersworkingforTheWallStreetJournalfilebreakingnewsstoriesonWSJ.comasthevariousautocompaniesreleasetheirdata.Whenallthedataisreleased,anoverallstoryispublishedthatexplainsallthefiguresandinterpretsthestateoftheindustry.GotoTheWallStreetJournalonline’s,“MarketDataCenter”foraquickread

ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandfindthe“AutoSales”link.OthersourcesincludethewebsiteoftheBureauforTransportationStatistics:

www.bts.gov/publications/national_transportation_statistics/.Thecar-makingcompanies,suchasGeneralMotors,FordMotor,Chrysler,Hyundai,Honda,andToyota,alsoprovidedetaileddisclosuresoftheirsalesfigures.

Whattowatchfor:Decreasesinnewautomobilesalesandleases.

Whatitmeans:Peoplearepullingbackduetofearsabouttheirfutureemploymentstatus.

Whattodo:Avoidinvestinginassetsusuallysensitivetotheeconomiccycle.Inotherwords,shunstocksinfavorofgovernmentsecuritiesandhigh-qualitycorporatebonds.

Risklevel:Medium.

Profitpossibility:$$

Chapter2ChainStoreSales

A

Coincident

MERICANSLOVETOCONSUMEstuff,andconsumptionisavitalpartofouroveralleconomicwell-being.Becausemostofusgotoretailersinorderto

buygoodsandservices,wecangaininsightsintothehealthofconsumptionbylookingatretailsales.Althoughmuchofthedataontheretailsectorisavailableonlylongafterthe

fact,someofitisverytimely,anditcomesfromsomeofthemostsophisticatedretailersintheworld,includingchainstoreslikeSaks(SKS)andTheGap(GPS)andmembershipwarehouseretailstoressuchasBJ’s(BJ)andCostco(COST).Together,thechainstoresrepresentonly10%ofoverallretailsales,butthedataaboutthesecompanies’salesisavailableeveryTuesdayfortheweekthroughthepriorSaturday.Thisdataisimportantformorethanjustitstimeliness.Chainstorestendto

operateacrosstheentireUnitedStatesandnotjustregionally.Sowecangetanationalreadonthestateofconsumption.Inaddition,chainstoresaremastersellers.Theyusethelatestselling

techniquesandhirethesavviestmarketers.Theyalsohavethefinancialweightandtherobustdistributionsystemstogetfirstdibsonthelatestnewgadgets.Whydoesthismatter?Becauseifthebigguysaren’tselling,thentherestoftheretailworldstandslittlechance.Therearetwosourcesofbasicdata:theJohnsonRedbookIndexandtheICSC-

GoldmanSachsWeeklyU.S.RetailChainStoreSalesIndex.Bothentitiesalsoputoutmonthlyfigures.(Forabroaderviewthatincludessmallerretailersaswell,seetheCensusBureau’smonthlyretailsalesreport.)

InvestmentStrategy

EconomicforecastersshouldwatchthisdatacloselybecauseofthegiantportionofoverallGDPthatconsumptionrepresents.Whenthedatashowsthatchainstoresaleshaveincreased,thentheconsumptioncomponentoftheoveralleconomyisprobablydoingquitewell.Whenchainstoresalesareweakorfalling,thentheoppositeislikelytrue.Dataonchainstoresalescanalsobeusedwhendecidingwhethertoinvestin

retailstockslikeSaks(SKS),Target(TGT),andJ.Crew(JCG).Butyouneedtobecareful.“Youhavetobereallygoodandnimbletobuya

stockbasedonthisdata,”saysKristinBentz,aveteranretailindustryanalystattheConshohocken,Pennsylvania–basedinvestmentbankPMGCapital.

Still,shehassomeusefultipsforthewould-beinvestor.Inthefirstplace,notallofthechainstoresalesdataisthatusefultoinvestors.Salesofbigretailersgoupanddownformanyreasonsincludingtheopeningandclosingofdifferentstores.Togetusefulinformation,newstores(thoseopenlessthantwelvemonths)needtobeexcluded.Instead,investorsinretailcompanieslookatthesalesofstoresopenforayear

ormore.Thedataisknownasthesame-storesalesintheUnitedStatesand(like-for-likesalesinBritain).It’sameasureoftheefficiencyofretailingoperations.ThisdataisavailablethefirstThursdayeverymonth,soit’snotastimelyastherawdatabutit’sfarmoreusefulforinvestors.“Whenpickingastocktobuyyouwantsequentialandyear-over-yearsame-

store-salesgrowth,”Bentzsays.Moresimply:Thedatashouldshowincreasedsaleswhencomparedtothesameperiodayearagoandwhencomparedtothepriormonth.“Thattellsyoutheproductisright,thetrendisright,andthecustomersare

comingbackmonthaftermonth,”sheexplains.Ontopofthatit’simportanttolookatwhatexpectationsofsame-storesales

wereforthatperiod.Acompanycanhavetherightyear-on-yearandsequentialresultsbutstillfallshortofwhatanalystswereexpecting,andinthatcasethestockwouldlikelysuffer.“Whenyougetsequentialandperiodgrowth,andthecompanyisbeating

forecasts,thenthat’sabuy,”notesBentz.Sheaddsthatduringtheboomyearsitmadesomesensetolookatexchange-

tradedfundsthattrackedthevalueofabasketofretailstocks,liketheSPDRS&PRetail(XRT)ETF.ButduringtheGreatRecessionthingschanged.Now,shesays,notallretailersarecreatedequalanditthereforemakessensetopickandchoosewhichstockstobuy.

EXECSUMMARY:CHAINSTORESALES

Whentolook:Formonthlysame-store-salesdata,beonwatchthefirstThursdayofthemonth;weeklydatafromICSCandRedbookdataareavailableearlyTuesdaymornings.

Wheretolook:TheWallStreetJournalcloselyfollowsretailsalesfigures.Journalreportersfilebreakingnewsreportsonretailsalesfiguresasthenumbersarereleased.Checkforarticlescoveringtheentireindustry,aswellasthosewithcompany-by-companydetail.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickread

ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”section,lookfor“U.S.EconomicEvents,”andfindthelinkstoICSCandRedbookonTuesdays.Monthlysame-store-salesdataisavailabledirectlyonmanypubliclytradedretailers’websites.TheJohnsonRedbookIndexisavailabletoclientsofRedbookResearch,

althoughtherearesomesamplesavailableatnochargeonitswebsite:

www.redbookresearch.com.Forthosewillingtopay,BentzrecommendsgoingtoRetailMetrics,where

proprietorKenPerkinsprovidesan“enormous”spreadsheetofallthedata.

Whattowatchfor:Increases(declines)inyear-over-yearsame-store-salesgrowth,aswellasmonth-to-monthincreases.

Whatitmeans:Storesaredoingwell(struggling).

Whatstepstotake:Buy(sell)asexpectationsofyear-over-yearsame-storesalesimprove(degrade).

Risklevel:Medium.


Chapter3ConsumerSentiment

T

Leading

HEUNITEDSTATESMAYbemanythings,butifnothingelseitisanationofspenders.Asaresult,investorsandeconomistsdevoteamassiveamountof

timeworryingwhat“theconsumer”thinks,orhowheisfeeling.Simplyspeaking,whenconsumersfeelbettertheyspendmore.Despiteallthatangst,veryfeweconomicindicatorsjustplainaskthe

proverbialmanonthestreet,“Howareyoufeeling?”Mostotherindicatorsmeasurewhatpeoplehavedoneoraredoing.ThesimpleideaofaskingwhatyouandIarethinkingorfeelinghasbeen

takenupbytwoinstitutions:TheConferenceBoardandtheUniversityofMichigan,whichpublishtheConsumerConfidenceIndex(CCI)andtheMichiganConsumerSentimentIndex(MichiganSentiment),respectively.Thesetwoindicesprettymuchmeasurethesamething:Howgoodareyou

feeling,economicallyspeaking,rightnowandhowdoyoufeelaboutthefuture?Thedataiscollectedbypollinghouseholds.Simplyspeaking,highernumbersontheseindicatorsindicatethatconsumers

believetheeconomywillimproveorthatitwillcontinuetochugalong.Forinstance,iftheCCIincreasesfrom49inAprilto55inMay,consumersbelievethatconditionsareimproving.Likewisealowerorfallingnumberdoesnotaugurwellforthefutureoftheeconomy.TheMichiganSentimentsurveyispublishedtwiceeachmonth,withthefirst

readingoutslightlyaheadoftheCCI.Inaddition,theMichiganSentimentisincludedinothergovernmentstatistics,whichgivesitaddedweightwithobservers.Butforthosewillingtodigbeyondtheheadlinefigures,theCCIisusefulalso.

Itincludessurveydataonspendingplansforbig-ticketitemssuchascarsandmajorappliances.Thereisalsodataoninflationexpectationsandabreakdownofsentimentbyageandincome.Aminorproblemwithbothoftheseindices:Theyareveryvolatile,andthere

isfrequentlysomuchnoise,somanyrandomupsanddownsintheresultsthatitmakesthemhardtointerpret.Partofthereasonforthisvolatilityisthatthepsycheoftheindividualbeing

polledcanbeaffectedbymanythings.Forinstance,aspikeingasolinepricesor

terroristattackscanweighdownonconsumersentiment.ThechartofUniversityofMichigan’sindexvisuallyillustratestheshort-runvolatility.Butitalsoshowsthatsentimentgenerallyfallsdramaticallygoingintorecessions.

InvestmentStrategy

Becauseofthehugevolatilityinthetwosentimentindicators,investorsneedtoproceedwithcautionwhenusingthem.“Whatwereallytrytodoislookatthetrend,notasinglepointintime,”saysArtHogan,chiefmarketanalystatinvestmentbankingfirmJefferiesinNewYork.Ormoresimply,onesunnydatapointdoesnotsignalaneconomicsummer.Ajumpinsentimentcouldoccurforanynumberofreasonsthatdon’treflectasustainabletrend.“Trytoblendoutthatone-monthfigureandlookatathree-monthmovingaverageandthatwillmakeawiserinvestmentdecision,”Hogansays.Sometimes,asin1980and2001,theindexaccuratelyreflectsdipsinthe

market.However,duringthe1981–82,1990,and2008–9recessions,bycontrast,consumerconfidenceincreasedandfellbackonce,twice,eventhreetimesbeforethoserecessionsended.Becauseofthetremendousnoiseinthedatait’salsogoodtousethese

indicatorsinconjunctionwithothereconomiccluesliketheindicatorsfoundinthisbook.Forinstance,lookatconsumerdurablesalesorwhetherbanksareincreasingtheavailabilityofconsumercredit.Whenyouarefairlysurethatsentimentisimproving,theobviousplaceto

lookforinvestmentopportunitiesistheretailsector.Hogansayscomingoutofarecessionhefirstlooksatconsumer-staplestocks—storeslikeWalmart(WMT)thatsellnecessitieslikebasicfoodstuffsandsundries.Hethenmovesontoretailerssellingso-calleddiscretionaryproducts—storeslikeCoach(COH)andTiffany&Co.(TIF)—thatsellproducts,oftenluxuries,thatdon’tabsolutelyneedtobepurchased.Likewise,whenitlooksliketheeconomyisheadedsouth,investorsshould

takethereversetackandgetoutoftheluxurynamesfirst.

EXECSUMMARY:CONSUMERSENTIMENT

Whentolook:At10a.m.ET,onthelastTuesdayofthemonth,lookforConferenceBoardConsumerConfidencedata.FortheinitialreadingoftheMichiganSentimentinformation,bealertonthesecondFridayofthemonth.

Wheretolook:TheWallStreetJournalcloselyfollowsconsumersentiment

surveydata.Journalreportersfilebreakingnewsreportsonthesemetricsastheinformationisreleasedbythedifferentorganizations.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickreadofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,

you’llneedtogotothe“Calendars&Economy”section.Lookfor“U.S.EconomicEvents”andfindthelinkstoConsumerSentiment(forMichigannumbers)andConsumerConfidence(forConferenceBoarddata)onthecalendar,postedonthesecondFridayandlastTuesdayrespectively.Inaddition,Briefing.comreportsbothindicatorswhentheyarepublished.The

FederalReserveEconomicDatabase(FRED)attheSt.LouisFedprovidesbasicdetailsontheMichiganConsumerSentimentdata.TheConferenceBoardinformationcanbefoundatConference-Board.org.

Whattowatchfor:Increases(decreases)inconsumersentimentoverseveralmonths.

Whatitmeans:Consumersfeelexuberant(prefertakingitcautiouslyforawhile).

Whatstepstotake:Buy(short)retailstocks,starting(ending)withsellersofnondiscretionaryitemsandending(starting)withsellersofdiscretionaryitems.

Risklevel:Low.

Profitpossibility:$

A

Chapter4ExistingHomeSales

Leading(SeealsoNewHomeSales,CopperPrice)

NENGLISHMAN’SHOMEISsaidtobehiscastle.ForAmericans,owningahomeisthedream.Eitherway,homesalesmatteronsomanylevels.Because

homesaresuchamassivepartofmanypeople’swealth,whathappensinthehousingmarkethasanimpactonthepsychologyandspendingpatternsofthenation.That’swhyeconomistsandmoneymanagerspaycloseattentiontothe

NationalAssociationofRealtors’(NAR)reportsonexistinghomesales.Asthenamesuggests,thereportindicateshowmanyhousesthathadpreviouslybeenoccupiedweresoldduringthemonth,andittypicallyrepresentsthevastmajorityofactivityinthehousingmarket(therestissalesofnewhomes).Butitdoesmuchmorethanthat!“Itcontainsthelevelofinventoriesanditgivesthemedianpriceofahomein

thecountry,”saysJoeBrusuelas,aneconomistatBloombergL.P.inNewYork.Thepriceofhomesingeneralisimportanttotheeconomybecauseof

somethingknownasthe“wealtheffect.”Whatitmeansisthatashousepricesrisehomeownersfeelwealthier,andthataffectshowtheyviewtheirfutureeconomicprospects.Specifically,whenpeoplefeelwealthier,theyspendmoreonaverage,eveniftheirregularincomehasnotchangedinanyway.Buttheswordcutsbothways.Fallinghomepricescanhaveanegativeimpactbyinducingpeopletocuttheirspending,sometimesdrastically.Thiswholephenomenongotoutofcontrolduringthehousingbubbleofthe

mid–2000s.“Consumersincreasinglyreliedontheincreasingvalueofthehomestofundcurrentandfutureconsumption,”saysBrusuelas.

Itwasn’tthatconsumersjust“felt”wealthier.Theyactuallywenttoabankandborrowedmoneyagainsttheincreasedvalueoftheirhometofundcurrentconsumption.Inadditiontothe“wealtheffect,”thereareothermoredirectimpacts.“Typicallywhenanindividualbuysahome,theybuynewfurniture,newhousingwares,andnewelectronics,”saysBrusuelas.“Inthatwaythesalesofexistinghomesreverberatethroughtheeconomy.”

InvestmentStrategy

Historically,homesaleshavebeenkeytotheeconomicrecovery.“Inthetenpostwarrecessions,housinghasbeenoneoftheleadingdriversofarecovery,”saysBrusuelas.HesaysitshouldbeintuitivelyobviousthatthishappensbecausetheFederalReserve,America’scentralbank,typicallycutsinterestratesduringarecession.Forpeoplewhoneedtoborrowtobuyahouse—andthat’smostpeople—the

cutininterestratesreducesmonthlymortgagepaymentsandoftenresultsinaboostinsales.(Salesofautomobilestypicallygetaboostfromlowerinterestratesaswell.)Inthewakeofthehousingbustof2008andonward,thebigquestioniswhat

role,ifany,housingwillcontinuetoplayineconomicrecoveries,saysBrusuelas.Itwillplaylittlerole,hethinks,butmaybemorethanamerecameo.Onetricktotrytodeterminewhetherthehousingmarketislikelytoimprove

soonistolookatthelevelofinventoriesofunsoldhomes.Inparticular,looktoseehowmanymonthsitwouldtakeforallthehomesavailabletosellatthecurrentrateofselling.Thisisknownasmonthsofavailableinventory.Clearlyifthenumberof“monthsofinventory”islow,thenthatcanauguran

improvinghousingmarketandperhapsanimprovingeconomy.Ifit’shigh,thenthereverseistrue:perhapsadeterioratinghousingmarketandaworseningeconomy.

EXECSUMMARY:EXISTINGHOMESALES

Whentolook:Existinghomesalesdataispublishedat10a.m.ETaroundthe25thdayofeachmonth.

Wheretolook:TheWallStreetJournalcloselyfollowsthehousingmarketandpublishesbreakingnewsreportsonsalesofpre-ownedhomesimmediatelyaftertheNationalAssociationofRealtorsreleasesthedata.GotoTheWallStreetJournalonline’s“MarketDataCenter”foraquickread

ofthedataandhowitcomparestowhatinvestorswereexpecting.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”section,lookfor“U.S.EconomicEvents,”and

findthelinksto“ExistingHomeSales.”YoucouldalsogodirectlytotheNationalAssociationofRealtors,which

makesthedataavailableatwww.realtor.org/research/research/ehsdata.Otherdataworthlookingatispendinghomesales,orsalesthataresettogothroughbuthaven’tyet.Itcanbefoundatwww.realtor.org/research/research/phsdata.Pendinghomesalesdatacanprovidecluesaboutwhatactivityiscomingdowntheroadinrelativelyshortorder.

Whattowatchfor:Increases(decreases)inexistinghomesalesanddecreases(increases)ininventorylevelsmeasuredinmonthsofavailableproperty.

Whatitmeans:Theeconomyislikelylookingup(headingforthedepthsofhades).

Whatstepstotake:Ifthehousingmarketisperkingup(andothermetricsindicatearobusteconomy),buyeconomicallysensitiveinvestments,suchasstocks.Iftheoppositeishappening—existinghomesalesdataandotherdatapointto

aslowdown—avoidstocksingeneral(especiallyhomebuildersandindustrials)andholdcashorbuygovernmentsecuritiessuchasU.S.Treasurybonds.Ifyoumustownstocks,gowiththoselesssensitivetoeconomiccycles,includingcompaniesthatmakeconsumerstapleslikeshampooandsoap.

Risklevel:Medium.


F

Chapter5UnderemploymentorSlack

LeadingRecession,LaggingRecovery

ORMERPRESIDENTBILLCLINTONsortofgotitwrongwhenheadoptedthecampaignslogan,“It’stheeconomy,stupid!”Itshouldhaveread,“It’sthe

jobs,stupid!”Why?Becauseforpoliticiansaweakeconomyissynonymouswithalackofjobs.It’simportantforinvestorstoo,butthewidelyreportedrawunemployment

rateisjusttoobluntameasure.Wecanlearnmuchmore—andmakemuchmoremoney—bydiggingdeeper.What’smuchmoreinterestingistheunderemploymentrate,whichmeasures

howmanypeopleworkparttimebecausetheycan’tfindafull-timegig.Thisindicatorisusefulbecauseithelpsustoseeintothefuture.Forexample,thenumberofemployeesworkingfewerhoursthanmakeupanormalworkweekrisesbeforeactuallayoffsbegin.That’sbecausemanagersaretypicallyreticentaboutfiringworkersatthefirstsignofabusinessslowdown.“You’regoingtotrytopreserveyourworkforcebecauseyou’vetrainedthem

andthereisacosttotrainingthem,”saysMarcPado,amarketstrategistatbrokeragefirmCantorFitzgeraldinSanFrancisco.Managersknowitcanbehardtorehireandexpensivetoretrainnewworkersifthebusinesslullturnsouttobejustablip.Itistypicallyonlywhenbusinesshasslumpedoffforanextendedperiodthat

managersstarttofiretheirworkers.Thatlagmakestrackingpart-timeworkaveryusefulindicatoroffutureunemployment.Fortunately,theU.S.BureauofLaborStatisticsbreaksoutthoseworkerswho

areworkingparttimeandspecifiesthosewhoaredoingsoeitherbecausetheycouldonlyfindpart-timeworkorbecausetheiremployerscutbackonthehoursofworkavailable.Collectivelythisisknownas“slack.”Economistsare

understandablymoreconcernedaboutpeoplewhowanttoworkmorehoursbutcan’tthanthosewhovolunteertoworkless.Ofcoursethereareexceptionstotherulethatpart-timeworkrisesbefore

firingbegins.Sometimesmanagerslayoffworkerswithoutsteppingthemdowntoparttimefirst.Soanuptickinslackdoesnotmapontofutureunemploymentclaimsone-to-one.Itis,however,agoodindicatorgoingintoaneconomicslowdown.Youcanseetherelationshipinthechartbelow.

Comingoutofarecessionthisindicatorislessreliable.Someemployerswillhireworkersparttimebeforehiringthembackpermanently,butmanywillwaituntiltheyclearlyneedanothersetofhandsfulltimebeforehiringagain.Soduringrecoveriesitisbesttochecktheemploymentreportforgrowthinovertime.Ifovertimeworkisstrongforseveralmonths,employerswilllikelystarthiringnewworkersbecausetheywillbecheaperthanpayingtimeandahalftoincreasinglyworn-outworkers.

InvestmentStrategy

Ifyouknowchangesinthelevelofunemploymentarecoming(becauseyouhavebeenassiduouslywatchingtheunderemploymentnumbers),thenyoucanadjusthowyouinvest.Thekeytosuccessisinunderstandingwhichpartsoftheeconomywilldowellandwhichwilldopoorly.“Asunemploymentrises,yougotothedefensivesectors,”saysCantor’sPado.

“Drugs,food,andalcohol:themainstaysofhumannature.”Bythathemeansitmakessensetoinvestincompaniesthatsellitemsthatpeoplekeepbuyingevenwhenjobsarescarce.Specificallyhepointstohealthcare,pharmaceuticals,food,andutilities,likegasolineandelectricity.Thesecompaniesalsotendtohavefairlystableearnings.Twoimportantthingstonotewhenusingthisindicator:First,don’tbefaked

outbythedata.Itispossiblefortemporaryworktoincreaseforashortperiodthathasnothingtodowiththeeconomyapproachingarecession,saysPado.Everydecade,forexample,theCensusBureauhiresscadsoftempsbutsoonafterreleasesthembackintotheemploymentpool.Makesureyouareconfidentthatthechangeintemporaryworkingisreflectiveofthebusinesscyclebylookingatsomeoftheotherindicatorsinthisbook.Second,Padonotesthatwhenbuyingdefensivestocks,it’saboutprotecting

yourassetsasthevalueofmoststockstendtofallgoingintoarecession.“It’samatterofwhatgoesdownless,”hesays.Orputanotherway,defensivestockswilllikelyloselessthanotherriskierstocks.

EXECSUMMARY:UNDEREMPLOYMENTRATEORSLACK

Whentolook:ThefirstFridayofthemonthat8:30a.m.ET.

Wheretolook:TheWallStreetJournalcloselymonitorsthejobssituationintheUnitedStates.AllacrossWSJ.com,headlinesandarticleswilldetailtheoverallemploymentsituationassoonasthedatacomesout.Toreallygetintotheweedsfordataonslack/part-time/underemployment,

you’llbebestservedgoingdirectlytotheBureauofLaborStatistics’swebsite,www.bls.gov,andsearchingforatabletitled“EmployedPersonsbyClassofWorkerandPart-TimeStatus.”

Notecarefully:Inearly2010,theBLSchangedsomeofitsstatistics.Investorsneedtowatchforsuchchangesbecausestatisticsareonlycomparablefromperiodtoperiodiftheyarecollectedandpresentedinthesamewayeachtime.Thatmattersbecauseanunawareinvestormightmistakeachangeinthenumbersforarealchangeineconomicconditionswheninrealityit’sjustachangeincollectionmethodorpresentation.

Whattowatchfor:Increasesinunderemployment.

Whatitmeans:Theeconomyisweakening.

Whatstepstotake:Buydefensivestockslikedrugmakers(legalones!),food,andalcohol.

Profitpossibility:Low.

Risklevel:$

Investment(I)

THISSECTIONISCOMPOSEDofelevenindicatorsthatprimarilytrackchangesinbusinessinvestment,whichinthiscontextmeansinventoryonshelvesandinwarehousesaswellasso-calledfixedinvestmentsinbuildings,vehicles,machinery,andevencomputersoftware.Theconstructionofnewresidentialhousing,bothsingleandmultifamily,isalsoincludedininvestment.Businessinvestmentconstitutesbetween15and20%ofGDP.Thatmay

seemtrivialcomparedtoconsumption,butinvestmentfluctuatesmassively,soitisveryimportant“atthemargin,”whichiswheretheactionis.Consumersmightcutback,butultimatelytheyhavetoconsumefood,clothes,andsoforthnomatterhowbadthefuturelooks.Businesses,bycontrast,donothavetoinvestinanynewplant,inventory,orsoftware.Likewiseindividualsdon’thavetobuynewhouses.Whenthegoinggetsrough,businessescutwaybackordon’tinvestatall.

Chapter6Book-to-BillRatio

H

Leading

ALFACENTURYAGOtheideaofacomputerinalmosteveryhomewouldhavebeenthestuffofsciencefiction,withtheemphasisonfiction.Nowit’snot

onlynonfiction—wehavelittlecomputersineverythingfromwatchesanddesktopandlaptopcomputerstoautomobilesandtelephones—butit’salsobigbusiness.Thoselittlecomputersarepoweredbymicroprocessors,alsoknownaschips

orsemiconductors,withamarketestimatedatbetween$300billionand$350billiongloballyin2010,accordingtoTripChowdhry,atechnologyanalystatSanFrancisco–basedspecialtyresearchboutique,GlobalEquitiesResearch.Becausesemiconductorsareusedinsomanycoolgadgets,bothathomeand

intheworkplace,wecangainsomeinsightintothehealthofthebroadeconomygenerally,andmorespecificallyintosomepartsofthetechsector,bylookingatthehealthofthesemiconductorbusiness.It’srelativelysimpletomeasurethehealthofthechipbusinessusingtheso-

calledbook-to-billratio,whichmeasurestherelationshipbetweenbookingsandbillings.Probablythebestwaytounderstandthosetwosomewhatobscurebusiness

termsistoexamineanexample.Ifacompanyhadordersfor100microprocessorsinamonth,thenthebookings,orbookedsales,wouldbe100.Butifduringthesamemonthonly80chipsweremadeanddelivered,thenthebillingswouldbe80.Thecompanybillsthecustomerfortheproductonlyafterit’sshipped.Inthisexample,thebook-to-billratiois100/80,or1.25.Thecompanyhasan

orderbacklog.That’sfrustratingforthecustomersbutisactuallyagoodpositiontobeinforthechipmanufacturer.TheSemiconductorIndustryAssociationcompilesabook-to-billratioforthe

entireindustry,ratherthanjustonecompany.Thattellsuswhethertheindustryhasanorderbacklogorisproducingmorechipsthancustomershaveordered.

InvestmentStrategy

Inthesimplestterms,abook-to-billratioof1.0orhigherisafavorablereading.Itmeansthatordersaregreaterthanwhattheindustryisabletofulfill.“Thatsaysweareinanexpansion,”saysChowdhry.Orputanotherway,

industry-widethereisabacklogofordersduetoincreaseddemandfromthetechsectortomakeallthosecoolgadgetslikePCs,iPads,cellphones,cars,andservers.Whentimesarebad,bycontrast,chipmakershaveexcesscapacity,sothey

manufacturemorechipsthancustomerscurrentlywant.It’sabadsignfortheindustryandtheoverallstateoftheeconomy.Aquicklookattheaccompanyingchartshowshowthebook-to-billratio

droppedprecipitouslyduringtheGreatRecession.Itfelltoalowof0.47inJanuary2009,meaningthatchipmakersweremanufacturingtwiceasmanymicroprocessorsastheywereselling.Itreflectedadireeconomicsituation.Thechipsthatweremade,butnotsold,

werepresumablyheldininventoryintheexpectationofbettertimestocome.Itwasableakeconomicpicture,butthecomingmonthssawasustained

improvementinthebook-to-billratiothatmovedaheadofthewholeeconomy.ByJuly2009thebook-to-billratiowasabove1,indicatingthattheindustryasawholehadorderbacklogs.Thatsignifiedstrongdemandfromthebroadeconomyastheworldretooled

andgotbacktowork.It’simportanttobecarefulwhenusingthismetricnottoinfertoomuch,

specificallywhenlookingatindividualstocks.Chowdhrysaysabook-to-billratioover1.0isgood,orders-wise,inthecellphoneindustry,thepersonalcomputermarket,andthemarketforthecomputerserversthatpowertheInternet.That’sausefuldatapointtohelpbuildathesisforbuyinganindividualstock.Butaloneit’snotenough,hesays.Anotherthingtorememberwiththebook-to-billratioisthatovertimethe

inventorymanagementphilosophyhaschanged.Leaninventoriesarealltheragenowinawaytheyweren’tinthepast,hesays.Thatmeansthatovertime,readingsofthebook-to-billratiomightnotbe

directlycomparable,saysChowdhry.

Still,greaterthan1isagoodsign.

EXECSUMMARY:SEMICONDUCTORBOOK-TO-BILLRATIO

Whentolook:Aroundthemiddleofthemonthforthepriormonth(mid-AugustforJulydata,forexample).

Wheretolook:TheSemiconductorIndustryAssociation(SIA)publishesthebook-to-billratio.Checkoutitswebsiteatwww.sia-online.org.Thesameinformationcanbefoundatwww.semi.org.

Whattowatchfor:Increases(decreases)inthebook-to-billratioabove(below)1.00.

Whatitmeans:Theeconomyisheatingup(coolingdown);thechipmanufacturingsectorisdoingwell(dyingbydegrees).

Whatstepstotake:Buy(sell)chipmanufacturerequitiesif,andonlyif,otherindicatorssupportthebook-to-billnumbers.

Risklevel:Mediumorhigh.

Profitpossibility:$$or$$$dependingonthestrategychosen.

Chapter7CopperPrice

I

Leading

T’SANINVESTINGMAXIMthatcopperisthemetalwithaPhDineconomics.Whyso?Well,itisn’treallythemetalitself,butratheritspricethatisthe

smartpartoftheequation.Broadlyspeaking,ifthepriceisrelativelyhighandrising,thentheindustrial

economyisdoingwell.Ifit’slowandfalling,thenthemanufacturingsectorishurting.Why?“Because,”accordingtoFrankHolmes,chiefinvestmentofficerofSanAntonio–basedU.S.GlobalInvestors,“copperhasuniquephysicalpropertiesthatmakeitthebackboneoftheindustrialeconomy.”Holmespointsoutthatcopperpricesarehighlycorrelatedwiththehealthofhousing,infrastructurespending,andmanufacturing.Itworkslikethis:Thesupplyofcopperisrelativelystable(andtypicallynot

toosensitivetochangingpricelevels),soasdemandincreases—foruseinelectricalwiringinhousesorbusinesses—thepricetendstogoup.That’swhatmakesthepricesocloselyalignedwitheconomicactivity.

Thegoodnewsisthatthiscloserelationshipislikelytostayaroundforawhile.Copperisoneofthemostcost-effectiveelectricityconductorsavailableandseemsunlikelytobedethronedfromthatpositionanytimesoon.(Goldis

betteratconductingthancopper,butit’snotcost-effectiveatallformostpurposes.Aluminum,ontheotherhand,hasanastyhabitofcatchingfirewhenusedforwiringhomesandoffices.)Aswellasbeingusedforwiringbuildings,copperisalsovitaltothemanufactureofautomobilesandsmallelectricappliances,whereitselectricalandheatconductivityiskey.

InvestmentStrategy

Watchingcopperpricescanhelppredictrecessions,saysBrianHicks,portfoliomanagerandcolleagueofHolmesatU.S.GlobalInvestors.Infact,Hicksgoesatadfurther,explainingthatthereisnow(intheearlytwenty-firstcentury)anextremelytightbalancebetweensupplyanddemand.Thatmeansthepricewillbeevenmoresensitivetochangesinsupplyanddemandthanithasbeeninthepast.Thekeytolookingatcopperpricesistolookforatrend,hesays.Ifpricesare

highandrising,thenthat’sasignofanexpansion.Ifpricesareonaplateau,thenthat’sasignthatperhapstheeconomywillbesomewhatsluggish.Asarecentexample,Hicksnoticedthepriceofcopperstartingtodropoffin

early2010.HethoughtthismightbebecausetheChineseeconomywasbeginningtoslowdown.Basedonthefallingcopperpriceaswellasotherfactorsthatconfirmedhissuspicion,Hicksmanagedtodumphisholdingsofcopper-relatedinvestmentswhilethemarketwasstillcresting.BythetimethemarketcaughtuptoHicks’sviewoftheworldandstockpriceshaddropped,he’dalreadysoldout.Highpricesarethosearound$3apoundor$6,600ametricton.Under$2a

poundoraround$4,400atonisconsideredlowandisalsobelowthepriceatwhichmostnewsuppliesofthemetalcanbedeveloped,Hickssays.Anoteofcautionwhenwatchingthepriceofcopper:Sometimespricespikes

havelittletodowithimprovingeconomicconditions.Insteadsuchmovementscanbecausedbyearthquakes,orindustrialactionbyworkersthatinterruptthesupplyofthemetal.Typically,pricesfallbackwhenfullproductionisrestored,notindicatingarecessionbutratherareturntosomenormalcyinthecoppermarket.

ExECSUMMARY:COPPERPRICE

Whentolook:Everybusinessday.

Wheretolook:ReportersofTheWallStreetJournalkeepacloseeyeontheindustrialmetalsmarketsandfilestorieswhennoteworthypricechangestakeplace.

Ifit’sjustthepricesthatyouwant,gotoTheWallStreetJournalonline’sMarketDataCenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“CommoditiesandFutures”sectionandlookunder“Metals.”Copperpricescanbefoundinaslewofotherplacesaswell.TheLondon

MetalExchange(LME),whichdominatesglobaltradingincopper,hasdataavailableonitswebsite,www.LME.co.uk.LikewisetheCOMEXdivisionofCMEGroupalsohasdataoncopperprices.Also,pricescanbefoundonwww.KitcoMetals.com,acommercialwebsitededicatedtoprovidingmetalsmarketinformation.Thetrickwithwhateversourceofdatausedforcopperpricesistomakesure

youuseaconstantbenchmarkprice.OntheLMEit’sthethree-monthprice(i.e.,thepricenowformetaldeliveredinthreemonths’time);forCOMEX,thebenchmarkdeliverypricemovesaround,makingittrickyforthenovicetogetahandleonthings.Forfurtherreference,theWorldBureauofMetalStatisticshasaproprietary

databaseatwww.world-bureau.com/searchlink.htm.Also,investorsonabudgetcangleansomehistoricaldatafromtheIMF’sPrimaryCommodityPricessiteatwww.imf.org/external/np/res/commod/index.asp.

Whattowatchfor:Increases(decreases)incopperprices,especiallyabove$3(below$2)perpound.

Whatitmeans:Housingandmanufacturingaregearingup(headedforsometoughtimes)andtheeconomyalongwithit.

Whatstepstotake:Ifyouaresurethepricemovementisduetoanincrease(decrease)indemandandnotasupplyshock,investin(getoutof)copperandmanufacturingstocksandrebalanceyourportfolioinfavorofeconomicexpansion(contraction).

Risklevel:High.

Profitpossibility:$$$

Chapter8DurableGoodsOrders

W

Leading

HENITCOMESTOlookingintothefuturewecanlearnalotbylookingathowbusinessesandconsumersarespendingonbig-ticketitems,orso-called

durablegoods.Forconsumers,“durablegoods”typicallymeanfridges,freezers,washing

machines,anddishwashers.Theyaredurable,whichmeanstheyareexpectedtolastawhile.Theyalsotypicallycostalotandsorequirethatconsumershavetheconfidencethatshellingoutafewhundreddollarsonasingle-useitemwon’tleavethemtooshortelsewhereintheirbudget.Forbusinesses,durablestypicallymeancapitalequipment.Inlayman’sspeak

thatmeansmachinesthatcanbeusedtomakestuffthatcanbesoldforaprofit.Itcanalsobeaircraft,whichareverybig-ticketitems,likeBoeing747s.Aswiththeconsumerdurables,ordersforcapitalequipmentareconsidereda

measureofsentiment.Ifbusinessequipmentordersarehighorrising,thenthattellsyouthebusinesscommunityasawholeisgettingmoreconfident.“Ittellsyoupeopleinbusinessareputtingtheirownmoneyatrisk,”says

MiltonEzrati,chiefeconomistandmarketstrategistatNewYork–basedassetmanagementfirmLordAbbett.“It’sagoodindicationofwherebusinessisgoing.”Morespecifically,businesseslikelywouldn’tordernewandtypically

expensiveequipmentiftheydidn’tseeareasonablechancethatthey’dhaveenoughcustomerstobuyallthethingsthenewmachinewasgoingtomake.

InvestmentStrategy

Oneimportantwrinkleisthatthetotaldurablegoodsordersindicatoralsoincludesveryexpensivedefenseproductslikewarshipsandjetfighters.Theseitemscomeandgoatthewhimsyofthegovernment,sotheytypicallydon’ttellusalotabouttheeconomy,orratherthesustainableprivatesectoreconomy.Fortunately,it’seasytostripoutthosebigDefenseDepartmentpurchases.It’s

alsoeasytoremovetheimpactofaircraftorders.Theytypicallyaresobigandsometimesseeminglysorandomthattheycanplayhavocwhentryingtointerpretthedata.Ezratinotesthat“evenifyousweepawayaircraftordersitisextremely

volatilefrommonthtomonth.Itisverylumpy.”That’swhyhesuggestsusingathree-monthandafive-monthmovingaverageaswellaslookingatthedatafromthepriormonth.Thatwayyoucanseeifthetrendisbeingbroken,hesays.Ingeneral,though,strongdurablegoodsorderstendtobeabullishsignfor

stocks.“Ithelpssupportthegeneraleconomy,”saysEzrati.Drillingdownfurther,Ezratisayshepaysparticularattentiontothecapital

equipmentspendingfigures,whichmeasurewhatbusinessesaredoingratherthanwhattheyaresaying.That’sararelookintothepsycheofbusinessesthatsomeotherindicatorsdon’tgive,hesays.IfEzratiisconvincedthatarecoveryisintheworks,hetriestofindsuitableinvestmentsinstocks.“Ifit’sbroad-basedstrengthacrossthedifferentcomponentsofdurablegoods,

thenthatspeakstothegeneraleconomy,”hesays.InsuchaninstanceitmightmakesensetolookatinvestmentstrackingbroadstockindicesliketheS&P500orperhapslookatthoseindicesthatfocusoncreatingdurablegoods,likebigmanufacturingconglomeratessuchasGeneralElectric(GE).Eventhen,Ezratisays,it’simportanttokeepaneyeonthepriceofstocks.Or

putanotherway,eveniftheeconomyisimprovingthatdoesn’tmeanoverpricedinvestmentsaresensible.

EXECSUMMARY:DURABLEGOODSORDERS

Whentolook:At8:30a.m.ETaroundthe26thdayofthemonth.Thedatacoversthepriormonth.

Wheretolook:EditorsandreportersatTheWallStreetJournalwatchthestateofthedurablegoodsmarketclosely.AsthedataisreleasedbytheCensusBureau,JournalreportersfilebreakingnewsstoriesforWSJ.com.Ifit’sjustthedatayouwant,gotoTheWallStreetJournalonline’s“Market

DataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“DurableGoodsOrders.”Alternativelyyoucangostraighttothesource:TheU.S.CensusBureau,at

www.census.gov/manufacturing/m3/.Historicaldataishere:www.census.gov/manufacturing/m3/historical_data/index.html.Forasimplifiedandeasy-to-useversion,tryBriefing.com’sEconomic

Calendarinitsfree“Investor”section.

Whattowatchfor:Increases(decreases)indurablegoodsorders,excludingdefenseandaircraftpurchases,overthreetofivemonths.

Whatitmeans:Theeconomyislikelytogrow(shrink)inthenearterm.

Whatstepstotake:Golong(short)abroadbasketofstocksliketheS&P500.Alternatively,themoreadventurousinvestormightconsiderbuying(selling)specificdurablegoodsmanufacturerslikeGeneralElectric(GE).

Risklevel:Mediumtohigh,dependingontheinvestmentstrategychosen.

Profitpossibility:$$or$$$forthestockpickers.

B

Chapter9HousingPermitsandStarts

Leading(SeealsoCopperPrice,NewHomeSales)

UYINGAHOUSEISabigpurchaseformostpeople.Forsomeothersit’sjustplainmassive.That’swhytheycallowningyourownhometheAmerican

dream.Notethe“dream”partofthat:Formanyitwillremainjustasunrealasadream.Housesareaspecialcaseofconsumerdurablesbecausetheyareexpectedto

lastyearsandyears.Fromstarttofinish,theytypicallytakeatleastayeartobuild.Thereasonwelookatthispairofindicatorsisthatanincreaseinthenumber

ofhousingpermitsappliedforandthecommencementofbuildingthosehouses(knownas“starts”)signalsconfidenceintheeconomyoverthenearandthemediumterm.Afterall,buildersusuallydon’tconstructnewhousesunlesstheyarefairlysurethatpeoplewillhavetheconfidencetobuythem.Remember,mostpeopleborrowthemoneytobuyahouseanddoingsoshowsthatpurchasersareoptimisticthattheywillkeeptheirjobsandincomeforasustainedperiodoftime.Duringthedepthsofarecessionthecostofborrowingmoneyistypicallyquite

lowandthatcanmeanthatbuyingahouseischeaperthanrentingone.That’showthecyclestarts:Cheapmoneyluresinhomebuyers,andhomebuildersknowthissotheyconstructhousesinanticipation.Increasesinthenumberofhousingstartsandhousingpermitsthathavebeen

issuedclearlyindicatethatincreasesinoveralleconomicinvestmentareintheoffingasbuildersbuylumber,bricks,cement,roofingmaterials,pipes,andsoforth.Inshort,thehousingbusinesscanturnthelightsbackoninmanydifferentindustries.

Itworksviceversatoo.Duringmosteconomicexpansionsthecostofborrowingmoneyincreasesastheeconomygetshealthier.Thathastheknock-oneffectofslowingnewbuildingandsoslowingtheeconomydown.

InvestmentStrategy

Typically,thenumberofbuildingpermitsissuedandthelevelofhousingstartsbegintoincreasebeforetheeconomyimproves.Asustainedpullbackinthesectortypicallycomesaheadofaneconomicslowdownorarecession.Thatmovementaheadofthechangesintheoveralleconomyisthereasonwethinkofhousingconstructionasaleadingindicator.(Note:Althoughhousingusuallybeginstoimproveaheadoftheeconomic

cycle,thatdidn’thappenduringtheeconomicexpansionthatgotunderwayin2009.ThatwasbecauseoftheexceptionalnatureofthehousingbubblethatprecededtheGreatRecession.Herewepresentwhatnormallyhappensbecausewewantthisbooktobeusefulacrossmanybusinesscycles,notjustthemostrecent.)

Therearemanywaystoprofitfromtheupsanddownsinthehousingmarket.Butthefirstthingtodoistoworkoutwhetherthesectorisimprovingordeclining.“Don’tjustlookatonemonth’sworthofdata;insteadlookatthetrend,”says

VinnyCatalano,chiefinvestmentstrategistatNewYork–basedBlueMarbleResearch.Catalanosuggeststhatinvestorslookatafewmonths’worthofdataataminimumtobesurethatthetrendisrealbeforelookingwhereinthestockmarkettoinvest.Theobviousfirstplacethatwilldowellinahousingrecoveryisthehome-

buildingcompaniesthemselves.CatalanopointstotheSPDRS&PHomebuilders(XHB)exchange-tradedfundasagoodfirstportofcall.Thevalueoftheso-calledXHBisdeterminedbythevalueofabasketofthesharesofcompaniesthatbuildhouses.Asthehousingsectordoeswell,sodothesestocks.Theso-calledbasketapproachmakessenseformostpeoplebecauseittakesawaytherisksofpickingthewrongstockevenifyougotthesectorcorrect.Catalanocautions,however,thatthevalueofstocksisdeterminedbyother

factorsaswell,suchasinterestratesandtheoveralleconomicclimate.“Pricesofhome-buildingstockscanzoomupinanticipationbeforethedataconfirmtherecovery,”headds.Inadditiontohome-buildingstocks,Catalanoalsosaysitmakessensetolookatothersectors.Forinstance,hesuggestsconsideringlumbercompaniesthatmakehouseframingmaterialsandminersthatdigup

coppertomakeelectricalwiring.

EXECSUMMARY:HOUSINGPERMITSANDSTARTS

Whentolook:At8:30a.m.ETaroundthe16thofthemonth.Thedatacoversthepriormonth.

Wheretolook:TheWallStreetJournal’seditorsandwriterswatchthehousingmarketclosely.Asnewsabouthousingpermitsandstartscomesout,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“HousingStarts.”Forthepermitsdatayou’llneedtogothesource,theCensusBureau,thesame

folksresponsibleforkeepingtrackofhowmanyAmericansthereare.Thedatacanbefoundatwww.census.gov/const/www/newresconstindex.html.

Whattowatchfor:Increases(decreases)inbuildingpermitsoverseveralmonths.

Whatitmeans:Theeconomyisheatingup(coolingdown).

Whatstepstotake:Buy(short)home-buildingstocksdirectlyoranETFliketheSPDRHomebuilders(XHB).

Risklevel:MediumfortheETF,highforpickingindividualstocks.

Profitpossibility:$$or$$$

T

Chapter10IndustrialProductionandCapacityUtilization

Coincident,Leading

HEWAYSOMERABBLE-ROUSERSandpoliticiansbemoanthestateoftheindustrialeconomyyou’dbeforgivenforthinkingthatmanufacturingof

goodsofalltypeswasonitslastlegsintheUnitedStates.Well,it’snotdeadyet.Thevalueofindustrialoutputtotalsabout$1.7trillion,ormorethanone-tenthofGDP.It’sstillasignificantandvitalpartoftheoveralleconomy.That’swhybothsavvyinvestorsandpointy-headedeconomistsalikepayclose

attentiontothehealthofthemanufacturingsector.Theydosobylookingattwocloselyrelatedeconomicindicators:industrialproductionandcapacityutilization.Wepresentthemtogetherhere.Industrialproduction(IP)measureshowmuchphysicalstuffisproducedinthe

economyeachmonth.IPincludeseverythingfromprescriptionmedicines,telephonehandsets,andTVstoingotsofgold,barsofsteel,andplanksofwood.Itisconsideredacoincidentindicatorsincetypicallyitneitherleadsnorlagsthestateoftheoveralleconomy.Bycontrast,capacityutilizationcomparesactualindustrialproductionwiththe

absolutemaximumamountofstuffindustrialcompaniescouldproduceiftheyraneverysinglefactoryflat-outallthetime.(Phew!Itsoundsexhausting.)Capacityutilizationisreportedasapercentagefigurewithamaximumpossibleutilizationof100%.Thisindicatoralsodoesagoodjobofmeasuringthecurrentstateoftheindustrialeconomy:Thehigherthepercentageutilization,thehealthiertheeconomyisrightnow.Increasesinthepercentageutilizationrateareseenasagoodsignforbusinessesbecauseitmeanscompaniesarenotlettingmachinesandotherassetssitidle.

INVESTMENTSTRATEGY

It’seasytoseehowcapacityutilizationandindustrialproductionriseandfallwiththestateoftheoveralleconomy.Utilizationratesfellmeaningfullyduringtherecessionsof1990–91,2001,and2008–9.It’snotablethatutilizationonlystartedincreasingamonthaftertherecessionended.Thefollowingtableshowsmonthlydata.Therecessionisindicatedbytheshadedareas:

Capacityutilizationcanalsobeusedtohelpseethefutureintwoways:First,highlevelsofCUtendtosignalfuturebusinessinvestment,possibleemployeehiring,andnewordersforcapitalequipment(newmachinestomakeevenmore

stuff).Asbusinessesmoveclosertomaximumcapacity,businesschiefsfindthemselveslessandlessabletomanagewiththeircurrentresources.“Companiesbridgethegapbyhiringpeopleandgettingbiggerorbetter

machines,”saysBillStone,chiefinvestmentstrategistatPNCWealthManagementinPhiladelphia.Thecompaniesthatsupplyindustrialmachinerydowellinthisenvironment.

“Thinkaboutwhosuppliescapitalequipment,”saysStone,pointingtoCumminsInc.(CMI),ABBLtd.(ABB),FluorCorporation(FLR),andtheircompetitorsasprimeexamples.It’sworthnotingthatthisindustrytendstoseebigcyclicalswingsinearningsandstockprices.Sotimingisthekeyforinvestors,hesays.Inadditiontoconsideringindividualcompanies,investorsmightalsowantto

lookatexchange-tradedfundsthattrackabasketofstocksinthesectorsuchastheVanguardIndustrialsETF(VIS).Thisisn’tanexactmatchforthesector,butitisbroadlyclose.Thesecondwaythisinformationcanbeusedtoforecast:“Whencapacity

utilizationgetsnearitsupperrangesyouneedtostartworryingaboutcostpressures,[orrisingpricesforinputmaterials],”explainsStone.Althoughtheoreticallyutilizationcanreach100%,therealityisthefigurestypicallydon’texceedthemid–80s.Whenutilizationneared90%inthe1970s,costpressuressoared,notesStone.Why?Theclosercompaniescometorunningtheirfactoriesatfullcapacity,

believesStone,themorecomfortabletheyfeelinincreasingthepricestheychargetocustomers.Butwhenallcompaniesdothattheremaybeanoverallbumpincosts.“Itmightcauseyoutofavorcommodity-basedcompaniesthatwouldbenefit

fromrisingrawmaterialscostsratherthanthosethatwouldsufferfromincreasedcosts,”saysPNC’sStone.Twoinvestmentsthatcoulddowellundersuchcircumstances:theVanguardMaterialsETF(VAW)andtheiSharesS&PNorthAmericanNaturalResourcesETF(IGE),bothofwhichtrackabasketofunderlyingstockstiedtonaturalresourcesandcommodities.

EXECSUMMARY:INDUSTRIALPRODUCTIONANDCAPACITYUTILIZATION

Whentolook:At9:15a.m.ETaroundthe15thofthemonth.Thedataisforthe

priormonth.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchindustrialproductionclosely.Asnewsaboutitandcapacityutilizationisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“IndustrialProduction.”Alternatively,youcanfinddataonindustrialproductionandcapacity

utilizationattheFederalReserve.Findthemostrecentdataatwww.federalreserve.gov/releases/g17/current.Historicaldataisavailableatwww.federalreserve.gov/releases/g17/current/table11.htm.

Whattowatchfor:Increases(declines)incapacityutilization.

Whatitmeans:Businessinvestmentisrising(falling)andtheeconomywillsoonfollow.

Whatstepstotake:Buy(short)capitalequipmentsupplierslikeFluor(FLR)orappropriateETFs.

Risklevel:Mediumtohigh.

Profitpossibility:$$to$$$

M

Chapter11InstituteforSupplyManagement(ISM)Manufacturing

Survey

Leading(SeealsoPhiladelphiaFed:BusinessOutlookSurvey,IndustrialProductionand

CapacityUtilization)

ANUFACTURINGISNOTASlargeapercentageoftheeconomyasitoncewas,butitisstillimportantenoughthatmuchoftheinvestingworldpaysclose

attentiontooneparticularsurveyouteachmonth:theISMManufacturingSurvey.ItmeasuresthehealthofthemanufacturingsectoroftheeconomyfromtheperspectiveofthepurchasingmanagerswhoworkatmanufacturingcompaniesthroughouttheUnitedStates.Purchasingmanagersarevitaltoanymanufacturerbecausewithoutthemthere

wouldbenorawmaterialsinplacetofabricateintofinishedandsemifinishedproducts.Thesemanagersspendmuchoftheirtimetryingtopredicttherawmaterialsneedsoftheirorganizations.Theythenmakedecisionsabouthowmuchofwhatstufftopurchasefromothercompanies.Forinstance,thepurchasingmanagersatFordMotor(F)mayneedtobuy

steel,paint,glasswindshields,andtires(amongmanyotherthings)inordertomakecars.Theybuyenoughofthosematerialstobuildthenumberofcarsthecompanythinksitwillbeabletosellinthecomingmonths.Asaresult,howpurchasingmanagersfeelaboutthestateoftheirbusinessrevealsalotabouttheoverallstateoftheeconomy.TheInstituteforSupplyManagement(ISM)surveysfourhundredcompanies

intwentymajorindustriesaboutneworders,production,employment,supplierperformance,inventories,pricesofmaterials,backorders,imports,andexports.Fromthedataonneworders,production,employment,supplierperformance,andinventoriesitcreatesaPurchasingManagersIndex(PMI),theISMsurvey’s

headlinefigure.InvestorsshouldlooktoseewhetherthePMIisinexpansionorcontraction

territory,explainsSophiaDrossos,astrategistatNewYork–basedinvestmentbankMorganStanley.Afigureabove50indicatesanexpansioninthesector.Afigurebelow50indicatesacontraction.Oneimportantnote:TheInstituteforSupplyManagementwaspreviously

namedtheNationalAssociationofPurchasingManagers(NAPM).So,ifyouseereferencestoNAPMinoldnewspaperreportsyou’llknowwhatitmeans.

InvestmentStrategy

WhenanalyzingtheISMindexit’simportanttodigdeeperthanjusttheheadlinefigure.That’sbecausewhiletheheadlinefigureisimportant,thesubindicescanbeevenbetterindicatorsofwhatisgoingtohappen.“Youcanlookattheneworders[index]asaleadingindicatorforfuture

economicactivity,”saysDrossos.Inotherwords,ifnewordersarestrong,orabove50,thenfutureactivityislikelytobegoodalso.Shealsopointstothe“employmentindex”asafairgaugeofthehealthofthe

marketformanufacturingjobs.Again,afigureover50showsgrowthinmanufacturingemployment.“Whenthose[theheadlinefigures,neworders,andemployment]are

expandingatthesametime,that’sconsistentforgrowthinthemanufacturingeconomy,”shesays.Drossosalsoaddsthatsuchanenvironmentwouldfavorso-calledhigh-betaassets,meaningthoseinvestmentsthataresensitivetochangesinthehealthoftheeconomy.Specifically,ahealthyandexpandingmanufacturingsectorusuallymeansstockswoulddowellandbondswoulddopoorly.

EXECSUMMARY:INSTITUTEFORSUPPLYMANAGEMENT(ISM)MANUFACTURINGSURVEY

Whentolook:Thereportisavailableonthesiteatabout10:00a.m.ETonthefirstbusinessdayofthemonth.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchtheISMdataclosely.Asnewsaboutitandcapacityutilizationarereleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter.”You’llfinditatwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ISMManufacturing.”Alternatively,youcouldgotothesource,theInstituteforSupply

Management’swebsite,www.ism.ws.Ithasthemanufacturingsurvey

informationavailabletoanyonewithaccesstotheWeb.Inaddition,www.Briefing.comprovidesasummaryofthedatainatimelymannerataboutthesametime.Althoughmuchofthesiteisforsubscribersonly,the“Investor”sectionisfreeandformostpurposesit’sadequate.

Whattowatchfor:IncreasesinPMI,orders,andemploymentabovethebreak-evenlevelof50.

Whatitmeans:Themanufacturingsectorisgrowingandlikelytheeconomyalongwithit.

Whatstepstotake:Gowithhigh-betasecuritieslikemanystocks,especiallythoseheavilytiedtomanufacturing.

Risklevel:High.


T

Chapter12InstituteforSupplyManagement(ISM)

NonManufacturingSurvey

Leading(SeealsoISMManufacturingSurvey)

HEREAREALOTofbusinessesthatdon’tactuallymakeanythinginAmerica.It’sstrangebuttrue.Thinkaboutit.Retailerssellfoodtoyoubutdon’tgrow

it.Brokershelpyoutobuyrealestatebutdon’tconstructit.Fillingstationssellyougasolinebutdon’trefineitfromcrudeoil.Banking,retailing,wholesaling,andthenonconstructionpartsoftherealestate

business,likeRealtors,areallservicesandtheyareabigdealtoeconomistsandinvestorsbecausetheymakeupaboutseven-tenthsoftheprivate(nongovernment)economyintermsofbothemploymentandGDP,explainsKurtKarl,chiefU.S.economistatinsurancegiantSwissReinNewYork.That’swhytheInstituteforSupplyManagement’smonthlynonmanufacturing

survey,frequentlycalledtheISMServicesIndex,issoimportant.“Itrepresentswhat’sgoingonintheservicessectorfromthepurchasingmanagers’viewpoint,”saysKarl.TheISMServicesIndexiseasytoreadtoo,justlikeitssisterindex,theISM

ManufacturingSurvey.TheheadlinefigureforthenonmanufacturingsurveyisasinglenumberknownastheBusinessActivityIndex.“Above50ismeanttobegrowthintheservicessector,”saysKarl.Likewise,

below50indicatesacontractionorslowinginthenonmanufacturingpartoftheeconomy.“The50figureisnotperfect,however:Wedon’thavealongenoughhistoryto

knowifthatiscorrect,”addsKarl.TheISMServicesdataonlygoesbacktothelate1990s,incontrastwiththemanufacturingdata,whichgoesbacktothe1930s.Thatlackofhistoryisseenasapotentialweaknessfortheservicesdata.

However,itdoescomeoutverysoonaftertheendofthemonthandsolotsofeconomistslikeKarltendtooverlookthatdrawback.OnebiggerproblemKarlpointsoutisthatpurchasingmanagersarenowhere

nearasimportantinservicesastheyareinthemanufacturingsector.Forinstance,theamountofpaperabankneedstoordergivesyoulittleclueastohowhealthythecompanyis,whereastheamountofcoalandironoreasteelmakerordersverymuchtellsyouhowwellthatfirmisdoing.

InvestmentStrategy

Karlsayshelikestolookatthe“neworders”figureasitis“moreforwardlooking”thantheheadlinefigure.Orinotherwords,thenewordersfiguretellsyoumoreaboutthefuturestateoftheservicesectorthandoestheheadlineISMServicesfigure.Bythesametoken,exportordersareanimportantindicatoroffutureeconomic

activity.Ifoneorbothofnewordersandexportordersshowconsistentreadingsover50,thenyoucanbe“reassured”thattheservicessectorwilllikelyseegrowthinthenearfutureifitisn’tgrowingalready.AsISMServicesDataisrelativelynew,Karlwarnsthatithasatendencyto

jumparoundlikeoneofthosebeansfromMexico.That’satleastpartofthereasonhelikestomakechartsoutofthedataandtheneyeballthem.Whenhehasachart,Karllooksfora“level”andnotatrend.Hesaysmovesofacoupleofpercentagepointsupanddownshouldnotbeseenasaproblemaslongasthefiguresstayabove50.

EXECSUMMARY:INSTITUTEFORSUPPLYMANAGEMENT(ISM)NONMANUFACTURINGSURVEY

Whentolook:Thethirdbusinessdayaftertheendofeachmonthatabout10:00a.m.ET.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchISMServicesDataclosely.Asnewsaboutitisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ISMNonManufacturing.”Alternatively,gostraighttotheInstituteforSupplyManagement’sown

websiteatwww.ism.ws,wherethedataandcommentaryarefreelyavailable.SeealsoBriefing.com,asreferencedpreviouslyforotherindicators.

Whattowatchfor:Increases(decreases)innewordersand/ortheheadline

figureabove(below)theputativebreak-evenlevelof50.

Whatitmeans:Theservicesectorisprobablygrowing(shrinking)andtheeconomyalongwithit.

Whatstepstotake:Nowisthetimetopurchase(sell)riskierassetslikestocksandtosell(purchase)old,recession-proofstandbyslikegovernmentbonds.

Risklevel:Low.

Profitpossibility:$

S

Chapter13JoC-ECRIIndustrialPriceIndex

Leading(SeealsoCopperPrice)

OMETIMESTOGETAreadontheeconomyyouneedtogetdownanddirty.Inthiscasethatmeanstakingalookatahodgepodgeofgrittyindustrial

commodities.Ugh?Wellmaybenot,becausealotofthedirtyworkhasalreadybeendonebythecompilersofthehelpfulJoC-ECRI(JournalofCommerce-EconomicCycleResearchInstitute)IndustrialPriceIndex.Itmightbeobscure,butthewaytheJoC-ECRIsignalschangesinthe

industrialeconomycertainlyisn’t.Thatpartoftheeconomyisn’tasbigastheservicesector,butit’salotmorecyclical.That’sgoodnewsforeconomicforecastersbecauseitmeanschangesinthatsectorcanbemucheasierforforecasters,economists,andinvestorstoidentify.TheJoC-ECRIIndustrialPriceIndexmeasuresthepricesofkeyindustrial

commoditiesthatgointomakingallthestuffproducedintheeconomy.Asindustrialcompaniesincreasetheirpurchasesofthesematerials,thepricesgetbidup,signalinganexpansion.Astheydecreasetheirpurchases,thepricespullback,foreshadowingaslowdownorevenperhapsarecession.Thenetresultisthatthepricesofindustrialcommoditiesactasaleadingindicatortotheeconomyasawhole.Theindexincludesenergyprices,basemetals(likecopper,tin,steel,nickel,

andaluminum),textiles,andamiscellaneouscategory(includingtallow,rubber,andplywood).Randomasthatlistmightseem,theelementsonitwerenotrandomlypicked.

Intheearly1980s,theguysattheNewYorkCity–basedEconomicCycleResearchInstitute,whichspendsallitstimestudyinghowdifferentpartsoftheeconomychangethroughthebusinesscycle,wenttogreatlengthstoinclude

onlycommoditieswithpricesthataresensitivetochangesintheeconomy.Forthatreason,ECRIexcludedagriculturalcommodities,wherepricestendto

shiftbasedonweather,andpreciousmetals,wherepricemovementsaresometimesbasedonspeculationandnotindustrialuse,explainsLakshmanAchuthan,managingdirectoratECRI.Ontopofthat,ECRImadeanothercriticaldecision.Notallofthe

commoditiespickedwouldbetradedonfuturesexchanges,althoughabouthalfofthem,likecopper,are.Thereason?“Normallyitdoesn’tmatter,butonceinawhilecommodities

becomeahotinvestmentclassandthatleadseveryoneandtheirbrothertopilein,”Achuthanexplains.“Theycangetreallyvolatile.”Iftheindexincludedonlyexchange-tradedcommodities,thenajumpinthe

indicatorcouldfalselyindicateacomingeconomicboomwhentherealitywasaspeculativefervor,heexplains.Havingabouthalfthecomponentsnottradedonexchangeshelpsguardagainstfalsereadsintheindex,hesays.

InvestmentStrategy

ECRI’sAchuthansayshelikesusingthisindexbecauseit’sreallysensitivetochangesintheeconomyandbecauseitmovessubstantially.Thetrick,hesays,istocharttheindexandthenhesaysaturnintheeconomywillbe“undeniable.”Forinstance,whentheeconomyreboundedfromtheGreatRecession,the

JoC-ECRIIndustrialPriceIndexranup50–60%.Thatsortofmovehelpsgiveyou“theconvictiontogoagainsttheconsensus,”hesays.Butmakingacallonaturnintheeconomyfromexpansiontorecessionor

slumpbacktoboomneedsmorethanachart.Achuthansaysit’simportanttofollowtheECRIanalyticalphilosophyofmakingsurethatthemoveintheindexispronounced(i.e.,itmovedalot),persistent(itcontinuestomoveinthatdirection),andpervasive(it’snotjustdrivenbyonecomponentoftheindex).Ifthechangeintheindexmovesaccordingtothese“threeP’s,”thenit’sprobablysafetocallaturningpointintheeconomy.Thegoodnewsforinvestorsisthatthestocksthatproducesuchindustrial

materialstendtomoveasviolentlyastheunderlyingcommodities.Orputanotherway,swingsinthepriceofcommodity-chemicalsmakerDuPont(DD)willbelargerthanthoseofcompanieslikeProctor&Gamble(PG),amanufacturerofconsumerstaplesliketoothpaste.

EXECSUMMARY:JOC-ECRIINDUSTRIALPRICEINDEX

Whentolook:Weekly.

Wheretolook:ECRIprovidesitsup-to-dateJoC-ECRIIPItoitsmembersforafee.Alternatively,Barron’smagazinepublishestheIPIdataeachweek.Again,you’dhavetopayforasubscription,butifyouneedup-to-datedatainatimelymanner,thenthatmaybethewaytogo.However,ifyouhavemoretimethanmoneyitprobablypaystoscourthe

pressfornuggets.ECRI’sAchuthansaysthatonewayoranotherabout70%oftheinformationonECRI’soutlookavailablethroughmediasources.Thecompanytriestokeepanarchiveofpresscoverageonitswebsiteatwww.BusinessCycle.com/news/press.

Whattowatchfor:ThethreeP’s(pronouncedandpersistentmovementintheindexdrivenbyalarge—orpervasive—numberofindustrialcommodities).

Whatitmeans:Theoveralleconomyisabouttosoar(tank).

Whatstepstotake:Buy(short)industrialstocks.

Risklevel:High.


S

Chapter14LondonMetalExchangeInventories

Leading(SeealsoCopperPrice,ISMManufacturingSurvey)

OMESMARTINVESTORSlookatthepriceofcopperasacluetothehealthoftheeconomy.That’sgreatstufftoknow,insofarasitgoes.Buthowcoolwouldit

beifyoucouldpredictthepriceofcopperandothermetals?Thewaysomesavvyinvestorsdothisistolookattheamountofmaterialthat

isn’tbeingconsumedandjustremainsidle.Orputanotherway,howmanytonsofcopperorofaluminumarejustsittinginglobalstockpiles?It’scounterintuitive,butit’simportant.Traditionally,therehasbeenaninverserelationshipbetweeninventorylevels

andprices.Wheninventoriesarelow,thenpriceshavetypicallybeenhighorrising.Itworksviceversaalso.Theproblemhasalwaysbeenthatit’shardtogetatruereadonwhat

inventoriesthroughouttheeconomyreallyare.Forinstance,howmanytonsofcopperdoesthewiremakerinBrooklyn,NewYork,reallyhaveinhisshed?Individually,suchthingstendnottomakemuchdifference,butwhenallthelittleplayersareaddedup,theircollectiveimportanceemerges.Inotherwords,gettinggooddatatoanalyzemetalsmarketsistricky.Oneclue

tosolvingthepuzzleisfoundattheLondonMetalExchange,acommodityfuturesorganizationthatdominatestheglobaltradinginfutures-stylecontractsofindustrialmetalssuchascopper,aluminum,zinc,lead,tin,andnickel.EachbusinessdaytheLMEprovidesdataontheamountofmetalthatisavailableinitswarehouses.Tobesure,itisn’tthewholepictureofworldwidemetalsinventories.Butitis

transparent(i.e.,whatyouseeiswhatyouget),timely(daily),and,inouropinion,agoodindextomonitor.

Notecarefully:Verylowinterestratescandistortthetraditionalinverserelationshipbetweenpricesandinventories.Whenthecostofborrowingmoneyisabnormallylow—likeduringtheGreatRecessionof2008–9anditsaftermath—speculatorssometimesdecidetosnapupcommoditiesasaninvestment.Asaresult,inventoriesstayhighwhenpricesdoalso.That’sinpartbecausethemetalownedbyspeculatorsisn’tavailableforfabricationbymanufacturers.

InvestmentStrategy

ThesizeofLMEinventoriescanindicatealotaboutthefuturehealthofthemetalsandminingbusiness.Ifinventoriesarehigh,thenit’slikelyasignthatbusinesswillslowdownasminersandrefinerscutbackonproduction.Likewise,ifinventoriesarelow,thenitcouldportendafuturepickupinbusinessforminersandrefiners.Thereisawrinkle:Dataaboutmostcommodities,includingmetals,canbea

bitmurky.Butthatmeansthesavvyinvestorwhoispreparedtoputinsomelegworkcanreallywinbig.Why?Becausethedatasituationisequallycloudyforallinvolvedandmostwon’tgotoanyextraefforttogetaclearerpicture.Ifyoudo,you’llhavetheadvantage.NeilBuxton,managingdirectoratLondon-basedconsultingfirmGFMS

Metals,sayshestartshisanalysisbylookingatLMEinventorylevels“asanindicatorofthemarketbalance.”Inshort:Isthemarketwellsuppliedwithlargestockpilesofmetal,orisittightwithlowlevelsofinventories?Inanyevent,whileitisuseful,theLMEinventorydatashouldbeaugmented

withstockpilefiguresfromtheCMEGroup’sCOMEXdivisionandalsofromtheShanghaiFuturesExchange,saysBuxton.TheirstatisticsaresimilartothoseprovidedbytheLMEandhelpprovideamorecompletepictureofmarketbalance.Bydoingthisextralegworkandcollectingadditionalnuggetsofdata,smartinvestorscangainamorecompletepictureofthemurkyworldofmetals.Ontopofthat,savvyinvestorsshouldlookatindicatorsthatreflectpossible

futuredemand.Inparticular,BuxtonsayshewatchesthevariousPurchasingManagersindices,orPMIs,liketheISMManufacturingSurveydescribedelsewhereinthisbook.ThesePMIstelluswhatmanufacturingbusinessesareplanningtodointhenearfuture.Ifbusinessconditionslookgoodtothepurchasingmanagers,thenthatwilllikelybegoodformetalsdemand.Inaddition,thehealthoftheChineseeconomyhasbeenaveryimportant

factorindeterminingmetalsprices.BuxtonsaysthatChinarepresents30–40%ofglobaldemandforsomeofthesemetals,andhenotesthattradedatafromthatcountryfrequentlyimpactmetalsprices.“Whenlookingatthesemarkets,theunderlyingfundamentalsdomatter,and

thatcomesthrough,”hesays.

EXECSUMMARY:LONDONMETALEXCHANGEINVENTORIES

Whentolook:Everybusinessday.

Wheretolook:TheLondonMetalExchangeprovidesprice,inventory,andothermarketdataonitswebsite,somefree,someforafeeatwww.lme.co.uk.TheCOMEXandtheNewYorkMercantileExchangearenowadivisionoftheCMEGroupatwww.cmegroup.com.TheShanghaiFuturesExchangewebsiteshowsweeklydataoninventorylevelsatwww.shfe.com.cn.

Whattowatchfor:Increasesordecreasesininventoriesofdifferenttypesofmetal.Inaddition,lookforincreasesordecreasesinChinesedemandandtherelativehealthofthemanufacturingsectorintheindustrializedeconomies(seevariousPurchasingManagersindices).

Whatitmeans:Typically,lowinventoriessignalathrivingmanufacturingsector.Highinventoriessignalastagnatingmanufacturingsector(exceptwheninterestratesareabnormallylow).

Whatstepstotake:Wheninventoriesarehigh,typicallyavoidstocksthataresensitivetothemanufacturingeconomy.Wheninventoriesarelow,buymanufacturingstocks.

Risklevel:High.


Chapter15PersonalSavingsRate

F

Coincident

ORMANYAMERICANSIT’Skindofboringtosave.Whybotherwhenyoucanspendnowandpaylater?Anyway,itkeepstheeconomyrevvingalong,

right?Well,almost.“Savingstodaycanhelplonger-termgrowthinthefuture,”

explainsDerekBurleton,deputychiefeconomistatTDBankFinancialGroupinToronto.Inshort,moresavingsinaneconomymeansmoreinvestment.Thatmoneyhas

togosomewhere,and,inthiscase,itgetsfromyoursavingsaccountintoloansandsecuritiesthatfinancetheconstructionofnewfactoriesortheretoolingofoldones.Savingsareimportanttoeconomistsforthisreason,buttheyarealsooften

difficulttocalculatebecausetheso-calledpersonalsavingsrateisn’tactuallytrackedanywhere.Instead,statisticiansbackintothenumberbylookingattheoverallincomeofallpeopleintheUnitedStatesandthensubtractingoverallspending.Theyassumethatifyouearneditbutdidn’tspendit,thenyoumusthavesavedit.It’salsoworthnotingthatahighsavingsrateinacountrycanhelpprotecta

governmentthatisdeepindebt.Forheavilyindebtedgovernments,thebigquestionis:Whereisthemoneygoingtocomefrom?Well,ifthemoneycomesfromsaverswithinthecountry,thenthereismuchlesstoworryabout.Atthetimeofwriting,Japan’sgovernmentisheavilyindebted,with

borrowingsofabout200%ofitsnationaloutputorGDP.That’sabouttwicethelevelofU.S.governmentindebtedness,percentage-wiseanyway.Buthere’sthething:InsomewaystheJapanesegovernmenthaslesstoworryaboutthantheU.S.governmentdoes.WhileJapan—anationofbigsavers—mostlyborrowsfromitsownpeople,theUnitedStatesisheavilydependentonforeignerslendingitthemoney.Americansarenotasthrifty.Asaresult,theJapanesegovernmentdoesn’thavetoworrythatforeignerswillsuddenlystoplendingtoit,whiletheU.S.governmentisconstantlyonguard.

InvestmentStrategy

Thereisabigproblemwiththesavingsratedata.It’sveryvolatile.That’sbecauseofthewayit’scalculated.Burletonexplainsthattheincomeandspendingfiguresarebothjustestimates.Ontopofthat,theyarebothverylargenumbers.Becausesignificanterrorscanbemadeintheestimates,thederivedsavingsratenumberscanoftenjumparoundviolently.“Wetrynottoreadtoomuchintolevelsofsavings—morethedirection,”says

Burleton.Or,inotherwords,helooksatwhetherthesavingsrateisgoingupordown,ratherthanwhetheritis3%or1.5%.Hesaysinvestorscanusethetrendinthesavingsratetoassessthemoodof

consumers.Ifthetrendisformoresavings,thenconsumersareprobablyprettynervous.Ifthetrendshowsprogressivelylowerlevelsofsavings,thenit’sagoodsignthatconsumershavetheconfidencetospend.

EXECSUMMARY:PERSONALSAVINGSRATE

Whentolook:At8:30a.m.ETaboutfourweeksafterthemonthreported.Itcomesintheformofthe“PersonalIncomeandOutlays”reportfromtheCommerceDepartment.

Wheretolook:EditorsandwritersatTheWallStreetJournallookcloselyatthedataonincomeandspending,therawmaterialsofthesavingsfigures.Asthedataisreleased,reportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatayouwant,gotoTheWallStreetJournalonline’s“Market

DataCenter.”Thereyou’llfindsummarydataonpersonalincomeandoutlays.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“PersonalIncomeandOutlays.”Foraderived“savingsrate”figureaswellastheincomeandspending

numbers,gototheU.S.BureauofEconomicAnalysisatwww.bea.gov/national/index.htm#personal.Forhistoricaldata,trytheSt.LouisFed’sFREDdatabase.

Whattowatchfor:Anincrease(decrease)inthesavingsrate.

Whatitmeans:Consumersareprobablyprettyjittery(feelingconfident).

Whatstepstotake:Ifthesavingsrateistrendingupward,thenit’slikelythattheconsumptionpartoftheeconomywillbeweak.Therefore,it’sbesttoavoidstocksofconsumer-drivencompanies.

Risklevel:Medium.


S

Chapter16UnitLaborCosts

Coincident(SeealsoISMManufacturingSurvey,PhiladelphiaFed:BusinessOutlook

Survery)

OMEWORKERSARELAZYorunproductiveandsomearehardworkingandefficient.Anyonewhohasheldajobknowsthat.Althoughsometimesonan

individual-by-individualbasisthatphenomenoncanbehardtomeasure,overallwecanknowhowefficientwearebylookingatsomethingcalled“unitlaborcosts.”Thisindicatormeasuresthecostofthelaborcomponentofmakingaunitof

industrialoutput.Probablythebestwaytothinkofitis:Howmuchofthecostofmakingasinglewidgetwasfromlabor?Overtimewhatbusinessesreallywanttoseeisdeclinesinunitlaborcosts.

Suchaneventmeansthatbusinessesarebeingmoreefficient.Andthat,inshort,iswhatunitlaborcostsare:ameasureofefficiencyandproductivity.“Bettermachinesmeanbetterproductivity,andthatwillmanifestitselfin

lowerunitlaborcosts,”saysCampbellHarvey,professoroffinanceatFuquaSchoolofBusinessatDukeUniversity.“Butthechangesinproductivitydon’thappenquartertoquarter;theyaremoreofalong-termfunction.”Ifthereisanoticeablechangeinunitlaborcostsoveraperiodof,say,threeyears,someofthatmightbeattributabletoimprovementsinproductivity,saysHarvey.Theexactoppositeofwhatmostbusinesseswanthappenedinthe1970sand

early1980s(seefigurebelow),whenunitlaborcostssoared,sometimesover10%ayear.Itwastheresultofhighwageinflation.Ifthisindicatorsoundscomplicated,don’tworrytoomuch.TheBureauof

LaborStatistics,agovernmentagency,calculatesitforyoubydividingemployerlaborcosts(wagesandbenefits)byrealvalue-addedoutput.Ifworkersproduce

morevalueandtheirwagesstaythesame,unitlaborcostswillfall,whichisgoodforbusinesses.

InvestmentStrategy

Thebiggestwrinklewiththeunitcostdataisnotinreadingwhetherlaborisgettingmoreorlessefficient.Bynowthatshouldbeeasy.Rather,therealknottyproblemisdeterminingwhatitmeansforthebroadereconomy.Thebigissue:Exactlythesamephenomenonmeanspreciselyoppositethingsdependingonwhereyouareinthebusinesscycle,explainsHarvey.Talkaboutdiabolical!Forthatreason,youneedtolookatthismetricinconjunctionwithotherindicators,likethoseinthisbook,totellwhereyouareinthebusinesscycle.Ifyouareinarecessionandunitlaborcostsaredrivenup,itcouldbeagood

thing.Thereasoning:Itmaybeasignthatworkersarebeingpaidbetter.Thatcaneventuallyshowupinincreaseddemandforgoodsandservices.Sounderthosecircumstancesinvestorsmightviewrisingunitlaborcostsasapositivesignofaneconomicrebound.Sagginglaborcostsduringarecession,however,couldalsosignaldeflationandanevendeeperdownturntocome.Conversely,inaneconomicboom,risinglaborcostsmightbeconsideredbad.

Thereason:Itmightbeasignofinflation.Specifically,ifthelaborcostcomponentofmakingstuffgoesupandthematerialscoststaysthesame,thenbusinessesmustincreasesellingpricesinordertomaintainthesamelevelofprofit.Lowerlaborcoststhataretheresultofimprovingworkerefficiencyduringaneconomicboom,however,wouldbeaverybullishsign.AsHarveyrecommends,itmakessensetoconsulttheotherindicatorsinthisbook.Ifitlooksliketheeconomyisimprovingandtheunitlaborcostsarefalling,

theninvestorsmightwanttoconsiderpurchasingassetsthataresensitivetotheeconomy,likestocks,especiallymanufacturingcompanies.Forinvestorswhodon’twanttopickindividualstocks,aninvestmentfund

thattracksabasketofindustrialstocks,liketheIndustrialSelectSectorSPDR(XLI)exchange-tradedfund,mightmakesense.

EXECSUMMARY:UNITLABORCOSTS

Whentolook:Thisdataispublishedquarterlyat8:30a.m.ETnearthebeginningofthemonth.ThedataisforthepriorquarterandcomesoutinFebruary,May,August,andNovember.Eachalsohasarevisiononemonthafter

thefirstread.

Wheretolook:ReportersandeditorsofTheWallStreetJournalcloselywatchlabortrends.AsnewsisreleasedbytheLaborDepartment,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter.”You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“ProductivityandCosts.”Toseethedatadirectly,gototheU.S.BureauofLaborStatisticsat

www.bls.gov/bls/newsrels.htmandlookfor“ProductivityandCosts”newsrelease.

Whattowatchfor:Changesinunitlaborproductivity.

Whatitmeans:Thisalldependsonwherethebusinesscycleis.Risinglaborcostsduringarecessionmightsignalarecoveryoranastyboutofinflation.Fallinglaborcostsmightmeanhigherproductivityoradeeprecession.

Whatstepstotake:Ifarecessionyousee,safetyyoumustseek.Arealexpansionoftheeconomyshouldbeanticipatedbyamoveintoriskierassets,likeequities.ButiftheexpansionismerelynominalduetoinflationthentakesomeTreasuryInflation-ProtectedSecurities(TIPS)andmineforgold(orbuyagoldETF).

Risklevel:Lowtohighdependingonhowwellyouintegratethisindicatorwithotherstodiscerntheeconomy’struedirection.

Profitpossibility:$to$$$$

Government(G)

GOVERNMENTHASAVORACIOUSappetiteforconsumptionofallkindsofstuff.Together,allthedurableandnondurablegoods,services(likeresearchanddevelopmentandeducation),andinvestmentinequipment(muchofitmilitary),buildings,andhighwaysaccountforabout15–20%ofGDP.We’veincludedonlyoneindicatorofitsactivity:thefederalgovernment

budgetdeficit.It’saparticularlyinterestingindicatorbecausewhileintheshortrundeficitsoftenpointtoincreasesinthegovernmentcomponentoftheeconomy—andhenceincreasesGDP—theyalsoportendproblemsaheadforotherpartsoftheeconomy.Notably,whenthegovernmenthasbigdeficitsittypicallyresultsin

decreasesintheconsumption(C)andinvestment(I)alittlefurtherinthefuture.Thatisbecauseasgovernmentexpandsitdoessousuallybyacombinationofincreasingtaxes,borrowing,orprintingpapermoney.Taxesofcoursedecreasefutureconsumptionandinvestment.Borrowingisnothingmorethanfuturetaxation,andprintingmoneycausesinflation,whichalsoactsasaformoftax,albeitasilentone.Taxesarenecessaryevils,thepricewepayforcivilization,inthewordsof

SupremeCourtjusticeOliverWendellHolmes(andtheIRS),buttheycanbeverydistorting.Aswellasinducingstrangearchitecturaldesigns(toavoidtaxesonwindows),hugehouseholds(todiminishtheimpactofataxonhouseholds),andbigformatnewspapers(todecreaseataxonthenumberofpages),poorlydesignedtaxeshavewreckedeconomies.Itusuallytakessometimetodosoandisn’tabusinesscyclephenomenon,butwefiguredthatwhileweareatitweshouldwarninvestorsthatbigdeficits(andtheinevitablechangesinthetaxcode)areworthworryingabout.

Chapter17FederalGovernmentBudgetDeficitsandtheNational

Debt

S

Coincidenttoleading

OMEPEOPLEHAVEMONEYleftattheendofthemonth,butthesedaysmostpeoplefindthattheyhavemoremonthleftattheendoftheirmoney.Well,if

youfeelabitstrappedforcashthesedays,don’tdespair,asyouarenotalone.Nationalgovernmentsaretoo.Whengovernmentspendsmoremoneythanitreceivesintheformoftax

revenues,theresultiscalledadeficit.It’slikeagapingholeinthebudget.Tofundthedeficit,governmentsborrow,andtheaccumulatedborrowingsformthenationaldebt.Atthetimeofwriting,theU.S.nationaldebttotaledover$14trillion.That’safourteenwithtwelvenumbersafterit.It’sawholelotofmoney,anditcouldbecomeaproblem.Thereasondeficits,andultimatelynationaldebt,areworrisomeisbecausethe

biggerthedebtgets,andthehigherinterestratesongovernmentbondsgo,theheaviertheburdenofthegovernment’sdebtservice.Inotherwords,agreaterportionofeachtaxdollarmustgojusttopayinterestonthedebt.Alsoproblematic,governmentsthatbecametooheavilyindebtedhaveoften

resortedtoprintingmoney.Whilethathelpsthempaythedebts,itultimatelycausesinflation.Tomakemattersworse,whileit’seasytoseeconsequencesofrunninglarge

deficits,it’sactuallyquitedifficulttointerpretdeficitdata.Thetroublewithlookingatoneyear’sdeficitofanycountryinisolationisthatagovernment’staxrevenueishighlycorrelatedtothebusinesscycle.Inarecessionthegovernmenttendstobringinfewertaxrevenues,andinaboomyearittakesinmuchmore.That’swhyyoucan’tgiveanyoneyear’sdeficitanyrealmeaning,saysDavidRanson,headofresearchatBeverlyFarms,Massachusetts–basedeconomicsconsultingfirmH.C.Wainwright&Co.EconomicsInc.Hesaysit’sbettertolookattheannualdeficitasapercentageofGDP.Thekeynumberis3%.“It’sconventiontoregard3%asanormaldeficitbecausetheeconomygrows

3%normally,”saysWainwright’sRanson.“Thatmeansthegovernment’sdebtisrisingonlyasfastasGDP,whichishealthy.”Inotherwords,itisn’tabigdealifthenationaldebtstaysataconstant

percentageofGDP.Butwhatifdeficitsgrowfasterthantheeconomy?

InvestmentStrategy

Thenationaldebtisaharbingerofinflation,butitslevelisnotcorrelatedwiththebusinesscycle.Annualbudgetdeficits,however,arecloselytiedtothebusinesscycle.“Overtime,thehigheryourdeficit,thenthehigherareinflationrates,andyoucouldgethyperinflationratesifthegovernmentisunabletoextricateitselffromthatpredicament,”explainsRanson.Orputanotherway,continualdeficitsleadtoarisingnationaldebt,andahighlevelofnationaldebtisaharbingerofinflation.Asalreadymentioned,thekeytoavoidinginflationisforaverageannualdeficitstostaybelow3%.Theproblemisthat,basedonprojectionsatthetimeofwriting,thecurrentU.S.deficitisover10%andprojectedtofallto4%andriseagain.“Itprobablywon’tgetmuchbetterthanthat,”hesays,andthatworrieshim.Ransonpointstogoldasagoodbetagainstinflationiftherearesustained

budgetdeficitsinexcessof3%ofGDP.Ontheotherhand,hesayscountriesinwhichthegovernmentcankeepalidonspendingandkeepdeficitsbelow3%willattractcapitalandasaresultgrowatafasterrate.“Thatincludesalotoftheemergingworldthesedays,”hesays.Accordingly,investorsmightwanttoconsidermutualfundsthatspecializein

investinginstocksofemergingmarketcompanies.

EXECSUMMARY:FEDERALGOVERNMENTBUDGETDEFICITSANDTHENATIONALDEBT

Whentolook:Fordeficitfigures,theU.S.Treasuryprovidesmonthlystatementsofitsreceiptsandoutlaysat2p.m.ETonthe8thbusinessdayofeachmonth.Inaddition,continuousestimatesforthenationaldebtareavailableviavarious

nationaldebtclockslikeUSDebtClock.orgatwww.usdebtclock.org/.

Wheretolook:EditorsandwritersatTheWallStreetJournalkeepacloseeyeonthefinancesoftheU.S.government.AstheU.S.Treasuryreleasesitsdata,reportersfilestoriesforpublicationonWSJ.com.Foralookatthedata,youcangostraighttotheU.S.Treasurymonthly

statementatwww.fms.treas.gov/mts/index.html.Toanalyzeitappropriatelyyou’llneedtoannualizethemonthlydata(i.e.,sumupthepriortwelvemonthsofdeficits)andthencomparethattotaltooverallGDP.Inaddition,theFREDdatabaseattheSt.LouisFederalReserveenrichesus

withhistoricaldataathttp://research.stlouisfed.org/fred2/series/FYFSD?cid=5,andmajornewsoutletsalsocoverbudgetnegotiations.Ifyouwanttotakeanin-depthlookatthecurrentfederalbudget,browsewww.whitehouse.gov/omb/budget/.

Whattowatchfor:Increases(decreases)inthenationaldebtasapercentageofGDP,usuallysignaledbyrecurringdeficitsgreaterthan3%ofnationalincome.

Whatitmeans:Thegovernment’sincentivetocauseinflationisincreasing(decreasing).

Whatstepstotake:Short(buy)traditionalgovernmentbondsandbuy(short)gold,and/oremergingmarketequitymutualfunds.

Risklevel:High.


NetExports(NX)

TheUnitedStatesdoesn’Texistinisolation.Wesellstufftoforeigncountriesandbuystufffromthem.Inshort,therestoftheworlddoescount.That’swhyweincludehalfadozenindicatorsofnetexportshere.Thedifferencebetweenwhatwesellabroad(exports)andwhatwebuy

(imports)iscallednetexports.EconomistsusethesymbolNX.Forsmall,openeconomieslikeIreland,NXispositiveandamajor

contributortoGDP.ForAmerica,however,NXistypicallynegative,shrinkingGDPbyabout5–10%.ImprovementsgenerallyentailNXbecominglessnegative,butstillbelowzero.Exportsandimports,itshouldbenoted,notonlyincludemerchandisebutalsoservicessuchastourism,consulting,andbanking.ThebiggestinfluenceonU.S.netexportsisthedollar.Whenthe

greenbackisweak,exportsimprove,andthenetpositionbecomeslessnegativebecauseU.S.goodslookcheaptoforeigners.LikewiseforeigngoodslookexpensivetoAmericans.Therefore,exportsincreasewhileimportsdecrease.Itworksviceversatoo.Intheshortterm,economictheoriststellus,thebiggestinfluenceon

exchangeratesisinterestrates,orrathertheexpectationofchangesinrelativeinterestrates.Longer-termexchangeratesrespondtorelativechangesintherealeconomy,thingslikepricesandproductivity.Tounderstandwhatisgoingtohappentoexchangerates,onemustknowwhatishappeningonthegroundintheworld’sothermajoreconomies,whichalsohappentobeAmerica’sbiggesttradingpartners.Thatiswhywehavealsoincludedinternationalandforeignindicatorsinthissection.Suchindicatorscanbeusedtogetafeelfordevelopmentsintheglobal

economy.Intimespast,onecountryorregioncouldsufferrecessionwhileanotherboomed.Today,we’reallconnected—aphenomenoneloquentlydiscussedbyauthorThomasFriedmanandothers.

Chapter18BalticDryIndex

T

Leading

HEFUNNYTHINGABOUTtheBalticDryIndex(BDI)isthatitinvolveslotsofwater.Specifically,it’sameasureofthepriceofmovingrawmaterialsacross

theworld’soceans.InthatsensetheBDIisquitewet.The“dry”referstothestateofthethingsshipped:ironore,coal,andgrains,typically.Theyaredrycargoes,asopposedtowetoneslikecrudeoil.The“Baltic”partofthemonikerreferstotheLondon-basedBalticExchange,

whichcalculatesandpublishestheBDIweek-days.It’snotlimitedtocargoesshippedacrosstheBalticSea,however.TheBalticExchangetracksthecostofmovingfreightalongkeyshippinglanesaroundtheglobe.Theindexitcreatesreflectsthecosttorentashiptodayintheso-calledspotmarket,ratherthanapricetorentoneatsomepointinthefuture.Theseso-calleddry-bulkshipsarereallylike“massiveoceangoingdump

trucks,”saysUrsDur,seniorequityanalystformarineshippingandlogisticsatLazardCapitalMarketsinNewYork.Howbig?Thelargestofthesevesselsissobigitcan’tsailthrougheitherthePanamaortheSuezCanal.InordertotraversetheglobetheseoversizeshipsmusttravelaroundtheCapeofGoodHopeorCapeHornatthebottomofAfricaandSouthAmerica,respectively.Asaresulttheseshipsarecalled“Capes.”OthershipcategoriesindescendingorderofsizearePanamax,Supramax,andHandysize,allofwhichcanmovethroughthecanalsandareincludedintheBDIalongwiththeCapes.ThesimplestwaytothinkaboutmovementsintheBDIisthatitgoesupand

downaccordingtothedemandforthevessels.Asdemandincreases,thepricetocharterashiprises.That’sbecauseintheshortrun,thenumberofshipsavailableistypicallyfixed.Sowhentheglobaleconomyhumsandtheneedforrawmaterialsincreases,thepricetorentashiprises.WetracktheBDIbecauseitgivesaninsightintothestateoftradeinthemost

basicindustrialmaterials.Notably,ironoreandcoaltogethermakesteel—anessentialinputforconstructionandakeytothemanufactureofautomobilesaswellasmanyotherconsumerdurables.LatelythatmeanswatchingChina.Lazard’sDursayshewatchesChineseiron

oreinventoriesandtheoverallhealthofthateconomy.Inparticular,whenironoreinventoriesarelowbuttheChineseeconomyisstillhealthy,increased

importsoforemightbeinthecards.

InvestmentStrategy

DursaysinvestorscanprofitfromchangesintheBDIbyfindingapubliclytradedshippingcompanywithrevenuesthatfluctuatedaytodayjustliketheBDI.SuchacompanywouldseeitsrevenuesincreaseastheBDIrises,anditsearningsfallastheBDIsinks.Findingsuchacompanyiseasiersaidthandonebecausesomeshipperslockin

therateatwhichtheyrentouttheirvesselsforyearsatatime.Theresult:TheirrevenuegyrateslessthandoestheBDI.OnecompanythatfitsthebillisBalticTradingLtd.(BALT).Dursaysthe

firm’sstatedgoalistorentoutshipsatspotmarketrates,ratherthanlockinginpriceswithmultiyearcontracts.“ThisisapureBalticplay,”hesays.Atthetimeofwritingthefirmhasnodebtandintendstopayoutmostofwhat

itearnsindividendstoshareholders,Dursays.OthercompanieswithsomespotmarketexposureincludeEagleBulkShipping(EGLE)andNaviosMaritimeHoldings(NM),hesays.SomeanalystsalsousechangesintheBDItopredictfuturecommodity-price

movements.Forexample,aslumpintheBDImightsuggestafalloffinmetalspricesinthenearfuture.Butthatcanberisky,Durcautions.HesaysBDIchangessometimeshavelittle

todowithchangesinunderlyingdemand.Forinstance,aspikeinpricesmightsimplyindicatethelimitedavailabilityofshipsintheareaneeded.Atanygivenmoment,thesupplyanddemandforshipsislocal.Ifanavailableshipishalfwayaroundtheworldfromwhereit’sneededthatcancauseapricespikeincharterrates,butitwillbeonlytemporary.Anotherwrinkletowatchfor:adropintheBDIcausedbynewly

manufacturedvesselshittingthewater.Theywilllikelyweighdownoncharterratesforallships,regardlessofunderlyingdemandforthecargoes.

EXECSUMMARY:BALTICDRYINDEX

Whentolook:Eachbusinessday.

Wheretolook:TheunderlyingdataisproducedbytheBalticExchangein

Londonatwww.balticexchange.com/,butthereisafeeifyouwantthedata.Alternatively,youcansnagachartfromInvestmentTools.comat

www.investmenttools.com/futures/bdi_baltic_dry_index.htm,orlookatthepublicsitesofthemajorwireservices.

Whattowatchfor:Increases(decreases)intheBDI.

Whatitmeans:Increased(decreased)demandforrawmaterialsusedinmanufacturing.

Whatstepstotake:Buy(short)publiclytradedshippingcompaniesthatareexposedtodailyfluctuationsinthecostofrentingdry-bulkships.

Risklevel:Medium.


Chapter19BigMacIndex

I

Leading

N1986AJOURNALISTatTheEconomistnewspaperinLondonwonderedwhatdifferentcurrencies,liketheJapaneseyenortheBritishpound,wouldbe

worthifaBigMacburgercostthesameineverycountry.TheideabecametheBigMacIndex(BMI).“TheBigMacIndexwasanamusingwaytomakeeconomicsmorefun,”says

PamWoodall,asenioreconomicswriteratthepublication,andtheinventorofthisindicator.“Peopleloveditandwekeptdoingityearafteryear.”Whileitlooksstrangeatfirstglance,thereissomeseriouseconomicsbehind

it:thetheoryofpurchasingpowerparity(PPP).Thistheorysaysthatifinternationaltradeisunfettered,thengoodsandservicesinallcountriesshouldeventuallycostapproximatelythesameamount.Inthiscasethe“good”ofchoiceistheubiquitousBigMacburgersoldbyfast-foodretailerMcDonalds.IfBigMacscostthreeeurosinFranceandthreedollarsinNewYork,thenthelogicalexchangerate,accordingtothePPPtheory,shouldbeonedollar=oneeuro.ThebeautyofusingtheBigMacisthattheyare(moreorless)identical

everywheretheyaresold.Thatmeansnoadjustmentsneedtobemadefordifferingqualityorsize,aswouldbethecasewithnonstandardgoods.Totheextentthattheactualpriceoftheburgerinanothercountrydiffersfrom

pricesintheUnitedStates,thatcountry’scurrencyiseitherovervaluedorundervalued.IfthesameBigMaccostsfiftycentsinBeijingbutthreedollarsinNewYork,

thenbythisindicator’sreckoningtheChinesecurrencyisundervalued.

InvestmentStrategy

ThemostusefulinvestingideabehindtheBigMacIndexistopredictthevalueofforeigncurrenciesoverthelongterm.LatelyabigquestioninforeignexchangemarketsandpolicycircleshasbeenwhethertheChinesecurrency,theyuan,isundervalued.Aquicklookatthe2010BigMacIndexprovidesadefinitiveanswer.Notonlyistheyuanundervalued,itisthemostundervaluedcurrency—possiblybyasmuchas50%.Bythesamemeasure,theMexicanpesoisalsoundervaluedbyover25%.SoshouldyouinvestincurrenciesthatareundervaluedaccordingtotheBMI?TheEconomist’sWoodallsayssomepeopleclaimthattheBigMacIndexisa

betterpredictorofthevalueofacurrencythanmoresophisticatedeconomicmodels.Shealsonotesthatmanyacademicstudiesshowitsvalidity.ButWoodallcautionsthatthereisawrinklethatdistortstheBMI.The

problem:AlthoughBigMacsaresoldlikeanyothergood,theycan’treallybestoredforuseweekslater.Weknow.Oneofustriedanditdoesn’tendhappily.ThatmakestheBigMacmorelikeaservice,somethingtobeconsumedwhereit’spurchasedlikeabackmassage.Sowhat?Well,therearesoundeconomicreasonswhyservicesshouldbecheaperinemergingmarkets:Wagesarecheaperthereandwagesareabigcostcomponentinservices.SothepriceofaBigMacshouldbesomewhatcheaperinBeijingthaninNewYork.Italsomeansthatevenwhencurrenciesarefullyvalued,theBMIwillshow

thatemerging-marketcurrenciesareundervalued.Sousethisindicatorasaguidetowhethercurrenciesareegregiouslyovervaluedorundervalued.Ifacurrencyisvastlyundervalued,expectittoriseinvalue,eventually.Viceversa,ifit’sovervaluedexpectitsvaluetofall.IfthesecaveatsaboutTheEconomist’sBigMacIndexmakeyounervous,

UBSWealthManagementResearchhasdevelopedaBMIvariant:ItcalculatesthenumberofhoursalocalworkermusttoiltopurchaseaBigMac.Adecreaseinthenumberofhoursmightindicateanincreaseinproductivityandhenceaneventualappreciationofthedomesticcurrency.Carefulthough—otherthingscanhaveanimpactonhowfastaworkerearnsthevalueofaBigMac,likechangingtastesordownwardmarketpressureonretailprices.Ifyoudecideyoudowanttoinvestincurrencies,asafewaytogoistolookat

thevariousexchange-tradedfundsthattrackthevalueofdifferentcurrencies

relativetotheU.S.dollar.ExamplesincludeCurrencySharesEuroTrust(FXE),CurrencySharesBritishPoundSterlingTrust(FXB),andtheCurrencySharesCanadianDollarTrust(FXC).ThereareotherfamiliesofETFsthatserveasimilarrole.Noviceinvestorswoulddowelltoavoidinvestingdirectlyinthecurrencymarketsortradingwithborrowedmoney.

EXECSUMMARY:BIGMACINDEX

Whentolook:WeeklyonFridays,whenTheEconomistispublished.

Wheretolook:TheonlineversionofTheEconomistnewspaper,Economist.com,publishestheBigMacIndex.

Whattowatchfor:CountrieswhereBigMacscostsignificantlyless(more)indollartermsthantheydointheUnitedStates.

Whatitmeans:Thelocalcurrencyisundervalued(overvalued)andhencelikelytoappreciate(depreciate)inthelongrun.

Whatstepstotake:Buy(short)undervalued(overvalued)currencies,possiblythroughacurrencyETF.

Risklevel:Astronomical.

Profitpossibility:$$$$+

T

Chapter20CurrentAccountDeficit

Leading(SeealsoTICData)

OSAYTHATU.S.consumersloveimportedgoodswouldwoefullyunderstatethesituation.No,thetruthisthatforatleastthepasttwodecadesAmericans

havegorgedthemselvesonimports,notablyfromChina.Asaresult,giganticimbalanceshaveemergedintheglobaleconomy.Theproblem,however,isnotinitselfthatAmericansbuylotsofforeign

knickknacks.Buyingstuffiswhatmakestheworldeconomygoround.TheissueisthatAmericanshavespentsomuchmoremoneyonforeignproductsthanforeignershavespentonU.S.goodsandservices.Suchasituationcanpersistforyearsbutnotforever.WecanmeasureexactlyhowmuchmorestufftheUnitedStatesbuysfrom

othercountriesthanforeignersbuyfromusbylookingattheso-calledtradebalanceorthe“currentaccount.”Formostcountriesthetradebalanceisroughlyequivalenttothecurrent

account.Inthenationalaccountsthecurrentaccountistechnicallythetradebalanceplusnetincomefrominterestanddividendsplusnetforeignaid.Sowhenpunditsandeconomiststalkaboutacurrentaccountdeficittheyalmostalwaysreallymeanatradedeficit,somethingAmericahasrunformanyyears.“Wepayforthoseimportsbyborrowingmoneyorbysellingassetstotherest

oftheworld,”saysPaulWachtel,professorofeconomicsatNYUStern.Insomewaysthisislikesellingthefamilysilvertoputfoodonthetable.Youcandoitonce,butit’snotsustainable.BecausetheUnitedStateshasrunarelativelyhightradedeficitforsolong,a

hugeimbalancehasbuiltup,explainsWachtel.Specifically,hemeansthatforeignershavelentAmericaalotofmoneytofinancethepurchaseofthose

imports.ThatcanspelltroubleaheadforthevalueoftheU.S.dollarandthehealthoftheoveralleconomy.“Themorewedothat,themoreyearsweareaccumulatingdebtstotherestof

theworld,”saysWachtel.“Thenthequestioncomesup:‘Gee,canyoupaytheinterestonthosedebtsandcanyoupaythemback?’”

InvestmentStrategy

Therealkeytomakingsenseofthecurrentaccountdeficitistolookatitssizerelativetothatoftheoveralleconomy.Inadditionitmustbelookedatoveraperiodoftimeandnotjustatonemoment.That’sbecausethetradebalancetendstofluctuatewiththebusinesscycle.Typicallyatradebalanceimprovescomingoutofarecessionandworsens

goingintoone.Soit’smoreimportanttolookatthetrendthanasinglemonthofdata.Wachtelsaysagoodruleofthumbisthatahealthyongoingtradedeficitis

under5%ofannualGDPforacountry.Whenit’sbiggerthan5%,itcanbeaproblem.“Whenwelookatsmalleremergingmarketcountriesit’sastrongindicatorof

aloomingexchangeratecrisis,”saysWachtel.Orinsimplerterms,thevalueofacountry’scurrencycouldfallprecipitouslyifthecurrentaccountdeficitexceeds5%ofGDP.HepointstoHungaryasarecentexampleofacountrythathadacurrentaccountdeficitofabout10%ofitsGDPrightbeforearapidcurrencydepreciation.HealsonotesGreecehadasimilarproblem.Theothersideoftheequation,saysWachtel,isthatcountrieswithconsistent

tradesurplusestendtoattractmorecapitalfrominvestorsand,asaresult,havefaster-growingeconomies.Thatshouldmeanthatemergingmarketeconomieswithbigsurpluseswillgrowfastinthefutureandthatmightbeagoodplacetoinvest.Americahashistoricallybeenaspecialcasewhenitcomestothetradebalance

becauseofthespecialroleoftheU.S.dollarastheworld’sreservecurrency.ThathasmeanttheUnitedStateshasbeenabletohavedecadesofsurgingimports(andhencemassivetradedeficits)withoutprecipitatingacurrencycrisis.Butlatelypeoplehavebeguntoaskthequestion:Canthistradedeficitgoon

forever?“Itmightnot,”saysWachtel.“Ifyougodowntheroadfiveortenyears,thingsmightchange.”Or,inotherwords,iftheUnitedStatesdoesn’tfixthetradebalanceproblemrelativelysoon,thevalueofthedollarcoulddrop—alot.

EXECSUMMARY:CURRENTACCOUNTDEFICIT

Whentolook:Thecurrentaccountdataisreleasedonceaquarterat8:30a.m.ETaroundthemiddleofthemonth,March,June,September,andDecember.

Wheretolook:EditorsandwritersatTheWallStreetJournalcloselymonitorthecurrentaccountdata.Whenit’sreleasedbytheCommerceDepartment,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“CurrentAccount.”Alternatively,trytheFREDdatabaseattheSt.LouisFederalReserve,which

haslotsofhistoricaldata.

Whattowatchfor:Tradedeficitsgreaterthan5%ofGDP(exceptfortheUnitedStates).

Whatitmeans:Anexchangeratecrisismayloom.

Whatstepstotake:Shortthatcountry’scurrency.


Profitpossibility:$$$$+

Chapter21OilInventories

M

Leading

UCHASFORMERU.S.vicepresidentAlGoreorPresidentBarackObamamightwantittohappen,Americahaslittlechanceofkickingitsaddiction

tooilanytimesoon.Theentireindustrialcomplexisanoil-guzzlingmonster:Trygettingtowork,

heatingyourhome,runningafactory,orbuyinganythingwithoutusinganyoil.Heck,halfthestuffinourhomes—forexample,anythingmadeoutofplastic—ismadefromit!Becauseourlivesdependsoheavilyonouroiluse,theoilmarketis

consideredasuperbandsensitivebarometerofthehealthoftheU.S.economy.Fortunatelyforthebuddingeconomistandwould-betraderthereisawealthofinformationontheenergymarket.NotablytheEnergyInformationAdministration,partoftheU.S.government,providesregularlyupdateddetailsoftheenergybusiness.Specifically,eachweek(usuallyonWednesdays)theEIAreleasesdataonthe

levelofenergyinventories.Orputanotherway,ittellstheworldhowmuchcrudeoil,gasoline,andfueloil(plusotherproductsrefinedfromoil)areonhandandavailableforuse.Thebeautyofthisregularreleaseofdataisthatanalystscancomparethestockpilelevelsweektoweek.“Lowoilinventoriesand/orabigdrawdowninthoseinventories[fromweek

toweek]isgenerallyeconomicallypositive,”saysEdwardMeir,aseniorcommoditiesanalystatNewYork–basedfuturesbrokerMFGlobal.“Itmeansyouhavestrongindustrialproduction,withfactoriesusingenergy,utilitiesusingenergy,peopledrivingtowork,flying,andboating.”Hesaysthat’sjusthowthingswerein2007and2008.Duringthattime

inventoriesweredrawndown,andthepriceofcrudeoilreachedarecordof$147abarrel,alevelthatremainsarecordatthetimeofwritingin2010.Meiralsonotesthatsuchhighpriceseventuallycrimpdemandaspeopleseektoavoidthecostofhigherenergycosts.

InvestmentStrategy

WhenwatchingtheoilinventoryfiguresthatcomeouteachWednesday,Meirsaysthekeyitemtowatchisthecrudeoilinventories(sometimesreferredtoasstocks)thatexcludethegovernment’sstrategicpetroleumreserve(SPR).TheSPRisnoteasilyavailableforuseunlessthegovernmentdecidestoreleasesomeandsoitdoesn’treallyrepresentapotentialsourceofsupply.MeiralsosaysmarketexpectationsplayabigpartinreactiontotheEIAdata.

If,forinstance,oilinventoriesareexpectedtofallbyacertainamountandtheyfallbyless,thenthatcanbeseenasasignthattheeconomyisweakerthanpreviouslythought.Likewise,abiggerdrawdownthanforecastcanleadpeopletobelievethattheeconomyisaheadofwhereinvestorsseemedtothinkitwas.Onecommoditiesmarketwrinkletowatch:Whenthecostofborrowing

moneyisabnormallylow,distortionscanoccurinthemarket,explainsMeir.Asmuchofthecostofowningcommoditiesisinhavingcapitaltiedup,whenborrowedcapitalischeapspeculatorsoftenfinditadvantageoustobuyoilasahedgeagainstinflation.Thatcanresultintheunusualphenomenonofrisinginventories(someof

whichareheldbyspeculators)andrisingpricesatthesametime.Normally,risinginventoriessignalasurplusofsupplyandgohandinhandwithfallingprices.Anotherwrinkletowatchforistemporarysupplyinterruptionscausingadip

ininventorieswhenithaslittletodowiththeunderlyingeconomicfundamentals.Sucheventscanincluderefineryexplosions,wars,drillingmoratoriums,andshipwrecks.Tobeclear,whilethesethingswillaffectthemarketpriceandinventorylevels,sucheventsfrequentlydon’treflectthehealthoftheunderlyingeconomy.

EXECSUMMARY:OILINVENTORIES

Whentolook:TheweeklydataisreleasedWednesdayat10:30a.m.ET.

Wheretolook:MarketseditorsatTheWallStreetJournalcloselywatchoilinventorydata.WhentheEIAreleasesthedata,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.

Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“EIAPetroleumStatusReport.”Alternatively,youcangettheinformationyourselfatwww.EIA.gov.

Whattowatchfor:Increases(decreases)inoilinventories(notcountingthegovernment’sstrategicreserves).

Whatitmeans:Demandisprobablyweakening(strengthening)duetounderlyingweakness(strength)intheoveralleconomy.

Whatstepstotake:Cyclicallyappropriateinvestments.Thatmeansavoid(embrace)riskyinvestmentslikestocks.Sell(buy)stocksthataresensitivetoeconomicconditions,likeindustrialcompanies.

Risklevel:Medium.


Chapter22TankanSurvey

I

Leading

FYOUAREOVERthirty,youmightjustrememberatimewhenAmericanstrembledinfearthattheJapaneseweregoingtobuyupallofAmerica’s

landmarksandthatJapanInc.wouldannihilateU.S.businesses.Itdidn’tturnoutthatway.Itseemsfunnynowaftertwodecadesofstagnation,butJapanisstill

important.It’sestimatedtobethethird-largesteconomyintheworld,justbehindChina,which,byvirtueofitsenormouspopulation,edgeditswayintothenumbertwoslotin2010.However,whileChina’seconomymaybelargernow,Japan’sisactuallymoreimportantinsomeways.That’sbecauseonaperpersonbasis,Japanisvastlyricher.ItmeansthatwhenJapaneseconsumersdecidetospendmoneyitcanhaveabigimpactontheglobaleconomy.ForanyonewantingtogetadeepunderstandingoftheJapaneseeconomy,the

TankanSurveyisthebestplacetogo.Everyquarter,Japan’scentralbankasksbusinessmeninaboutninethousandsmall,medium,andlargefirmswhattheythinkaboutbusinessconditionsinJapanandwhattheirexpectationsareregardingfuturechangesinprices,sales,employment,andexchangeratesaswellascreditconditions.It’sprobablythemostcomprehensiveeconomicindicatorontheplanet.Insomewaysit’slikeagiantJapaneseversionoftheInstituteforSupplyManagement’ssurveysonmanufacturingandservices.ThemainTankanSurveyindex,thebusinessconditionsdiffusionindex,is

easytoread:Anythingabovezeroisseenaspositiveorindicativeofeconomicgrowth,saysKurtKarl,aneconomistinNewYorkforinsurancegiantSwissRe.Likewise,areadingbelowzero,negative,isindicativeofaslowdownorrecession,hesays.Karldescribesthesurveyas“wideanddeep,”meaningthereislotsof

informationforeconomiststodigintoshouldtheyfeelthedesire.

InvestmentStrategy

IfyouareinterestedininvestinginJapan,theTankanisafantasticleadingindicator.TheaccompanyinggraphshowsJapaneserecessionsinlightgray,andthelinesshowthebusinesscommunity’sreadontheeconomy,brokendownbysmall,medium,andlargebusinesses.Togetherthesebusinessexecutivescalledrecessionandrecoveryinadvance,sometimesonlybyalittlebutsometimes,asin1990–94,wellaheadoftime,andwithnofalsesignals.NotonlyistheTankanagreatleadingindicatorbutitalsotakesongreater

weightthanitwouldinothercountriesbecauseinJapansomeothergovernmentdataisn’tasreliableas,say,intheUnitedStates.Forexample,KarlnotesthatJapan’sGDPfiguresaresubjecttowhatwouldelsewherebeconsideredwildrevisions.“It’ssomethingyoustrugglewithwhenforecastingJapan’seconomy,”saysKarl.HepointstoaninstanceofstrongpositivegrowthforJapaneseGDP

eventuallybeingrevisedtoacontraction,ornegativegrowth.Orinotherwords:Astrongexpansionwaslaterrevisedintobeingarecession.That’sprettyridiculousifyouaskus.NotonlydoestheTankanSurveynotgetrevised,butitalsoisaveryreliable

indicatorofthehealthofJapan’seconomy,Karlsays.Infact,heprefersittothegovernment’sGDPfigures.YoucanlearnalotfromjustreadingtheheadlinenumbersoftheTankan

Survey.Butyoucanlearnevenmorebydiggingdeeperandreallygettingintotheweeds.Thereareseparatedataseriesforthedifferentpartsoftheeconomy.Forinstance,inadditiontotheheadlineTankandatathereisalsoinformationthatrelatessolelytothemanufacturingsector.KarlsayshisfavoritepieceoftheTankanSurveyisthemanufacturing

indicator.Hesaysit’s“thebestindicatorofthehealthofthewholeeconomy.”HealsosaysthatwhiletheoverallqualityoftheTankandataisgood(and

betterthanthegovernment’sGDPdata),thequalityofthedatathatissubmittedbythecountry’slargemanufacturersisevenbetter.That’sinpartbecauseit’seasierformanufacturerstomeasureoutputthanitisformanagersworkingintheservicesector.Whenthereisaclearindicationofimprovingeconomicgrowthaheaditcan

makesensetolooktoinvestinJapanesestocks.Smallinvestors,orthosewithouttheresourcestoresearchindividualJapanesestocks,mightconsidertheiSharesMSCIJapanIndex(EWJ)exchange-tradedfund.IttracksabasketofJapanesestocks.Thereareothersimilarproductsavailablefromothercompaniesaswell.

EXECSUMMARY:TANKANSURVEY

Whentolook:ThebeginningofApril,July,andOctober,andmid-December,at8:50a.m.Japanesetime(that’seither6:50p.m.ETor7:50p.m.ET,dependingontheseason).

Wheretolook:ThedataispostedinTheWallStreetJournaldatacenterasitisreleased.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“InternationalEconomicEvents”for“TankanSurvey.”Alternatively,youcangototheBankofJapan,whichcreatesandpublishes

theTankanSurvey.ThankfullyitputsoutanEnglishversionatwww.boj.or.jp/en/type/stat/boj_stat/tk/index.htm.AnotherimportantindicatorforJapanistheIndustrialProductionreport,whichcanbefoundhereatwww.meti.go.jp/english/statistics.

Whattowatchfor:Surveyresultsinpositive(negative)territory.

Whatitmeans:TheJapaneseeconomyisgoingtogrow(shrink)soon,regardlessofwhatofficialgovernmentstatsmightsay.

Whatstepstotake:Buy(sell)someJapanesestocksorETFs.

Risklevel:High(duetoexchangerateuncertaintiesmostlyandJapan’soverallpooreconomicperformancesinceca.1990).


A

Chapter23TicData

Leading(SeealsoCurrentAccountDeficit,FederalDeficit)

MERICANSLOVETOSPEND,notjustconsumersbutthegovernmentalso.It’sbeenabigpartofwhathasmadeAmericathewayitis.Butthebigdirty

secretisthatnoneofthiswouldbepossibletoquitetheextentithasbeenifitweren’tforawillingnessbyforeignerstolendusthemoneytodoit.Ifforeignersweren’teagertolend,thenyoucanbesurewe’dallhavetopaya

lotmoretoborrowmoneyforeverythingfromcreditcardbalancestomortgagesandcarloans.OrthevalueoftheU.S.dollarwouldhavetobealotlowertoboostourexportsandcurbourseeminglyinsatiabledesireforoilandChinese-madestuff.Thatwillingnessbyforeignerstolendusmoneyisquantifiedindollartermsin

theTreasuryInternationalCapital,orTIC,data.TICgivesusasnapshotoftheflowsofcapitalintoandoutoftheUnited

States,explainsFrankWarnock,professorofeconomicsattheDardenBusinessSchoolattheUniversityofVirginia.Warnockdidn’tinventtheTICdata,buthedidworkondevelopingthecurrentincarnationtomakewhattheTreasurypublishesmoreusefultoresearchers.ThisdatanotonlytellsushowmuchcapitalflowedthroughAmerica’sborders

inagivenmonth,butalsoitsvariousoriginsanddestinations.Morespecifically,thedatatrackscross-borderpurchasesandsalesofstocksandbonds,pluscross-borderflowsofloansandrepaymentsbetweenbanks.Itdoesn’t,however,includeforeigndirectinvestment,wherecompaniessetuporclosedownfactories.Thisindicatormattersbecause,inthemostsimpleterms,themoreforeigners

wanttopurchaseU.S.securitiesthebetteritisforeveryoneintheUnitedStates.

That’sbecausetherateofinterestchargedtoborrowersisinlargepartdeterminedbythesupplyofanddemandfordebtsecurities.Investorspayparticularlycloseattentiontohowmuchforeignersarewillingto

paytobuyU.S.governmentsecurities.Suchsecuritiesareconsideredrisk-freeinvestmentsandallotherborrowersofnon-tax-advantagedU.S.dollarspaymoretoborrowmoney.Ifthereisasustaineddrop-offindemandbyforeignersforU.S.governmentbonds,thenit’slikelyonlyamatteroftimebeforeinterestratesriseacrosstheboard.Intheearlytwenty-firstcentury,thebigworryofinternationalinvestorsisthe

fiscalconditionoftheU.S.government.Thefederalgovernmentborrowsindollarsandcanmakedollarsatwill,sounlike,sayGreece,itstechnicalsolvencyisnotatissue—atleastnotyet.Whatinvestorsfretaboutisthefuturepurchasingpowerofthedollar,whichcandropveryquicklyindeed,notonlyathomebutespeciallyabroad.Thebigquestionintryingtopredictexchangeratemovementsoverthelonger

termis“whetherforeignersaresatiatedwithU.S.securitiesand,ifso,wouldtheythenpulloutofdollar-denominatedassets?”saysWarnock.

InvestmentStrategy

WarnocksayslookingattheTICdatafromtheyears2004–5helpedexplainaphenomenonthathadbeenpuzzlingsomeeconomists.Specifically,whywasitthatU.S.interestratesweresoloweventhoughtherewereanumberofeconomicindicatorsthatsuggestedthatinterestratesshouldgohigher?Thereason?“ForeignerswerebuyingmassiveamountsofU.S.treasury

bonds,”saysWarnock.Thatwasdrivingbondpriceshigherandinterestrateslower.“TheTICdatawerebestsuitedtocapturingthatphenomenon.”SowhenlookingattheTICdata,trytofigureoutwhetherdemandisstrong

andclimbingorwhetherit’sslackandfallingbylookingathistoricalflowsaswellascurrentones.Ifdemandlooksslack,thenit’shighlylikelyinterestrateswillrise,andeconomicgrowthinAmericawillbelower.ThereareacoupleofissueswiththeTICdata,mostnotablyitslackof

timeliness.Althoughthedataispublishedeverymonth,theperiodcoveredis,onaverage,sixweeksago.Soit’sliketryingtodrivewhileonlylookingintherearviewmirror.

EXECSUMMARY:TICDATA

Whentolook:TICdataisreleasedat9a.m.ETaroundthemiddleofthemonthforflowstakingplaceamonthandahalfearlier,(e.g.,mid-DecemberforOctoberdata).

Wheretolook:ForTICdata,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“TreasuryInternationalCapital.”Alternatively,youcangetTICdatafromtheU.S.TreasuryDepartmentat

http://treas.gov/tic/.ForTIC-likedataforothercountries,theIMF(InternationalMonetaryFund)istheplaceatwww.imf.org/external/data.htm.

Whattowatchfor:Increases(decreases)inforeigndemandforU.S.securities.

Whatitmeans:Pressureoninterestrateswillbedownward(upward).

Whatstepstotake:Watchforadditionalsignsofinterestratemovements,andthenmakeappropriateinvestments,e.g.,buying(selling)fixedincomefundsifratesappeartobeheadingdown(up).

Risklevel:Medium.


MultipleComponents

MANYECONOMICINDICATORSPOINTtochangesinmultiplecomponentsofGDP:consumption,investments,government,importsandexports(C,I,G,andNX),whichare,afterall,juststatisticalabstractionsofverycomplexandinterconnectedeconomicphenomena.Consumption,forexample,isintimatelylinkedtogovernmentviataxes—

whenweconsumemore,webuymorestuff,whichmeanssomebodysoldittousandsothatmeansprofitsgrowandcorporatetaxesarehigher.Likewise,whenbankslendmoneytobusinesses,thecompaniestakingon

theloansmightbuymachinery(boostinginvestment:I)andinturnwouldlikelygooutandhireworkerstooperatethosenewmachines.Theworkersnowemployedspendmoremoney(increasingconsumption:C)andpaymoretaxes(helpinggovernment:G).It’snotsurprising,then,thatweincludesixteenindicatorsthatpointto

multiplecomponentsofGDPinourFantastic50.

Chapter24BeigeBook

T

Coincident

HEVERYCOLORBEIGEsummonsimagesofinstitutionalmediocrityandblandneutrality.Butdon’tletthatdeceiveyouintothinkingtheFederalReserve’s

so-calledBeigeBookhasnothingtosay.Itdoes—andhow.Butunlikemanyoftheotherindicatorswecompiled,theBeigeBookdoesnotprimarilyconsistofaseriesofnumbers.RatheritisacompilationofanecdotesonthestateoftheU.S.economy.That’s

right,theFedactuallytalkstohumanbeings—specificallybusinesspeopleandeconomistsfromeachoftwelvedistrictsthatcovertheUnitedStates.Seethemaponpage133foreachdistrict’sboundaries.Thefinalreportincludesanoverallsummaryofthestateofthebroad

economy.Butmoreimportantlyitalsogivesanecdotaldetailoneachofthetwelvegeographicdistrictsseparately.It’sthatgranularinformationthatforecasterslikereading.Thebadnewsisthatmeansthereisalottoplowthroughforanyonewantingtousethisindicator.Thegoodnewsisthatthebookisonlypublishedeighttimesayearandit’s

freetoanyonewithaccesstotheWeb.OfcoursethemembersoftheFed’spolicy-makingteamgetitbeforeyoudo—abouttwoweeksbeforethescheduledFederalOpenMarketCommitteemeetings.“ItgivesusasenseofwhattheFedgovernorsarereadingandforthatreason

givesinsightintotheirownoutlookontheeconomy,”saysJoeBrusuelas,aneconomistatBloombergL.P.“Itcanbeusefulbecauseitcomesoutaheadofotherdata.”SpecificallyitcanhelpinvestorsworkoutwhethertheFedwillincreasethe

costofborrowing,leaveitthesame,orlowerit.Itcanalsoalertsmartinvestorstoforthcomingproblems.SometimesinformedpeoplewilltellyouthattheFedpublishestwomuch

moreimportantbooks:theBlueBookandtheGreenBook.Theproblemwiththosetwoisthatthepubliccan’tlookattheminatimelymanner.Thatfactmakesthemveryusefulforhistoriansbututterlyirrelevantforeconomicforecasting.Nomatterhowgoodtheinformationinanyreport,ifyoucan’tseeit,thenit’suseless.

InvestmentStrategy

Liketheotherindicators,theBeigeBookcanbeusedtohelpmakeinvestmentdecisions.CheckoutwhattheSanFranciscodistrictreportedintheNovember2006edition:

Creditqualitywashighingeneralwithfewdelinquencies.However,contactsprovidedscatteredreportsofdelinquenciesonloanstohomebuilders,andbankshaveincreasedtheirvigilanceovertheseloans.

Hindsightistwenty-twentyastheysay,butthewarningsignsabouttheapproachingfinancialcrisisthatledtotheGreatRecessionwerethereforthosesavvyenoughtospotthem.Inthatparticularcase,avoidinginvestinginhousingstocksandmortgage-relatedinvestmentswouldhavebeenprudent.Clearly,eventsliketherecentfinancialcrisisarerare,sofindingevidenceof

impendingdoomislikelytoberelativelyuncommoninthepagesofthispublication.ButtheBeigeBookdoesstillprovidenuggetsofpotentialgoldtoinvestors.“Signsofsofteningintheeconomyisbullishforbondinvestors,”says

Brusuelas.WhentheBeigeBook’sanecdotespaintapictureofaweakeconomy(oratleastaweakerthanpreviouslythoughtbusinessenvironment),thenitmaybeasignthattheFederalReservewilllowerthecostofborrowingbytrimmingshort-terminterestrates.That’sgoodforbondinvestorsbecausethevalueofbondsincreasesasinterestratesdecline,explainsBrusuelas.Thesamelogicapplieswhentheeconomyisimproving.“IftheBeigeBook

saystheeconomyisstrong,itprobablymeansinterestrateswillgoupsoonerratherthanlater,”saysBrusuelas,meaningtheFederalReservewilllikelyraisethecosttoborrowmoney.Itcouldindicateit’stimetoavoidbonds,whichwoulddeclineinvalueasinterestratesrise.TheBeigeBookcanalsobeusedtogaininsightintothestrengthofdifferent

sectorsoftheeconomy,suchastechnologyormanufacturing.That’sbecausedifferentindustriestendtobeconcentratedincertaingeographicareas.Forinstance,toseehowthetechnologysectorisdoingitwouldbesmarttoreadthesectionofthereportprovidedbytheSanFranciscoFed,saysBrusuelas.TechnologycompaniesareclusteredaroundSiliconValleyinNorthern

California.Ifthereportshowsfavorableeconomicconditionsfortechnologycompanies,thenitmightbeworthinvestinginthetechsectorofthestockmarket.Bywayofexample,theProSharesUltraTechnologyexchange-tradedfund(ROM)tracksthevalueofaslewoftechnologycompanies.Brusuelasnotesthatbecauseofitsanecdotalnaturethisindicatorshouldbeusedinconjunctionwithotherindicatorsratherthanalone.

EXECSUMMARY:BEIGEBOOK

Whentolook:At2p.m.ETtwoWednesdaysbeforethenextFederalOpenMarketCommitteemeeting.ForascheduleofitsFOMCmeetings,browse:www.federalreserve.gov/fomc/.

Wheretolook:ReportersandeditorsofTheWallStreetJournalreadtheBeigeBookdiligentlywhenitisreleased.ReportersfilesummarystoriesastheFedpublishesthereport.AsummaryisalsopostedatTheWallStreetJournalonline’s“MarketData

Center”atWSJMarkets.com.Gotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“BeigeBook.”Alternatively,youcangodirectlytotheFeditselfat

www.federalreserve.gov/FOMC/Beigebook/.

Whattowatchfor:Cluesinthereport’sanecdotesabouttheoverallhealthoftheeconomyandspecificsectors.

Whatitmeans:Afacelessbureaucratheardsomethingfromtheregionalbusinesscommunityandconsidereditimportantenoughtonote.

Whatstepstotake:Dependsonwhattheanecdoteis,e.g.,iftheeconomyappearstobeweakening,buybonds!

Risklevel:Varies.

Profitpossibility:Varies.

Chapter25CrackSpread

W

Leading

EKNOWYOUAREgoingtolovethecrackspread,butnotjustbecauseyoucanmakelotsofconstructionworkerjokes.Therearegoodeconomic

reasonsforgettingdownanddirtywiththisparticularindicator:gasoline.“Thecrackspreadisanindicatorofrefineryprofitability,”saysAdam

Sieminski,chiefenergyeconomistatDeutscheBankinWashington,D.C.Specifically,itisameasureoftheprofitabilityofrefiningcrudeoilintogasolineandheatingoil.Whenthecrackspreadiswide,it’smoreprofitabletorefine.Whenthespreadisnarrow,it’slessprofitable.Ifitwereevertogonegative,andstaythatway,thenrefiningwouldactuallybealoss-makingpropositionandwe’dlikelyhavenogasolineatthepumpswithwhichtofillourtanks.Still,there’dbeplentyoftimetoreaduponothereconomicindicatorsinstead.It’scalledacrackspreadbecausecrudeoilissaidtobecracked,orbroken,

intootherstuff,likegasoline,dieselfuel,heatingoil,andlotsofotherpetrochemicals.Thetruthisthattherearemanydifferentcrackspreads,buttheoneinvestors

mostcareaboutistheonebetweencrudeoilandgasoline.Itmakessense.Afterall,muchofoureconomyrunsongasoline.Thecrackspreadwidensandnarrowsbecausethepriceofgasolineandcrude

oildonotmoveinsync.Why?“Becausethethingsthatinfluencethecrudeoilmarketandthegasolinemarketaredifferent,”explainsDeutscheBank’sSieminski.“Ifarefineryshutsdownbecauseofafireorexplosion,thenheatingoilorgasolinepriceswouldlikelyreactbutnotthoseofcrudeoil.”Likewise,announcementsfromOPEC(OrganizationofthePetroleum

ExportingCountries)likelywouldaffectthepriceofcrudeoilbutprobablywouldn’thaveanimmediateimpactongasoline,hesays.

InvestmentStrategy

Thefirstimportantthingtonoteisthatcrackspreadsareseasonal:Moregasolineneedstobeproducedduringthespringandsummerandmoreheatingoilinthefallandwinter.Moreover,duringtheannualproductionfacilitymaintenanceperiod—traditionallyinlatewinter—crackspreadsriseasfewerrefinersaremakinggasoline.Thatmeansthefewthataremakingfuelcanchargemore.ManyobserversbelievethattotalU.S.oil-refinerycapacityisbelowthat

requiredduringpeakperiodsofdemand.Withthosecaveatsalwaysinmind,investorscanusethecrackspreadto

predictfuturesupplyanddemandconditionsforfossilfuels.Whenthecrackspreadislow,refinersarenotmakingmuchprofit.(Thespreadonlyoccasionallygoesnegative,butlongbeforethatitcanbecomeunprofitableforsomehigh-costcompaniestorefineoil.)Refinersarethereforenotlikelytoincreaseproductionanytimesoon,solookforadecreaseindemandforcrudeandadecreaseingasoline/heatingoilinventories.Whenthecrackspreadishigh,bycontrast,refinerstrytomakewhilethemakingisgood,sodemandforcrudewillrise,aswillsuppliesofgasolineandheatingoil.DB’sSieminskisaysinvestorscanprofitfromwidercrackspreadsbylooking

atthoseenergycompaniesthatareheavilyinvolvedintherefiningbusiness.InparticularhehighlightsValeroEnergy(VLO).Whencrackspreadsarewide,Valerowillbenefitfromtheimprovedprofitability.Whenthecrackspreadsarenarrow,thefirmwilllikelyseeitsprofitsdiminish,hesays.It’simportanttonotethatjustbecauseacompanyisintheoilbusinessdoesn’tmeanitisheavilyexposedtotherefiningbusiness.You’llneedtodoyourownresearchbeforebuyinganystock.Notealsothatthecrackspreadprovidesinformationaboutonlyonesideof

eachmarket,thedemandforcrudeandthesupplyofitsdistillates.Useotherindicators,liketheBalticDirtyTankerIndex,todiscernthefuturesupplyofcrudeanddemandforitsdistillatesandyou’llbepreparedtoprofitinthosemarketsandalsotobetterunderstandtheeconomy’spositioninthebusinesscycle.

EXECSUMMARY:CRACKSPREAD

Whentolook:Continuouslyforenergyprices.Energytradesaroundtheworldmostbusinessdays.

Wheretolook:EnergypricescanbeeasilyobtainedinTheWallStreetJournalonline’s“MarketDataCenter.”You’llfinditatwww.WSJMarkets.com.Whenyouarethere,you’llneedtogoto“Commodities&Futures”sectionandlookunder“Energy”for“Petroleum.”Thereyouwillfindpricedataonlightcrudeoilandgasoline.That’sjustthefirststep.Afteryouhavethepricesofthenear-termcontracts,you’llneedtodosomemath.Calculatingthecrackspreadisalittletricky,though.Crudeoilpricesarequotedbythebarrel,whilegasolineandheatingoilarequotedbythegallon.(Thereareforty-twogallonsinabarrel.)Thereisalsothequestionofweighting.Traditionally,threebarrelsofcrudewillproducetwoofgasolineandoneofheatingoil,butothercombinationsarepossible.Usingthetraditional3–2–1method,thecrackspreadequationis:(84gasolineprice+42heatingoilprice—3*crudeprice)/3.Alternatively,

theNewYorkMercantileExchangedivisionoftheCMEGroupprovidesahandycalculatoratwww.nymex.com/calc_crack.aspx/.Togetregularhistoricalchartsofcrackspreads,you’lllikelyhavetosubscribe

toafee-baseddataservice.

Whattowatchfor:Higher(lower)crackspreads.

Whatitmeans:Refiningoilintogasolineismore(less)profitable.

Whatstepstotake:Buy(sell)refinery-heavystockslikeValero.

Risklevel:High.


T

Chapter26CreditAvailabilityOscillator

Leading(SeealsoLibor)

HEFILMCABARET’sfamoussong“Money,Money”getsitalmostrightwhenitsays“Moneymakestheworldgoaround.”Thetruthisthatforbusinesses

andtheeconomyit’scredit,orborrowedmoney,thatreallykeepsthingsgoing.Theworldfoundoutexactlyhowmuchcreditkeepsthingsgoingwhenitall

driedupinthefallof2008duringtheGreatCreditCrunch,whichquicklywentontobecometheGreatRecession.Ifthecreditcrisisof2008taughttheworldanything,it’sthatwithoutthefree

flowofborrowedmoney,theworldofbusinessquicklycomestoastandstill,andwiththatsodoestheeconomy.Broadlyspeaking,whenloansaremoreavailabletobothbusinessesand

individuals,moreeconomicactivityoccursandtheeconomyexpands.Whenloansarehardtocomeby,youcanexpectbusinessactivitytoslowdownandtheeconomytofalter.Thatwastheideainmindin2007whensomesavvybondmarketanalystsat

PhiladelphiainvestmentbankJanneyMontgomeryScottdevelopedtheCreditAvailabilityOscillator.Thattheirworkpredatedthecreditcrisisonlyshowshowprescienttheywere.GuyLeBas,headoffixedincomestrategyatJanneyandakeyarchitectofthe

CAO,sayshewaskeenlyawareoftheeconomy’sdependenceoncredit.“Borrowingavailabilityisahugepartofconsumerspending,”saysLeBas.In

2007hewasparticularlyworriedaboutwhatwouldhappentospendingifhomeownerscouldn’trefinancetheirmortgages.That’swhyhedevelopedtheCAO,whichispronounced“cow.”Nojoke.AlthoughJanneykeepstheCAO’sexactinternalworkingstopsecret,LeBas

doesdetailsomeofthemanymetricsused,whichincludebothqualitativeandquantitativeinputs.Theyareallfocusedondetermininghoweasyorharditistoborrowmoney.Asurveyofqualitativedataiscollectedquarterlyonthedifficultyofobtaining

differenttypesofloans.Thatquarterlydataissupplementedwithdailyquantitativeinputs.(Thoseinputsshouldbecalledmoos—moosinthecao.Geddit!)TheresultisadailyCAOreading.Thequantdataincludesthepricesatwhichcertaintypesofbondsaretrading,

particularlythoseinvolvingautomobileloansmadetoconsumersaswellasborrowingbypeoplewithalessthanstellarcredithistory,so-calledsubprimeborrowers.Alsoincludedaretheinterestratesatwhichbankslendtoeachother,theLiborrate,akeymeasureofhowwellcreditisflowingbetweenlendinginstitutions.AlthoughtheCAOwasonlydevelopedin2007,Janneyhasdeveloped

historicaldatatoprovidecontext,asshowninthefollowingchart.

InvestmentStrategy

Unlikesomeothereconomicindicators,theCAOisrelativelyeasytounderstand.Zeroindicatesaneutrallevelofcreditavailability.Ittellsyouthatit’sneitherveryeasynorveryhardtoobtainaloan.Apositivereadingsayscreditisflowingrelativelyfreely.Inthemid–2000s,theindicatorregisteredinthe20sand30s,butinlate2006theindexplungedandturnednegativeforthefirsttimesince2002.“Itwastellingusthatlendingconditionswererapidlydeteriorating,”says

LeBas.“Theimplicationsareverybroadbecauseitsuggestsweakercorporateprofitability,lowerdemand,andsoftereconomicgrowth.Thosearethebigpictureimplications.”CAOdatathatincludesqualitativesurveydatafromtwoorthreequartersisof

coursemoreindicativeoftrendsthanasingledatapoint.BecauseLeBashasaccesstothecomponentdatainputs,hecanalsoseewhetheranypossibletrendisbroadlymatchedbythemajorityofinputsorwhetherit’stheresultofadataanomaly.Specialnote:AveryhighCAOmightbeusedtohelpidentifyanassetbubble,

suggestingthatinvestorsshoulddeleverage(orpaydowntheirloans)andmoveinvestmentstocash.

EXECSUMMARY:CREDITAVAILABILITYOSCILLATOR

Whentolook:WhenyourJanneyMontgomeryScottresearchreportarrives.

Wheretolook:TheCAOisaproprietaryindexofJanneyMontgomeryScott.That’sgoodnewsifyouareaclientofJanney’s.LeBassaysinformationontheCAOisprovidedtothefirm’sclientsthroughitspublishedresearch.Ifyou’renotaJanneyclient,thenfollowingtheCAOwillbemoretricky,but

notimpossible.ResearchreportsofallthemajorbankshavetypicallymanagedtofindtheirwayacrosstheWeb.SoscouringtheInternetmightbeausefulstart.Inaddition,thissortofindicatortendstogetfollowedbythepressespeciallywhentherearemarkedchangesinthelevels.That’spreciselythetimeyou’dwanttohearaboutit.

Whattowatchfor:TheCAOmovingup(down).

Whatitmeans:Borrowingiseasier(harder)sotheeconomywilllikelygrow(shrink)inthenearterm.

Whatstepstotake:Lookslikeagoodtime(reallystinkytime)togoforbrokeinthestockmarket.

Risklevel:Medium.


W

Chapter27FederalFundsRate

Leading(SeealsoLibor,TedSpread,CreditSpreads,YieldCurve)

HENYOUDRIVEAcar,yousteponthegaspedaltomakeitgofasterandthebraketoslowthingsdown.Well,theFederalReserve,theU.S.central

bank,hasasimilargadgetfortheeconomy.IftheFedwantstoslowdowntheeconomy,itraisesitsso-calledFedfundsinterestrate,therateatwhichbankslendtoeachotherovernight.Ifitwantstospeeduptheeconomy,itlowerstherate.Ofcoursedrivingtheeconomythiswayisabittrickierthandrivingacar.The

FedfundsrateisatargetsetbytheFed’sFederalOpenMarketCommittee(FOMC).It’seffectivebecausetheratedirectlyaffectsotherinterestrates,includingmortgagepaymentsforadjustable-ratemortgages(so-calledARMs),creditcardrates,andtheinterestthatbankspaytocustomersontheirsavingsaccounts,explainsEllenZentner,aNewYork–basedeconomistattheBankofTokyo-Mitsubishi.“WhentheFOMCchangestherate,itchangesthecostofdoingbusinessfor

thebank,”saysZentner.“Whenthosecostsareraised,theyareimmediatelypassedontotheconsumers.”SoiftheFedraisesratesithasaquickimpactofincreasingthecostof

consumerloansandcreditcarddebt.Thatleavespeoplewithlessmoneytospendongoodsandservices.Forthatreason,theeconomywilltendtoslowdown—oratleastgrowthwillmoderate—whentheFedfundsrateishiked.AlthoughtheFOMCtendstoraiseratesinsmallincrements,itcanhaveabig

impactonsomepeople.“AtinychangeintheFedfundsratecouldrepresentthestrawthatbreaksthecamel’sbackforanyhouseholdthatisburdenedwithdebt,”explainsZentner.Likewise,adropintheFedfundsratecanbemannafrom

heavenforpeopledeepincreditcarddebt,asitlowerstheirmonthlypayments.

InvestmentStrategy

TheFedfundsrateissocloselywatchedthatotherbusinessatthebigbankscancometoahaltwhentheFOMCisexpectedtomakeadecisiononwhethertochangeinterestrates.Thevalueofstocksandbondsisdeterminedinpartbyinterestrates.In

general,lowerFedfundsratesmeanbondsareworthmore.Stockscanalsobeworthmorewhenratesarelowbecauseitmeansthecostofborrowingislower,meaningmoremoneyisleftforprofitsandlesspaidtothebank.Forthatreason,sometimesunexpectedlybadeconomicdataonjobs,

manufacturing,andsoforthcanactuallycausebondandequitymarketstomovehigherbyincreasingexpectationsthattheFedwillcutitstargetrateoratleastleaveitunchanged.TheFedfundsrateisnoteasytopredict.Butit’snotablethatnotasingle

recessionsinceWorldWarIIhasendedwithoutagood-sizereductioninFedfundsrate.Onseveraloccasionsinthe1960s,70s,90s,and2000s,theFedbegancuttingratesbuttoolatetopreventarecessionfromoccurring.Asshownintheotheraccompanyinggraph,therecessionof2008–9wasoneofthoseinstances.

EXECSUMMARY:FEDERALFUNDSRATE

Whentolook:At2:15p.m.ETondaysthattheFederalOpenMarketCommitteemeets,whichisatleasteverysixweeks.Foraschedule,browse:www.federalreserve.gov/fomc/.

Wheretolook:GotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Lookunder“Bonds,Rates&CreditMarkets”tabfor“ConsumerMoneyRates”andfindthe“FedFunds”targetrate.TheSt.LouisFed’sFREDdatabaseisanotherfavoritesourceforhistorical

dataontheFedfundstarget(andallotherinterestratesandlotsmorebesides).AnynumberofnewsoutletswillposttheFOMC’smostrecentannouncementwithinsecondsofitsrelease.ForexpectationsaboutfutureFedfundsratechanges,seethefederalfunds

futures.HowFedfundsfuturesworkisnicelydescribedbytheClevelandFedat

www.clevelandfed.org/research/data/fedfunds/.

Whattowatchfor:Increases(decreases)inthefederalfundstargetrate.

Whatitmeans:Theeconomyislikelytoslowdown(speedup)inthecomingmonths.

Whatstepstotake:Startselling(buying)manufacturingstocks.Alsothinkaboutwhichcompaniesaregoingtomakeitthroughthecomingeconomicstormrelativelyunscathed.

Risklevel:Low.

Profitpossibility:$

Chapter28FertilityRates

I

Leading

FSEXDOESN’TMAKEtheworldgoround,itcomesprettyclose.That’sbecausebirthsofpeople—thefrequentresultofhavingsex—drivesspendingpatterns

fordecadesafterward.Theideahereisthatpeopleasagrouptendtofollowdistinctpatternsof

activitydependingontheirage.Forinstance,Americanstypicallygetmarriedandhavechildrenintheirlatetwenties.Atthesametimetheytendtobuyhouses.Laterthechildrengrowup,leavehome,andthentheparentssavetogetreadyforretirement.However,eachgenerationisn’tuniforminsize.AfterWorldWarII,ahuge

spurtinbirthsintheUnitedStates—thebabyboom—createdademographicbulgethathasdrivenmanytrendsinthelatterhalfofthetwentiethcenturyandthefirstpartofthetwenty-firstcentury.“Thebabyboomgenerationhasraisedtheirfamilies,hasstartedsavingtheir

money,andnowtheyarebeginningtoretire,”saysHarryS.DentJr.,authorofTheGreatDepressionAhead(2009).Denthasstudiedbirthtrends—alsoknownasthefertilityrateinthejargonofdemographers—andwhat’sparticularlynoticeableisthatthegenerationbornimmediatelyfollowingtheboomers,generationX,ismuchsmallerinsize.Becausethesegenerationsdifferinsize,thewaythatoverallincomewillbe

dividedamongdifferentareasoftheeconomywillchangeradicallyovertime.Forinstance,theportionofincomespentonhealthcareissettoincreaseasthebabyboomersage.Thisstudyoflikelyoverallspendingpatternsgiveseconomistsandinvestorsalikeaglimpseofthefuture.Theotherthingweknowaboutfertilityratesisthattheygodownascountries

getricher.Ormoresimply,womenintherichernationsoftheworldtendtohavefewerbabies.Thetheorybehindthisisthatthereislesseconomicincentivetohavechildreninrichercountries.Forinstance,inpoorcountrieschildrencanbeputtoworktohelpmakeends

meet.Alsowhenpeoplegrowold,morechildrenareavailabletolookaftertheirparents,ifnecessary.Thosethingsarelessofanissueinthericherstatesoftheworldwheretosomeextentlawspreventchildrenfrombeingputtoworkandwheregovernmentstypicallyprovideasocialsafetynetfortheelderly.

Thuseconomieswherepeoplearegettingricherwillseesmallerfamiliesandmorediscretionaryincomeforspendingonthingslikeeducation,automobiles,andhouses.

InvestmentStrategy

Fertilityrateshavesomeseriousimplicationsforinvestors,especiallywhenitcomestoassetallocation.Forexample,DentpointsoutthatthedemographicslookpositivefortheU.S.healthcareindustry,sothosestocksmaybeworthalookforinvestorswillingtotakearisk.Thereasoningworksasfollows:Mostpeoplespendmoreonhealthcareastheyage.Thebabyboomersarenodifferent,butbecausethereareproportionatelysomanymoreboomersthantherearepeopleinothergenerationsintheUnitedStates,healthcarebusinesseswillneedtogrowfasterthantheoveralleconomyinordertokeepupwithdemand.Thepubliclytradedhealthcarestockswillinalllikelihoodbenefitfromthis

trend.Forthatreason,demographicssuggestthatinvestorsmightwanttoconsideroverweightingtheirassetallocationtowardhealthcarestocks.Asusualtherearemanyfactorsatplay,sosavvyinvestorsshoulddotheirownresearchbeforemakinganydecisions.Dentalsoseesthedemographicbulgecausedbythebabyboomleadingtoan

increaseintheoverallsavingsrate.Thethinkingbehindthisisclear:Aspeopleheadclosertoretirement,theytendtosavemore.Thisisnothingnew;theparentsoftheboomersdidthesame.Andiftherewerenotademographicbulge,thisfactwouldhavenoeconomicimpact.Ifthatwerethecase,increasedsavingbytheboomergenerationwouldbeoffsetbymorespendingbythesubsequentcohort,generationX.Butthereisademographicbulge,sospendingbygenerationXwillnotfillthe

voidcreatedbyboomersincreasingtheirsaving.DentseestheincreaseinsavingsasdetrimentaltotheU.S.economy.High

savings,inhisview,willmeanlowergrowthforaconsiderableperiodandasluggishstockmarketforaboutadecade—throughabout2020hesays.Inourviewthenetincreaseinsavingsalsomeansmoremoneywillbe

availableforinvestment.Economistsareforevertellingpeoplethatsavingsmustequalinvestmentwhenlookedatintheaggregate.It’struethatthemoneybeinginvestedwon’tflowtothesameplacesasit

wouldifitwasspentforconsumption.Butitwillgosomewhere,andthetrickistofollowwherethatinvestmentmoneyisgoing.Todoso,you’llneedtousetheothereconomicindicators.Inparticular,checkoutdurablegoodsorderstoseeif

thereisgrowthinmachineryinvestment.

EXECSUMMARY:FERTILITYRATES

Whentolook:Thelagsonbirthdataarelongandvariabledependingonthecountry.Sograbrecentdatawheneveryoucan.

Wheretolook:FortheUnitedStatesupto1998,useHistoricalStatistics,aswedidabove.Formorerecentdata,seetheNationalCenterforHealthStatisticsatwww.cdc.gov/nchs/,especiallytheannualreportHealth,UnitedStates.Fordataonothernations,gotoNationMaster.comatwww.nationmaster.com/graph/peo_bir_rat-people-birthrate.OrcheckouttheCIAWorldFactbookatwww.cia.gov/library/publications/the-world-factbook/rankorder/2054rank.html.YoucanalsolookatHarryDent’sbook,TheGreatDepressionAhead:Howto

ProsperintheCrashFollowingtheGreatestBoominHistory.Wedon’tnecessarilybuyalltheideashepromotes,buthedoesshowhowbirthratedatacanbeusedtohelpinvestorsmakeallocationdecisions.

Whattowatchfor:Demographicchanges,especiallyfertilityrates.

Whatitmeans:Futurechangesinaggregatedemandandthedemandforspecificgoodsandservices,suchaseducationandhealthcare.

Whatstepstotake:Buyhealthcarestockswhiletheboomersageandstillhavethemoneytopay.Buyhighereducationstockswhensmallbulgesareduetoentercollege.

Risklevel:High.


Chapter29GrossDomesticProduct(GDP)perCapita

H

Coincident

OWDOWEKNOWifwearegettingricher?PercapitaGDPisoneofthebestwaystoanswerthatquestion.Orputanotherway,howmuchdoesthe

averagepersonearn/produceinacountry?ThehigherpercapitaGDPisthericherthepeopleinthatcountryare,onaverage.Despiteitsobviousimportance,thisindicatorreceivessurprisinglylittleexplanation.Here’sanexample:Forthefirsttimeinoveracentury,China’seconomyisprojectedtobebiggerthanthatofJapanin2010.DoesthatmeantheChinesepeopleareonaveragericherthantheJapanese?Yomino!(YomiistheShintowordforhell,bytheway.)China’sslightlyhighertotalincomeisdividedamongmany,manymorepeople.TheofficialestimatesfromtheCIAshowbothcountrieswitheconomiesof

about$5trillionin2009.Buthere’stherub:Japanhasonly130millionpeopletoChina’s1.3billion.SoGDPpercapitainJapanwasabouttentimesthatofChina.“Inthesamewayadoctorlistenstotheheartbeatofapatienttodetermine

theirbasichealth,aneconomistlooksatthepercapitaGDPtounderstandthehealthoftheeconomy,”saysRobertDye,senioreconomistatthePNCFinancialServicesGroupinPittsburgh.“AhighpercapitaGDPcountrywillhaveamoredevelopedeconomy.”DyesaysthatpercapitaGDPisoneofthekeydeterminantsofstandardof

living.Ingeneral,peoplewholiveincountrieswithhighpercapitaGDPtendtohavehigherstandardsofliving.Animportantcaveat,hesays,isthedistributionofincome.Isincomewidely

distributedwithmostpeopleearningclosetotheaverage?Orisincomeconcentratedinthehandsofanelitefewwhohavemassiveincomeswhiletherestofthepopulacescrapesby?Clearly,thosetwoscenariosaren’tcomparable.ThebestwaytomeasureequalityistheGinicoefficient.Atzero,allincomes

areexactlyequal.At1(or100),onedudehasitallandeveryoneelsenothing.Neitherhaseverbeenobserved,notevenincommunistcountriesorSaddamHussein’sIraq.ManycountrieswithGinicoefficientsbetween.15and.45—prettyequalincomes—exist.Thatisimportantbecausecountrieswithwidelydispersedincomes(lowerGiniscores)aremorepoliticallystableandalsoarebetterforbusinessrelativetothosewhereincomeisconcentratedinthehandsof

afew.

InvestmentStrategy

Ascountriesgetricher,thepeopleinthosecountriescanstarttoaffordmorethanjustthebasicnecessities.“Whenyouliveonadollaraday,thenyoucan’taffordmuchmorethanfood,”saysDye.“Butasyougetricheryoucanstartspendingonluxuries.”Atthatlevel,we’reprobablytalkingaboutshoes,clothes,andlightbulbs.Still,

that’showprogressstarts,oneconvenienceorcomfortatatime.Countriesbeginningtosurfupthe“rich”scalecanprovidegoodmarketsfornewproductsforagrowingconsumerculture.Again,therearecaveats:Checkoutthelegalstructureinthosecountries.In

general,agoodlegalstructureforbusinessesprotectspropertyrightsandensuresminimalcorruption.CountriesatthebottomofthepercapitaGDPladdertypicallyengageinlow

value-addedagricultureandlowvalue-addedmanufacturing.Togetuptheladdertheyneedtostartengaginginhighervalue-addedbusinesses.Watchforcountriesthatareusinggovernmentpolicytodrivethatdevelopmentprocessaspotentiallyfast-growingeconomies.Chileinthe1970sisagreatexampleasisSouthKoreainthe1960sthroughthe1990s.Ingeneral,investorsliketoinvestinfast-growingeconomieswithfriendly

legalsystems.Aswithanything,thepotentialforhighrewardscomeshandinhandwithbigrisks.Sotomitigatetheriskofinvestingdirectlyinso-calledemergingeconomies,typicallythroughlocalstocks,itcanmakesensetopicksophisticatedcompaniesthataredoingbusinessinthoseplaces.U.S.-basedmultinationalcorporationsareagoodplacetostart.

EXECSUMMARY:GROSSDOMESTICPRODUCT(GDP)PERCAPITA

Whentolook:ThefirstestimatesforGDPcomeoutat8:30a.m.ETthefinalweekofJanuary,April,July,andOctober.Amonthlaterarevisionisreleasedandamonthafterthatasecondrevision.Soneartheendofeverymonthyou’llfindsomesortofanestimateofGDP.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchGDPdata

closely.Asnewsaboutitisreleased,Journalre-portersfilebreakingnewsstoriesforpublicationonWSJ.com.Alternatively,MeasuringWorth.comhasannualdataforAmericaandthe

UnitedKingdom.ForothercountriesseeNationMaster.comortheCIAWorldFactbookatwww.CIA.gov.TheOECDprovidesdataatwww.OECD.org,andtheWorldBankwebsitesatwww.worldbank.orgarealsogoodsourcesforothercountries.

Whattowatchfor:IncreasesinrealpercapitaGDP,alowordeclininglevelofincomeinequality,andatolerableadministrationofjustice.

Whatitmeans:Rapideconomicdevelopmentmaybeintheoffing.

Whatstepstotake:Takeequitystakesinmultinationalenterpriseswithheavyexposuretotheemergingmarketor,fortheriskloving,itsdomesticcompanies.Multinationalenterprisesarethosecompanieswithextensiveoperationsacrosstheglobe—thinkPepsi,GeneralMotors,andCaterpillarasexamples.

Risklevel:Mediumtoastronomical.

Profitpossibility:$$to$$$$

Y

Chapter30Libor

Leading(SeealsoCreditAvailabilityOscillator,TedSpread)

OUMIGHTFEELTHATsometimesthebankdoesn’ttrustyou.Well,ifyouthinkthat’sbad,getthis:Sometimestheydon’teventrusteachother.

Wecanmeasuretrust(orthelackthereof)bylookingattheinterestratebankschargeeachotherforshort-term,unsecuredloans—meaningthereisnothingbackinguptheloansotherthanthegoodfaithandcreditworthinessoftheborrowingbank.Thecostinpercentagetermsforabanktoborrowmoneyundersuchtermsis

knownastheLibor,ortheLondonInter-bankOfferedRate,andit’spublisheddailybytheBritishBankers’Association(BBA).AshrafLaidi,chiefmarketstrategistatCMCMarketsinLondon,saysrising

Liborratesreflectadeclineintheavailabilityoffundsandstressesintheoverallfinancialsystem.Ormoresimply,whenLiborrises,moneyisn’tflowingasfreelybetweenthebanks.“WhentheLiborisbeingresetinLondonatelevena.m.,thatispartiallyapulseofliquidityamongstbanks,”hesays.Liboriscalculatedfortendifferentcurrencies,includingtheAmerican,

Australian,Canadian,andNewZealanddollars,Britishpoundssterling,Swissfrancs,Japaneseyen,Danishkrones,andSwedishkronas.Theratesarealsosetforvaryinglengthsofloans,fromasshortasovernightthroughaslongastwelvemonths.Inshort,it’salotofnumbers.OfficialLibordatagoesbackto1986whentheBBAhelpedtostandardizethe

measurementoftheserates.Thatwasparticularlyimportantatthetimeduetotheintroductionofathen-newfangledderivativeproductknownasaninterestrateswap.Liborhasimplicationsfarbeyondjustwhatbanksthinkofeachother.That’s

becauseLiboristhebasisforhowmuchinterestischargedformanyadjustable-rateloansmadetoconsumersandotherbusinesses,includingfloating-ratemortgages.ThatalonemakesLiborimportantbecausehousingcostsusuallyrepresentthe

biggestmonthlyexpenseformostconsumers.Whenmortgagecostsjump,peoplehavelessmoneytospendonotherthingsandatworstcanleavepeopleunabletopaytheirmortgages,andwedon’thavetotellyouthatcanspellbigtrouble.

InvestmentStrategy

Forthemostpart,Libordoeswhatinterestratesnormallydo—fallduringrecessionsandriseduringbooms.Theeconomicsofthisissimple:Demandbyconsumersandbusinessestoborrowmoneychasesupinterestratesduringtheeconomicgoodtimes.Theoppositeoccursduringaneconomicslump—fewerpeoplewanttoborrowlessmoneysointerestratesfallback.Liborisparticularlyinsightfulduringfinancialcrises.Itdroppedleadinginto

therecessionof2008aswewouldexpect,butthenitspikedduringthefinancialcrisisthatfall,astheso-calledcreditcrunchtookhold.Laidisaysthatspikesinrates,justliketheonein2008,wereasignoflackof

liquidityinthefinancialsystem.Thespikeinratesalsorepresentedariskpremium,alargepaymentdemandedofthosewithmoneytolendduringperiodsofmassiveuncertainty.Afterthepanickedatmospheresubsided,Liborfelltonewlows,indicatingthatnormalcywasreturningtothebankingsystem.

EXECSUMMARY:LIBOR

Whentolook:Daily.

Wheretolook:LibordataiseasilyfoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tabandlookunder“ConsumerMoneyRates”forLibor.Alternatively,theBritishBankers’Associationhassetupaweb-site

specificallyforthepurposeofprovidinginformationonLibor,www.bbalibor.com,whereyoucandownloadcurrentandhistoricdataonLiborratesindifferentcurrencies.ItalsohasaTwitterfeed:twitter.com/BBALIBOR.NotethattheBBAstressesthedataisforpersonaluse,notforbusinesses.Thatmaybegoodenoughforyourpurposes.Anotheravenueworthpursuing:LibordataisavailablefromEconomagic.com

atwww.economagic.com/libor.htm.

Whattowatchfor:Increases(decreases)inLiborrates.

Whatitmeans:Theeconomyisheatingup(coolingdown)orbanksare

demandingahigh-riskpremiumduetouncertainty.

Whatstepstotake:Takeappropriatecyclicalactionifthechangeappearslinkedtothebusinesscycle;scrambleforcashifaspikeisduetopanic.

Risklevel:Medium.


M

Chapter31M2MoneySupply

Leading(SeealsoCreditSpreads)

2ISAMEASUREofhowmuchmoneythereisintheeconomy.Itisrelativelyeasyforyouandmetodeterminehowmuchmoneywehave(ordon’t

have),butit’smuchhardertoknowthesamefortheoveralleconomy.That’sbecauseforeconomists“money”isanebulousterm.It’snotjustbillsandcoins,butalsocanincludebankaccounts.Andthere’swhereitstartstogettrickybecausetherearemoneylikeaccountsthatworkjustlikebankaccountsatplacesthataren’tbanksandsomebankaccountsthatcan’tbeincludedforonereasonoranother.Soeconomistscameupwithdifferentmeasuresofmoney,fromverynarrow

(M0)toverybroad(M3)ones.M2isabroadmeasureofhowmuchmoneyisintheeconomy,anditincludespaperbills(notes)andcoinsaswellascheckingandsavingsaccounts.Notallbankaccountbalancesareincluded,onlythoseworthlessthan$100,000.Also,somenon–bankaccounts,likeretailmoneymarketmutualfunds,areincluded.TheFederalReservecaninfluencethesizeofM2becauseithastheabilityto

createmoneyoutofnothingandtoreturnittothatsamenothingness.TheFedperformsthismoneymagicbybuyingorsellingU.S.governmentdebt,orsimilarfinancialinstruments.WhentheFedsellsTreasuries,itdoessoforcashandbydoingsoittakesthatcashoutoftheeconomyandreducesthemoneysupply.WhentheFedbuysTreasuries,itusescashtomakethepurchase.Orinotherwordsitpumpsmoneyintotheeconomy,expandingthemoneysupply,includingM2.Typically,theFeddeliberatelyincreasesM2tospeeduptheeconomy.It

decreasesM2toslowtheeconomy.Butit’snotjusttheFedthatdetermineshow

muchmoneyisintheeconomy.Commercialbanks,likeWellsFargoandtheBankofAmerica,cancreateordestroymoney,specificallydeposits,aswell.Theydosobymakingloansandcreditingtheborrowers’checkingaccounts.Duringaneconomicexpansion,whentheeconomyisgrowing,bankersmakeloansmorefreely.Inrecessionstheyarestricteraboutmakingloans,leadingtotheadagethatabankergivesyouanumbrellawhenthesunisshining,buttakesitawayonceitrains.

InvestmentStrategy

M2canhelpforecastwhethertheeconomyisabouttoexitarecessionorenterone.It’snotfoolproof,butifusedcarefullyyoucangetanideaofwhatisgoingonsoonerthanbywaitingtoseeGDPdata.Bythentheturningpointislonggone.ThetheoryisthattheeconomygrowswhentheM2growthrateincreasesbut

contractswhenM2declines.Forexample,theU.S.economywasinrecessionfromMarchuntilNovember2001.ThedatashowsthattheannualrateofM2growthslowedconsiderablyin1999,andin2000itremainedbelowthe1997–99average.M2leaptin2001,duringtherecession,predatingtheactualrecovery.Foraninvestorthat’sreallyusefultoknowbecauseittellsyouwhatisgoing

tohappenaheadoftime.Thisforesightgivesyoutimetochangeyourinvestmentstothoseareasthatdowellearlyinarecovery,whichhistoricallyhavebeengrowthstocksandsmallcompanies.However,it’snotfoolproof.“[T]hegrowthrateofbroadmoney[is]animperfectproxyfornominaldemand[orGDP],”wroteMichaelDarda,directorofresearchatGreenwich-basedtradingfirmMKMPartners,inaresearchreportin2010.Why?Becausethespeedatwhichmoneymovesaroundtheeconomy,theso-

calledvelocityofmoney,sometimesvaries.Economistsbelievethatslow-movingmoneyhaslesseconomicimpactthanfast-movingmoney.Furthertothispoint,Dardaobservesthattherecoveryoftheearly1990sandthesecondlegoftheGreatDepressionin1937sawadropinmoneyvelocity,makingM2growthlessreliableasanindicator.Hedoesnote,however,thattherewasaverytightrelationshipbetweenM2

andGDPgrowthfrom1960to1989.Aruleofthumbisthatasthecostofcorporationsborrowingmoneydeclines—relativetothatofgovernmentborrowing(theso-calledcreditspread)—thevelocityofmoneyincreases.

EXECSUMMARY:M2MONEYSUPPLY

Whentolook:EveryThursdayat4:30p.m.ETfordatafromtwoweeksprior.

Wheretolook:ForthedatagotoTheWallStreetJournalonline’s“Market

DataCenter”atwww.WSJMarkets.com.You’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“MoneySupply.”AlternativesourcesincludetheFederalReserve’smainwebsiteandtheFRED

databaseattheSt.LouisFed.

Whattowatchfor:Increases(decreases)inM2.

Whatitmeans:Theeconomyisheatingup(maybecoolingdown).

Whatstepstotake:Getintostocks(liquidassetssuchascash)becausetheeconomymaybeimproving(deteriorating).

Risklevel:Medium.


T

Chapter32NewHomeSales

Leading(SeealsoExistingHomeSales,HousingStarts,andPendingHomeSales)

HEAMERICANDREAMFormanyistoowntheirownhome.Butforaluckyfewitgoesfurther:Theirdreamisbuyingabrandnewhousethatnoonehas

livedinbefore.Salesofnewhomesaren’tthelargestpartofthehousingmarket,buttheyarea

goodleadingindicatoroffutureeconomicactivity,explainsMikeLarson,arealestateanalystatJupiter,Florida–basedboutiqueWeissResearch.Newhomesnormallyaccountforaround15–25%oftotalhomesaleswiththe

remaindermadeupofexistingorpre-ownedhomes,hesays.Hepointsoutthatinthewakeofthepoppingoftherealestatebubble,thatnumberhadfallencloserto5%in2010,butheexpectsittoreboundtothenormatsomepoint.Newhomesalesactasaleadingindicatorbecausenewhousesarefrequently

purchasedbeforetheyarebuilt.Unlikewithexistinghomesales,thenewhomesalesdatameasureswhencontractsaresigned,notwhenthekeysarehandedovertothenewowners.Newsthatthousandsofnewhomesweresoldinagivenmonthsaysthatthere

willbefutureeconomicactivityasthehousesactuallygetbuilt.Workersneedtobehired,andlumber,floortiles,roofingmaterials,andelectricalwiring,tonamejustafewthings,mustbemanufactured,transported,andware-housedbeforefinallybeingusedattheactualconstructionsite.AllofthatactivityshowsupasincreasedGDP.Sorisinglevelsofnewhome

salestendtoforeshadowbettereconomictimes.Likewise,consistentlyfallingsalesofnewhomestendtoportendaweakeningeconomy.Anytypeofhome—condo,loft,orhouse—isamajorpurchasethatmany

peopleneedtoborrowtomake.Todoso,buyersneedtohaveconfidencein

theirabilitytoholddownajobandthatanyothersourcesofincomearereasonablysecure.Typically,thatmeansthatstronghomesales,newandexisting,gohandinhandwitharobustjobsmarket.

InvestmentStrategy

Theclaimthatstrongandrisingnewhomesalesactuallyaugurbettereconomictimesisborneoutintheaccompanyingchart.Ifyoulookclosely,you’llseethatnewhomesalestypicallyturndownjustbeforerecessionsstrikeandmoveupwardbeforetherecoveryoftheoveralleconomybegins.Thedatacanalsobeusedtoseewherethehousingmarketisheading.Ideally,whatyouwanttoseeinthenewhomesalesdata,whichisprovided

eachmonthbytheCensusBureau,areaffordableprices,lowinventorylevels(representedinmonthsofsupply),andlowcostsofborrowing,saysLarson.Allofthatcouldpointtogoodgrowthinhomesalesahead.Ontopofannualizedsalesfigures,thenewhomesalesdatagivesusaslewof

otherhandynuggets.Yougetthemedianandaveragehousepricesplushowmanysoldindifferentpriceranges.Also,there’sinformationontheinventoryofunsoldhomesandthenumberofmonthsofsupplythosefiguresrepresent.Asifthatweren’tenough,thereisalsoaregionalbreakdownofsales.LarsonpointstotheSouthandWestregionsasthemostimportant.Usingallofthatdatatogetherwiththeknowledgeofwheredifferenthome-

buildingcompaniesoperate(thegeographicareainwhichtheyoperateandthepricerangeofthehomestheybuild)canbeagoodwaytodecidewhetherit’sworthinvestinginthedifferenthome-builderstocks.Alternatively,forthosenotwantingtoinvestinspecificstocks,investors

mightwanttoconsiderlookingattheSPDRS&PHomebuilders(XHB)exchange-tradedfund,whichtracksabasketofhomebuilders.“Strongnewhomesalesdatawouldbegoodforcabinet-makers,tilemakers,

homebuilders,manufacturersoffaucets,andthosesellingrawwoodproductslikeWeyerhauser,”saysLarson.

EXECSUMMARY:NEWHOMESALES

Whentolook:Monthlydataismadeavailableat10:00a.m.ETaboutfourweeksafterthefact.That’saroundthe25thdayofthemonth.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchhomesales

dataclosely.Asnewsaboutitandcapacityutilizationisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatathatyouwant,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“NewHomeSales.”NewhomesalescanalsobetrackedthroughtheCensusBureau,atwww.census.gov/newhomesales.

Whattowatchfor:Increases(decreases)innewhousingstarts.


Whatstepstotake:Purchase(sell)home-builderstocksorETFsandthesharesofcompaniesthatsupplyhomematerialslikelumber.



P

Chapter33PhiladelphiaFed:TheAruoba-Diebold-ScottiBusiness

ConditionsIndex

Coincident(SeealsoWeeklyLeadingIndex,PhiladelphiaFed:BusinessOutlookSurvey)

HILADELPHIASHOWSITSELFtobetrulythecityofbrotherlylovebygivinginvestorssomespecialkindness:aslewofeconomicindicators,publishedby

thePhiladelphiaFederalReserve,partofAmerica’smightycentralbank.Unlikemen,whichtheDeclarationofIndependencesaysareallcreatedequal,

oneindicatorfromPhillystandsoutabovetherest:theAruoba-Diebold-ScottiBusinessConditionsIndex.That’samouthfultopronounce(andspell),butyoudon’tneedtosay(orspell)ittouseit.We’llcallitADSheretosaveyouandthisbook’scopyeditorsanyfurtherconsternation.Thisindextakesinavarietyofeconomicdata,mashesitalltogether,and

comesoutwithanup-to-the-minutereadingontheeconomywithafrequencyofatleastonceaweek.Itsavescommoninvestorslikeyouandmealotofhardworktryingtograpplewiththeindividualpieces.Theinputdataincludesacompositeofquarterlyoutputdata,unemployment

indicators,industrialproduction,personalincomelesstransferpayments,andmanufacturing/tradesales,plusGDPgrowth.“WhattheADSdoesisaggregateallthisdatainastatisticallymeaningful

manner,”saysKeithSill,directorofreal-timedataresearchattheFederalReserveBankofPhiladelphia.TheeconomicwhizzesatthePhillyFeduseafiltertohelpsmooththedataso

thattheimpactoflessfrequentdata,liketheGDPgrowthfigures,blendsseamlesslywiththoseofmorefrequentindicators,likeweeklynewclaimsforunemploymentinsurance.

UnliketheotherPhillyFedindicatordiscussedinthisbook,theBusinessOutlookSurvey,theADSlooksattheentireeconomy,notjustthePhillyFed’srathertinydistrict.Additionally,becausetheADSisupdatedsofrequently—atleastonceaweekandsometimesmorefrequently—it’sareal-timereadontheeconomythatanalystsdon’thavetowaitalongtimefor,unlikethequarterlyreadonGDP.

Note:WeconstructtheADSIndexusingthelatestdataavailableasofJuly2,2010.Thisincludes(1)initialjoblessclaimsthroughtheweekendingJune26,2010,(2)payrollemploymentthroughJune2010,(3)industrialproductionthroughMay2010,(4)realpersonalincomethroughMay2010,(5)realmanufacturingandtradesalesthroughApril2010,and(6)realGDPthroughthefirstquarterof2010.LightergrayshadingindicateshistoricalNBER-designatedrecessions.Darkergrayshadingindicatestherecentrecession,designatedbytheNBERtohavestartedinDecember2007butnotyetdesignatedbytheNBERtohaveended(asofthedateofcreationofthisfigure).WeenditinJuly2009,whichappearslikelyconditionaloninformationpresentlyavailable,butweusedarkergrayasareminderthatourdatingisnotofficial.

InvestmentStrategy

ReadingtheADSiseasy.Theaveragevalueiszero.Higherthanzeroisaplusfortheeconomy.Negativefiguresareseenasdowners,economicallyspeaking.AccordingtothePhiladelphiaFederalReserve,“TheADSindexmaybeused

tocomparebusinessconditionsatdifferenttimes.Avalueof–3.0,forexample,wouldindicatebusinessconditionssignificantlyworsethanatanytimeineitherthe1990–91orthe2001recession,duringwhichtheADSindexneverdroppedbelow–2.0.”Nowthereareacoupleofwrinkleswiththisindicator.Thezeroaveragegets

recalibratedperiodically.WhatthatmeansinpracticeisthatallthehistoricalADSdatayouhaveneedstobejettisonedperiodicallyandthenewrecalibratednumbersused.SillssaysthebestwaytolookatareadingistocompareagivenADSlevelto

thatofsomepointinthepastwithasimilarreading.Becausethedataisestimatedallthewaybackto1960,therearemanybusinesscyclestolookatandcompare.Fortunatelyforthebuddingeconomicforecaster,thePhillyFedputsoutatime

serieschartoftheADSwithbarsindicatingrecessions.ThisenablesinvestorstoeasilycomparethereadingsoftheADSgoingintoandoutofpastrecessions.

EXECSUMMARY:PHILADELPHIAFED:THEARUOBA-DIEBOLD-SCOTTIBUSINESSCONDITIONSINDEX

Whentolook:Daily.

Wheretolook:DataandotherresourcesontheADSBusinessConditionsIndexareavailableforfreeatthePhillyFed’sReal-TimeDataResearchCenteratwww.phil.frb.org/research-and-data/real-time-center/.Thedatais“updatedasdataontheindex’sunderlyingcomponentsarereleased.”

Whattowatchfor:Increases(decreases)inADS.


Whatstepstotake:Getinto(outof)riskierassetslikestocksorhighyield/junkbonds.

Risklevel:Medium.


I

Chapter34PhiladelphiaFed:BusinessOutlookSurvey

Leading(SeealsoPhiladelphiaFed:TheAruoba-Diebold-ScottiBusinessConditions

Index)

MAGINEARATHERPLAIN-LOOKINGunopenedtuboficecream.Nowimaginewhenopeneditwasjammedfullofallthegoodiesyouknowyoulove,like

pecansandcaramel,plussomemorenibblesyounevertastedbeforebutnowloveevenmorethanyourpreviousfavorites.That’sthewaytothinkaboutthePhiladelphiaFederalReserve’sBusiness

OutlookSurvey.Forpeoplewhowanttogetintotheweedsatthemostgranularlevelpossible,thisisamust-readindicator,theclosestthingtoJapan’sTankanSurveyavailableinAmerica.(ThePhillyFedalsopublishestheAruoba-Diebold-ScottiBusinessConditionsIndex,whichsavvyinvestorsshouldkeepacloseeyeonalso.)OnthesurfacetheBOScanlookratherdrab.Itisafterallasurveyabout

manufacturinginjustonesmallareaoftheeconomy,easternPennsylvania,southernNewJersey,andallofDelaware.Butdon’tletthatfoolyouintodismissingitasirrelevant.Itsfirstbeautyissimplicityinthemetricitself,the“diffusionindex.”That’s

themetricthatmeasureshowthesurveyparticipants—manufacturersinthedistrict—feelaboutagiventopic.Theheadlineindexmeasuresanswerstothequestion:“Whatisyourevaluationofthelevelofgeneralbusinessactivity?”However,thesurveyasksnotonlyhowtheeconomyisnow,butalsohowgoodorbadwillitbeinsixmonths.Anumberoverzeroindicatesanexpansion,orgrowthinthemanufacturingsub-sectoroftheeconomy.Anumberbelowzeroindicatesacontraction.Nowherecomesthereallygoodstuff.Ontopoftheoveralldiffusionindex,

thereareaslewofsubtopicsonveryspecificpartsofthebusinessworld:neworders,shipments,unfilledorders,deliverytimes,inventories,pricespaid,pricesreceived,numberofemployees,averageworkweek,andcapitalexpenditures.“WhatcomponentIammostinterestedinissomewhatdependentonwherewe

areinthebusinesscycle,”explainsTimQuinlan,aCharlotte-basedeconomistatbankingpowerhouseWellsFargo.Forinstance,intheearlystagesofarecoveryQuinlanlooksatthe

employmentfigures.Beforehiringstartstogetgoing,thehoursworkedstarttoincrease.Quinlansaysbusinessownershavetheattitudethat“Iwillgraduallycallpeoplebacktowork,butonlyonceIhavemyfull-timestaffbackworkingasmanyhoursastheycan.”Thatmeanssustainedincreasesinhoursworkedcanbeanimportantleading

indicator,oronethatmovesaheadoftheoveralleconomy.

InvestmentStrategy

Whiletheabsolutelevelofthediffusionindexisimportant,thereadingsneedtobeusedinconjunctionwiththechangeinthelevelfromthepreviousperiod.Forinstance,adropintheindicatorfromverypositive(like26)toonlyslightlypositive(maybe3)isaworryingsign.Likewise,amovefromverynegative(–30)toonlyslightlynegative(–5)can

lookpositive,especiallyifitsignalsaturningpointintheeconomy.Theothertrickwiththisindicatoristodigintothesubindexesandlookat

whichstocksmightdowelliftheparticularindexchanges.Quinlansayshelikestolookatthenewordersmetric.“Isthatincreasingor

not?Ifitis,thenIwouldexpecttoseeacommensurateriseinbusinessspendingandthenfactoryordersandcapitalgoodsatalaterdate,”heexplains.“Inanormalbusinesscyclethatwouldeventuallymeanincreasedprofitabilityformanufacturersinthedistrict.”Ifotherindicatorspointinasimilardirectionitmightmakesensetotrackdownstocksofcompaniesinthedistrictwithaviewtoinvesting.Quinlancautionsthatasgreatasthesurveyis,itisameasureofsentimentand

not“harddata.”Thesix-monthoutlookisalsolessreliablethanthecurrentdata,hesays.Still,sentimentismuchofwhatdrivesthebusinessworld.Andifsentimentis

weak,it’sunlikelytoaugurarobusteconomy.

EXECSUMMARY:PHILADELPHIAFED:BUSINESSOUTLOOKSURVEY

Whentolook:NoonETonthethirdThursdayofthemonth.

Wheretolook:GotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“PhiladelphiaFed.”Alternatively,forthefullreportgodirectlytothePhiladelphiaFederalReserve,whichpublishestheBusinessOutlookSurveyeachmonthandmakesitavailableatwww.phil.frb.org/research-and-data/regional-economy/business-

outlook-survey/.

Whattowatchfor:Increases(decreases)inthediffusionindex.


Whatstepstotake:Buy(sell)riskierassetslikestocksandhighyieldcorporatedebtandgetoutof(into)saferinvestmentslikegovernmentbondsandcash.Forthemoreadventurous,exploitinformationinoneormoreofthe

subindexestopickoutpossiblemovesinspecificindustriesorsectors.



F

Chapter35RealInterestRates

(Leading)

EDWATCHING,ORTRYINGtoworkoutthepolicystanceoftheFederalReserve,hashistoricallybeenamind-numbingexperience.Listeningtotestimony

fromitsgovernorsandvariouschiefsgivesnewmeaningtothedescriptionofeconomicsasa“dismalscience.”Itdoesn’tnecessarilyneedtobethatway.Wecanlearnalotaboutwhatthe

Fedistryingtodobylookingatso-calledrealinterestrates.That’sactuallybothquitesimpletodoandquiterevealingatthesametime.“It’sagoodmeasureoftheaccommodativenatureofmonetarypolicy,”says

GuyLeBas,chieffixedincomestrategistatinvestmentbankingfirmJanneyMontgomeryScottinPhiladelphia.Toworkouttherealinterestrateyouadjustthestated,ornominal,interestrate

forthewitheringeffectsofinflation.(Realinterestrate=nominalinterestrateminusinflation.)Or,inotherwords,whatgoodsandserviceswillthemoneyyouinvestingovernmentsecuritiesbuyyouwhenyougetbacktheprincipalplusinterest?Ifitwon’tbuyyouasmuchasitwouldnow,thentherealinterestrateissaid

tobenegative.Ifitwillbuyyoumoreinthefuture,thentherealinterestrateispositive.Sowhat?Well,thesimplefactofknowingwhetherrealinterestratesare

positiveornegativetellsyoualotaboutthepolicyoftheFederalReserve.Specifically,ittellsuswhethertheFedhasanaccommodatingpolicyorarestrictivepolicy.Accommodativepolicyiswhenrealinterestratesarenegativeandis

conducivetospeedingupeconomicgrowth.Restrictivepolicy,whenrealratesarepositive,tendstoslowdowngrowthintheeconomy.

Thelowerrealinterestratesare,themoreborrowerswanttoborrow,bolsteringtheconsumptionandinvestmentcomponentsoftheeconomy.Asrealinterestratesincrease,peoplewanttoborrowless,andthathurtsinvestmentandconsumption.

InvestmentStrategy

Realinterestratesriseduringexpansionsandfallduringrecessions,largelyduetochangesindemandformoney.Realinterestratestypicallyfallbeforearecoveryasnominalinterestratesstayflatandinflationexpectationsrise.Therehavebeenacoupleoftimesinhistorywhenacentralbankloweringthe

costofborrowinghadlittleeffectonstimulatingtheeconomy:forexample,theUnitedStatesduringtheGreatDepressionandJapanduringitsGreatStagnation(1990–present).Thereasonissimple:Peopleexpecteddeflation,orafallinthegeneralpricesforgoodsandservices.Thatmeant“realinterestrates”remainedhigh,toohighforaneconomicrecovery.Realinterestrateshaveimplicationsforinvestorsalso.“Intheory,ifreal

interestratesarenegative,nomatterwhatyouthrowyourmoneyintoyoushouldmakeaprofit,”saysJanney’sLeBas.“Thetheorybreaksfromrealityinthatshort-termmarketvolatilitycanalwaysbeatoutaprofit.”LeBaspointstocommoditiesingeneralandindustrialmetalsinparticularas

assetsthatdowellduringtimesofnegativerealinterestrates.Hesuggestsavoidingthestocksofmetalscompanies,asthatexposesinvestorstostockmarketrisk.Conversely,hesays,whenrealinterestratesarehigh,that’sagoodtimeto

lookatthebondmarket.HealsonotesthatithasbeendecadessincerealinterestrateswerehighintheUnitedStates.Oneotherimportanttip:LeBassaystherearemanywaystocalculatereal

interestrateswithmuchoftheproblemcenteredonhowtomeasureinflation.LeBasfavorsthePersonalConsumptionExpenditure(PCE)deflatorusedinthecalculationofgrossdomesticproduct,asittakesintoaccountthechangingpreferencesofconsumers.“CPI[ConsumerPriceIndex]assumesthatsomeonewhoboughtabasketof

goodsayearagowillbuythesamebasketofgoodstoday,”hesays.“That’snotnecessarilythecase:IfBriepricesrise,theymaygowithStiltoninstead.”

EXECSUMMARY:REALINTERESTRATES

Whentolook:Daily,orasnewdataoneitherinterestratesorinflationcomes

out.

Wheretolook:Tocalculatethisindicatoryou’llneedtolookfortwopiecesofdata.Takeanominalinterestrateseriesandsubtractameasureofinflation,beitCPI,PPI,theGDPPCEdeflator,orsomeothermeasure.ThedataforinflationandnominalinterestratescanbefoundatTheWallStreetJournalonline’s“MarketDataCenter.”You’llfindthedatacenteratwww.WSJMarkets.com.Inflationdatawillbefoundwithinthe“Calendars&Economy”section,whereasinterestrateinformationwillbewithinthe“Bonds,Rates&CreditMarkets”section.OrfindthenecessarydataatFRED,whichalsohasdataonTIPSorTreasury

Inflation-ProtectedSecurities.Undernormalmarketconditions,TIPScanserveasadirectmeasureofinflationexpectations.Seehttp://research.stlouisfed.org/fred2/categories/82.However,underabnormalconditions,likeduringtheGreatCreditCrunchof2008–9,thevalueofTIPSdeclinedsomuchthattheindicationofinflationexpectationswaserroneous.

Whattowatchfor:Increases(decreases)inrealinterestrates.

Whatitmeans:Theeconomywillshrink(grow)inthenearfuture.

Whatstepstotake:Buyhardassetswhenrealinterestratesarenegative,butbewareshort-termfluctuations.Buybondswhenrealinterestratesarepositiveasnominalinterestrateswillprobablymovelower,sparkingabullmarketforbonds.



Chapter36ShortInterest

B

Leading

ETTINGAGAINSTACOMPANYseemsun-American.Weareafterallanationofoptimists.Still,wecanlearnsomethingfromthenaysayers,notablythose

whobetagainstthestocksofpubliclytradedcompanies.Theseso-calledshortsellersmakemoneywhenstocksgodowninpriceandwecanusetheiractivityasaninvestmentindicator.Shortsellersbetagainstapubliclytradedcompanybysellingstockthatthey

haveborrowed.Theshortsellerprofitsifthepriceofthesharesgoesdownbeforehehastoreturntheborrowedstock.It’sjustsellhighandbuylow,insteadofbuylowandsellhigh.Thetotalamountofstocksoldshortofaparticularcompanyisknownasshort

interest.Tobeabsolutelyprecise,shortinterestisaninvestmentindicator,notaneconomicone,butitisincludedherebecausethetwoareverycloselyrelated.Also,it’sworthnotingthatthisbookisaboutindicatorsandhowtousethemtomakemoney.Inthatregard,thisonefitsthebill.Sellingsharesshortattractsamassiveamountofnegativepublicity.Perhaps

notsurprisingly,managersofpubliclytradedfirmsoftendisliketheircompanies’sharesbeingshorted.Occasionally,thegovernmenttemporarilybansshortingcertaintypesofstock,suchaswithsomebanks/financialsharesduringtheheightofthefinancialcrisisin2008.Despitethebadpublicity,theinformationthatshortsellersgiveusisvery

useful.That’sbecauseshortinterestisacontraryindicator.Inthesimplestterms,whenmanysharesofastockhavebeensoldshortit’sbullishforthestockprice.Thenumberofsharessoldshortrepresentsa“well”ofpotentialbuyingpower.

Thereason:Shortscan’tstayshortforever.Eventuallyshortsellersmustreturnthesharestheyborrowedandsold.Thereareacoupleoffinancialreasonsforthis.Whenyousellsharesshortyoumustpayinterestforborrowingthemplusthevalueofthedividendsduethelender.Inaddition,ifthepriceofthestockgoesup,thenthebrokerthatlentthesharesmayaskforcollateraltocoveranylosses.Suchralliessometimesforceshortsellerswhocan’tposttheextracollateralto

buybackstockto“cover”theshortposition.Thatextrabuyingcansendthestockevenhigher.Insimpleterms,highshortinterestcanbeabullishsignfora

stock.

InvestmentStrategy

Onaverage,stockpriceshavetrendedupwardoverlongperiods,soindiscriminatelyshortingsharesislikelynotawinningstrategy.Successfulshortsellersmustlookforspecificreasonsforaspecificsharetodecline,astheydidwithLehmanBrothersin2008.Butquitefrequentlyshortsellersarewrong.Andwhentheyare,savvy

investorscanprofit.Thetrickistofindastocknotonlywithrelativelyhighshortinterest,butthat

isalsoawell-runandattractivelyvaluedcompany,saysAdolfoRueda,atechnicalanalystatWJBCapitalGroupinNewYork.“Thattellsmesomeonehasthefundamentalsincorrect.”Thebestwaytogaugewhetherastockhasalotofshortinterestistolookat

howmanydaysitwouldtaketocoverthenetshortpositionbasedonrecenttradingvolumeinthestock.Theresultingfigureisknownastheshortinterestratio.Ashortinterestratioof2meansitwouldtakeasmanysharesasweretradedintwodaystocompletelybuybackallthesharessoldshort.Asatechnicalanalyst,Ruedalooksatpatternsinstockpricechartsto

determinewhethertobuyastock.Heusestheshortinterestdatatoaugmentsuchanalysis.“Ifinditbettertolookforthegoodchartsorthosewithpositivetrend,andthenbackintoitbylookingattheshortinterestdata,”hesays.Or,inotherwords,whenhefindsachartwithbullishtrendsandonethathasalotofshortinterest,heconsidersbuyingthestock.Thesameapproachwouldworkforsomeonewhoanalyzesacompanyby

readingfinancialstatements.Ruedasaysit’sprobablynotsmarttodrawtoomanyconclusionsfromlookingatshortinterestinexchange-tradedfundslikethosethattrackmajorstockmarketindices,suchastheSPDRS&P500(SPY)ETF.TheproblemisthatsomemoneymanagersusesuchETFsforsophisticated

hedgingactivitythatsometimeshaslittletodowithwhethertheyexpectaspecificindextodeclineornot.3

“Itkindaskewsthedata,”Ruedasays.

EXECSUMMARY:SHORTINTEREST


Wheretolook:SomeusefuldataonshortinterestisfoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“U.S.Stocks”tabandlookfor“Quarterly/MonthlySnapshots,”whereyouwillfindalistofthebiggestshortpositions.Inaddition,majorexchangesliketheNYSEandNASDAQpublishshort

interestreports.DailyFinance.comalsoprovidesshortinterestdata,includingtheshortinterestratio,asdoeshttp://shortsqueeze.com/.

Whattowatchfor:Increasesintheshortinterestratioofacompanywithgoodmanagementandsolidfundamentalsorabullishtechnicaltrend.

Whatitmeans:Shortsellersmayhavebittenoffmorethantheycanchew.

Whatstepstotake:Buythecompany’ssharesandhopethattheshortswillbidupthepricewhenthey“cover,”orbuysharestoreturnthemtothelender.


Profitpossibility:$$$$

I

Chapter37Russell2000

Leading(SeealsoRiskStructureofInterestRates)

FYOULIVEINAmerica,chancesareyouworkforasmallcompany.Smallbusinessesfuelmostjobcreation,buttheyaremoreriskythanlarger

enterprises.It’sthatextrariskandinvestorattitudetowarditthatcanhelpuslearnalot

aboutthebroadereconomy.Trytoenvisionasmallboatontheoceannexttoalargewarship.Wavesknockthesmallervesselhitherandthitherwhilethelargervesselremainsstable.Thesameistrueofcompaniesgettingknockedaboutbyeconomicshocks.Investorsknowinvestinginsmallercompaniesisriskierthaninvestingin

largerones.Buttheyalsoknowthatsmallercompaniesbenefitmuchmorefromfairereconomicconditionsthanbigonesdo,justassmallerboatsbenefitmorefromcalmerseasthanlargerships.That’swheretheRussell2000comesin:Ithelpsusmeasureinvestorrisk

appetite,andfromthatwecaninferhowtheeconomyisdoing.Specifically,theRussell2000(RUT)Indextrackstwothousandsmallerpubliclytradedstocks.Theindexitselfistheoneagainstwhichmostmutualfundmanagersspecializinginsmallcapitalization(smallcap)stocksarebenchmarked.What“capitalization”meansis:“Howmuchisthiscompanyworth?”It

specificallyreferstothedollarvalueofallofacompany’soutstandingstockatitscurrentstockprice.That’stheeasybit.Whatcountsas“small”isabitofamovingtargetthatchangesovertime.For

themostpart,thinkaboutcompaniesworthlessthan$1billion.TheaveragemarketcapofcompaniesintheRussell2000wasaround$400millioninmid-2010,accordingtoRussellInvestments’website.Orputanotherway,the

averagefirmintheindexisaso-calledsmallcapworthlessthanhalfabilliondollars—prettysmallpotatoesthesedays.Thatcompareswithover$170billionforGeneralElectriconthesamedate,

forinstance.Clearly,theRussell2000stocksaretinyincomparison.Sowhatcanwelearnbylookingatthisindex?“Ifthebroaderindiceslikethe

S&P500(GSPC)aremeanderingalongandthesmallcapsareup,thenyoumightbeseeingriskappetitereturn,”saysBarryRitholtz,CEOofNewYork–basedassetmanagementfirmFusionIQ,andauthorofBailoutNation.Thegoodnewsaboutanincreaseininvestorappetiteforriskyassetsisitcan

presageeconomicexpansion.Ifthemoveismatchedintherealeconomy,withbusinessesbuyingnewmachineryandequipment,thensmallcompanieswilltendtodowell.

InvestmentStrategy

Theproblemwithanyindexisthatmarketscansometimesbevolatile.Twentieth-centuryeconomistJohnMaynardKeynesputitwell:“Marketscanremainirrationallongerthanyoucanremainsolvent.”ForthatreasonRitholtzsaysit’simportantnottojumptoerroneous

conclusions.Forinstance,hesayswhentheRussell2000jumpedinlate2009andearly2010,thequickrisemayhavebeenduetogreaterriskappetite,butitalsomayhavebeenbecausetheindexhadbeensobadlypummeledearlierintheyear.Stocksareoftenobservedtobouncebacksomewhatfollowingalongperiodof

falling.Somecallthisa“technicalbounce,”othersa“deadcatbounce.”Sometimesithaslittletodowithchangesintherealeconomyorinvestorexpectations.Ritholtzsaysthatmarketindicescanbelikeaninkblottestwherewhatisseen

isopentoavastarrayofinterpretations.Forthatreasonhesuggestsguardingagainst“seeing”anythingthatisn’treallytherebutthatperhapsyou’dliketheretobe.Inotherwords,cometodatawithanopenmind,notapreconceivednotionthatyouarehell-benton“proving”nomatterwhat.Goodquestionstoaskyourself:Isthereanotherreasonableexplanationforthe

phenomenonI’mseeing?Dootherpiecesofdatasupporttheconclusion?ThissortofskepticismworksnotonlywhenlookingattheRussellbutalsomanyoftheotherindicatorsinthisbook.ForthosewantingtoinvestintheRussell2000,probablytheeasiestwayof

doingsoisthroughtheiSharesRussell2000IndexFund(IWM)exchange-tradedfund,whichtracksthevalueoftheindex.

EXECSUMMARY:RUSSELL2000

Whentolook:Continuously.

Wheretolook:FordataontheRussell2000,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“U.S.Stocks”tabandlookunder“OtherU.S.Indexes.”

Inaddition,dataontheRussell2000tradingpricescanbefoundatYahoo!Financeatwww.finance.yahoo.com.DetailsoftheindexitselfcanbefoundonRussellInvestments’websiteatwww.Russell.com.

Whattowatchfor:Increases(decreases)intheRussell2000.

Whatitmeans:Theappetiteforriskmaybegrowing(shrinking)duetoinvestorexpectationsabouteconomictrends.

Whatstepstotake:Ifyouthinkthefirstupward(downward)movementsintheindexrepresentachangeinsentimentratherthanatechnicaldeadcatbounce(minorcorrection),buy(sell)aRussellETF.

Risklevel:High.

Profitpossibility:$$$xs

H

Chapter38WeeklyLeadingIndex

Leading(SeealsoJoCECRIIndustrialPriceIndex)

ERE’SATALLORDER:Developametrictogivearelativelyaccuratereadonthefuturestateoftheentireeconomy.Makeit“see”notjustonemonthdown

theroad,butasfaraseightmonths.Anditneedstobetimelytoo,sothatthereistimetotakeevasiveactionbeforethecrash.That’smoreorlesswhattheManhattan-basedEconomicCycleResearch

InstitutetriedtodowhenitdevelopedtheWeeklyLeadingIndex(WLI)inthe1980s.ThepeopleatECRIbasicallyspendalldayeverydayfiguringoutthewhatandwhyofbusinesscycles.“[TheWLIis]basicallythesequeltotheoriginalleadingindicatoridea,which

cameintobeinginthe1960s,”saysLakshmanAchuthan,managingdirectoratECRI,referringtotheConferenceBoard’smuch-admiredleadingeconomicindicator(LEI).AchuthansaystheinputsthatmakeuptheWLIincludemeasuresofthe

moneysupply,theJoCECRIIndustrialPriceIndex,measuresofhousingactivity,jobsandlabormarketindicators,equityprices,andsomebondmarketprices.Inacoupleofkeyways,ECRItriedtoimproveontheoriginalLEI,justlike

automobileengineersimproveduponHenryFord’sclassicModelT:First,theWLI’sdatacomesoutweekly,notmonthly—soit’smoretimely.Inaddition,allbutoneofthenumbersthatmakeuptheWLInevergetrevised.“Revisionsmakeahandyexcuseforforecasters,”saysAchuthan.“So,we

removedthatexcusefromourselves.”

InvestmentStrategy

Thebigproblemwithmanyeconomists’forecastsisthattheytellyou,“Ontheonehandthis,ontheotherhandthat,”saysAchuthan.Thisambivalencemakesitdifficulttoknowwhateconomistsarereallysaying,

iftheyaresayinganythingusefulatall.Therefore,theWLIwasdesignedasaone-armedeconomist.Asheexplains,“Itgivesyouadirectionalcallontheeconomiccyclewithoutsayingontheonehandthis,butontheother...”ThetrickisnotinreadingtheWLI,butratherininterpretingit.Somepeople

managetomisreadtheWLIandthengetitwrongwhentheycalltheendorbeginningofarecession.Achuthansaysthesemisinterpretationsoftenhappenbecausewhat’sneeded,andnotalwaysused,isadisciplinedapproachtothemetric.ECRIclaimsnevertohavemadeabadcallonarecessionendingor

beginning.Aswithitsotherindicators,liketheJoCECRIIndustrialPriceIndexcoveredearlierinthisbook,ECRIusestheso-calledthree-P’sapproachwherebymovementsintheindexthatcatchtheirattentionarepronounced(bigmovement),persistent(lastsliketheEnergizerBunny),andpervasive(basedonnumerousinputs,notjustafew).It’sthelastelementthattripsupmanyforecasters.Forinstance,followingthe

spectaculardropinthestockmarketin1987theWLIdropped,butthemovewasn’tpervasive,becausestockswerereallytheonlyelementoftheWLItomove.SoECRIcoollyandcorrectlyshiedoffcallingarecessiondespitethewidespreadfearinthemarkets.Otherforecastersweren’tsolevelheaded.If,ontheotherhand,thereisaturn

intheWLIgrowthratethatsatisfiesthethreeP’s,thenarecession(ortheendofone)canbeexpectedseventoeightmonthslater.“TheWLIisveryunemotional[and]itdoesn’tgetcaughtupinthenarrativeof

theday,”Achuthansays.It’simportanttonotethattheWLIisameasureofwhat’sgoingtohappenfor

theentireeconomywhereastheJoCECRIIndustrialPriceIndexspecificallyfocusesinontheindustrialsectorandperhapsforthatreasonisbettersuitedtogaugingthehealthofmanufacturing.

EXECSUMMARY:WEEKLYLEADINGINDEX

Whentolook:Weeklyat10:30a.m.ET.

Wheretolook:TheECRIWLIdataispostedfreeonwww.businesscycle.com.ItalsoprobablypaystoscourthepressfornuggetsinordertogetECRI’scallsonwhethertheeconomyisgoingtoboomorflop.

Whattowatchfor:Increases(decreases)intheWLIthatarepronounced,persistent,andpervasive.


Whatstepstotake:IfYodawerehere,hewouldsaysomethinglike:“WhentheWLIgoesdown,riskyassetsyoushouldsell.LetTheForceguideyoutothesafetyofbondsanddefensivestocks.WhentheWLIrises,asmustiteventually,riskyassetsyoushouldbuy.LukeSkywalkerhaveyouseenrecently?”

Risklevel:Medium.


Chapter39YieldCurve

E

Leading

VENFORECONOMISTS,MONITORINGtheU.S.governmentsecuritiesmarketcanbelikewatchingpaintdry.Still,forthosewiththepatiencetodoso,itcan

yieldbigprofits.Butfirstyouneedtoknowwhattolookforandwhatitmeans.Whattowatch

isthedifferencebetweentheyieldsonlong-termgovernmentsecurities(ten-yearbonds,a.k.a.ten-yearT-note)andtheyieldsonshort-termones(thethree-monthTreasurybill).Monitoringthedifferenceinratesisknownaswatchingtheyieldcurve,andit

canhelpidentifyturningpointsintheeconomy,suchasthebeginningofarecession.(Aplotoftheyieldsofmorethantwomaturitiesofgovernmentsecuritiesproducesacurveonachart.)Whenthedifferenceinyieldsisnegative—inotherwords,whentheyieldontheten-yearTreasurynoteislowerthantheyieldonthethree-monthT-bill—thechanceofarecessionfourquarterslaterrisesdramatically.Evenmoreinterestingly,thehighertheT-billrateisabovetheten-yearT-noteratethegreateristhelikelihoodofarecession.“Itisoneofthebetterindicatorsoutthere,”saysAnthonyCrescenzi,strategist

andportfoliomanageratNewportBeach,California–basedbond-fundgiantPimco.Hepointstoaclassic1995NationalBureauofEconomicResearch(NBER)studybyArturoEstrellaandFredericMishkinthatdetailedhowthedifferencebetweentheten-yearnoteandthethree-monthbillwashighlycorrelatedwitheconomicactivityoneyearinthefuture.Whyisthisindicatorsopowerful?Onesimplewaytothinkaboutitisthatthe

long-terminterestrate(theten-yearT-note)isacumulativebetonwheretheshort-termratewillbe,explainsCrescenzi.Inotherwords,theten-yearrateistheone-yearratetentimes.Afallingten-yearratethensuggeststhatshort-termrateswillbeheading

south.Why?LikelybecausetheFederalReserve,theU.S.CentralBank,willlowerratesinresponsetoweakeconomicconditions.“Onecouldsayabouttheyieldcurvethatit’sthecombinedjudgmentof

millionsofinvestorsaroundtheworld,”saysCrescenzi.“Theexpectationsofinvestorsareembeddedinthoseyieldsacrossthecurve.”

InvestmentStrategy

MishkinandEstrella’spaperlaysoutarelationshipthatwe’vereplicatedhereshowingtheincreasingprobabilityofaU.S.recessionthemorenegativethedifferencebetweentheten-yearT-noteandthethree-monthT-billis.Notably,whentheyieldcurveissimplyflat—thedifferenceinratesis

approximatelyzero—thechanceofarecessiononeyearlateris25%,oroneinfour.Thechancesofaslumprisetoapproximately70%whenthespreadwidenstominus1.5percentagepoints.Bestofall,becauseit’ssoforwardlooking,investorshaveplentyoftimetoact

ontheinformation.Specifically,ifyouspyarecessiononthehorizon,thenonestrategyistostartlookingtomoveawayfromso-calledriskyassetstowardlessriskyones,saysCrescenzi.Inthiscase,investorsshouldstayawayfromjunk-rateddebtinvestments(so-

calledhighyield)infavorofhigh-qualitybondsorgovernmentsecuritiesthatwillriseinvalueasinterestratesfall.Lookalsotoavoidsharesofcompaniesthatareseenaseconomically

sensitive,likehomebuildersandretailers.Instead,Crescenzisuggests,buydefensivestockslikethosethatsellconsumerstaplesorcatertobudget-consciousconsumers.

EXECSUMMARY:YIELDCURVE


Wheretolook:TheWallStreetJournalpublishestheyieldcurvedaily,inclassicchartformat.DataonyieldsofdifferentmaturitiesofTreasurysecuritiescanbefoundinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tab.Alternatively,youcanfindthedataintheFREDdatabaseattheSt.LouisFed.TheMishkinpaperisavailableallovertheWeb.Here’soneplacetograbit:

http://ideas.repec.org/p/nbr/nberwo/5279.html.4

Whattowatchfor:Increases(decreases)inthespreadbetweenlong-andshort-

termTreasuries.

Whatitmeans:Theeconomyisheatingup(coolingdown).Thehighertheshort-terminterestraterisesoverthelong-termone,themorelikelytheeconomyisheadedintorecession.

Whatstepstotake:Appropriatecyclicalinvestments,e.g.,buyhigh-qualitybondsandconsumerstaplesandavoidhigh-risksecuritieswhenitlooksliketheeconomyiscoolingdown.

Risklevel:Medium.


Inflation,Fear,andUncertainty

OURREMAININGELEVENINDICATORSarearguablythemostimportantofallbecausetheypointtothepossibleapproachofthethreehorsemenoftheapocalypse.Well,theinvestmentapocalypseanyway.Theyareinflation,fear,anduncertainty.Often,theyareabsolutelycrucialtoseeingimpendingrecessionsbefore

theinvestingherddoesbecausetheycanpresagemajordownticksintheGDPcomponentsofconsumption,investment,government,imports,exports,andthecombinationindicators(C,I,G,andNX).Wheninflation,fear,oruncertaintyreartheiruglyheads,arapidresponsecansaveinvestorsabundleandgreatlyrewardtheboldandthebrave.

I

Chapter40GDPDeflator

Coincident(SeealsoProducerPriceIndex,BigMacIndex)

NFLATIONMATTERSBECAUSEit’slikeasilenttax.Ingoodtimesitslowlyeatsawayatthepurchasingpowerofyourmoneyorcash.Inbadtimesithasa

voraciousappetiteandquicklyrenderspapermoneyworthless.Thissilenttaxhurtsthosewhocanleastaffordit:thepoorandthoseonfixed

incomes.UndoubtedlyitcontributedtostrifebetweentheworldwarsinGermanywhenpeopleneededwheel-barrowsfullofcashtobuybasicfoods.Becauseoftheseconsequences,economists,politicians,andthepublictakenoteofit.Therearemanymeasuresofinflation,andnotoneofthemisperfect.Butthe

GDPdeflatorhassignificantmerits,accordingtoMichaelWoolfolk,managingdirectorandforeignexchangestrategistatBankofNewYorkMellon.TheGDPdeflatortellsushowmuchthepricesofgoodsandservicesrose

duringagivenmeasurementperiod.It’susedto“deflatetheGDP”figuresandtellushowmuchtheeconomygrewin“real”terms.Forthatreasonweseeitcomeoutonceperquarteralongwithdetailsofhowmuchtheeconomygrew.TheGDPdeflatorhasanadvantageoverthemorewidelyrecognizedCPI

(ConsumerPriceIndex).Ittellsuswhatpricesdidforallgoodsandservicesacrosstheeconomy,whereastheCPIlooksonlyatarelativelysmallbasketofgoods.Thatgenerallyfixedbasketcanleadtodistortionsinmeasurementofinflation.WoolfolkalsopointstothefactthatU.S.CPI(ConsumerPriceIndex,which

tracksthechangingpriceofabasketofgoodsandservices)isn’treallycomparableacrossnationalboundaries.“TheGDPdeflatoristhemostbroad-basedmeasureofinflationandarguably

itisthemostcomparabletoinflationmeasuresinothercountries,”hesays,notingthatCPIcalculationsindifferentcountriestendtousetotallydifferentmetrics.

InvestmentStrategy

WoolfolkusestheGDPdeflatortohelpanalyzethecurrencymarkets.That’sgenerallyconsideredtobeaprettytallorderascurrencymarketsaregenerallyconsideredtoberatheropaque.Ontopofthat,governmentshavebeenknowntointerveneincurrencymarkets,throwingoffotherwisesoundeconomicanalysis.However,Woolfolkgetsahandleononepartoftheproblem—thatofthe

economicanalysis—bytryingtoadjusthisforecastsfordifferencesinrelativeinflationlevels.Thedifferencebetweentheratesofinflationtellsushowmuchfasterthespendingpowerofonecurrencyisdepreciatingrelativetotheother.Ifallelsestaysthesame,thenthatmeansthecountrywiththehigherinflationshouldseethevalueofitscurrencyfallrelativetothecurrencyofthelower-inflationcountry.HeusesanexampleoftheJapaneseyenandtheU.S.dollar.IftheUnited

Stateshasinflationof3%andJapanzero,anot-unfamiliarsituationformuchofrecenthistory,thenWoolfolkadjustshiscurrencyprojectionsbythedifference.Soaprojectionofonehundredyentothedollarwouldbereducedtoninety-sevenyeninthisexample.Aswithmanyoftheindicators,however,theGDPdeflatorhasitsdrawbacks,

too.Notably,itonlycomesoutquarterly.TheConsumerPriceIndexandtheProducerPriceIndexarebothpublishedmonthly.Separately,ifusingthisdataforcurrencytrading,it’sworthnotingthatthe

currencymarketsaredominatedbyhugeplayersincludingcentralbanks(liketheBankofEngland)andmassivecommercialbankslikeCitigroup.Thatmeanssmallinvestorsoftenstandtolosewheninvestinginthem.Becautiousbeforedippingatoeintothecurrencymarkets!

EXECSUMMARY:GDPDEFLATOR

Whentolook:At8:30a.m.ET,thethirdorfourthweekofthemonth.ThedatacomesoutintandemwithGDP.Therearethreeestimatesgiventoeachquarter’sdata.

Wheretolook:TogettheGDPdeflatordata,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,

you’llneedtogotothe“Calendars&Economy”sectionandlookunder“U.S.EconomicEvents”for“GDP.”TheGDPdeflatoristhesamethingastheGDPpriceindex.Alternatively,theFREDdatabasepublishestheGDPdeflator,asdoesthe

BureauofEconomicAnalysisatwww.bea.gov.It’salsoeasytogetdatafromthefree“Investor”sectionofthewebsiteBriefing.com.

Whattowatchfor:Changesinrelativeinflationratesbetweentwocountries.

Whatitmeans:Thecurrencyofthecountryexperiencingmoreinflationwilleventuallydepreciatevis-à-vistheother.

Whatstepstotake:Buythecurrencyexperiencingrelativelylessinflationandsitouttheshort-termfluctuationsandgovernmentinterventionsthatregularlyrockforeignexchangemarkets.



Chapter41GoldPrice

Y

Leading

OU’VeHEARDOFTHEgoldenrule—whoeverhasthegoldmakestherules.It’strite—ratherlikesaying,bericher.Whatisn’tsotrivialisthefactthatgold

canbeusedasameasuringstickofsentiment.Broadlyspeaking,goldisahighlysensitivebarometerofallthingsdodgyeconomically,financially,andgeopolitically.Whentheeconomyisrobust,thefinancialsystemissound,andtheworldis

notinvolvedinmajorupheaval,investorsdon’ttendtobuygold,andpricesforthemetaltendtoremainsubdued.Duringthe1980sand1990s,forexample,mostinvestorsshunnedgold,

preferringotherinvestments.Asaresult,goldremainedinabearmarketforthetwodecadesfrom1980through1999,duringwhichthepricefellfromapeakof$850toalowaround$250anounce.Thatalsocoincidedwithgreattimeseconomically:highgrowth,lowinflation,andnoprolongedwars.Contrastthatwiththedecadestarting2001.Duringthattimegoldpriceshave

morethanquintupledfromaround$260anouncetoover$1,300bylate2010.Thatcoincidedwiththeburstingofthetechbubble,theriseandfallofaspeculativemaniainU.S.realestate,thenearcripplingoftheworldbankingsystem,andthedrawn-outinvolvementbytheUnitedStatesintwomajorwars:IraqandAfghanistan.OntopofthattheU.S.governmentisborrowingunsustainableamountsofmoney,raisingthethreatofinflation.That’swheregoldstepsinasaviableinvestment.Themetalhasbeenshown

tobeastoreofvalueovertheverylongterm,whilepapermoneyinvariablylosesmuchofitsvaluewithinmeredecadesifnotmorequickly.VeterangoldinvestorGeorgeGeropointsoutthatinthe1930sakiloofgoldwouldbuyyouanicefour-doorcar;itwillstilldoexactlythesamethingtoday.That’sdespitethefactthatadollar,oranyothercurrency,willbuyyouatinyfractionofwhatitoncedid.

InvestmentStrategy

Thekeytousinggoldasasentimentindicatoriswatchinginvestmentdemandforthemetal.Abouttwo-thirdsofthegoldproducedintheworldgoesintomakingjewelry.Butwhatismostcorrelatedwithsurgesinthegoldpriceishowmuchgoldinvestorsaresockingaway.JeffChristian,headofNewYork–basedcommoditiesconsultingfirmCPM

Group,notesthatthegoldpricetendstodowellwheninvestmentdemandisover20millionouncesayear.“Wearestillusingthatrubric,”saysChristian.Thebigdifferencenowisthat

investorsaresnappingupevengreaterquantitiesandlooksettocontinuedoingso,hesays.Sohowdoyouusethisinformationtomakesomemoney?Youcouldtryto

followthesmartmoneyandinvestingoldwheninvestorsarebuyinglotsofthemetal.However,thatmightbebetterlefttoprofessionalslikeChristianbecausethegoldmarketismurkytosaytheleast.Whatyoucando,though,isusegoldasportfolioinsurance,orinsurance

againsteconomiccatastrophes.“Myviewhasalwaysbeenthataportionofyourportfolioshouldbedesignedtoprotectagainstdisasters,”saysChristian,whohasbeenactivelywatchingthegoldmarketsincethemid-1970s.“Butmostofyourportfolioshouldbedesignedtobenefitfrommoreprobableeconomicscenarios.”Orputanotherway,putapercentageofyourportfoliointogold.Thepriceof

goldhasbeenshowntobeuncorrelatedwiththepricesofotherassets,andthatlackofcorrelationmeansthatitreducestheswingsintheoverallvalueofaninvestmentportfolio.Iftheworsthappens,thenthevalueofthegoldwilllikelyappreciate.Iftheworstdoesn’thappen,thentheotherinvestmentswilldowell.Mostprofessionalsthinkputting5–15%ofyourtotalportfoliointogoldisappropriate.Thereareafewmethodsofbuyinggold.ThesimplestistheSPDRGold

Sharesexchange-tradedfund(GLD),whichisboughtjustlikestocks.Youcanalsobuyphysicalgoldintheformofcoins.Butmakecertaintopurchaseonlybullioncoins,thosewhosevalueisdeterminedbythegoldcontentandnotbyfinishorrarity.PopularcoinsincludeAmericanEagles,SouthAfricanKrugerrands,andCanadianMapleLeafs.

EXECSUMMARY:GOLDPRICE

Whentolook:Goldistradedmostbusinessdays.

Wheretolook:Forgoldprices,gotoTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Commodities&Futures”sectionandlookforgoldunderthemetalssection.Inaddition,WorldGoldCouncilhasawealthofinformationonallthingsgold

atGold.org.Itsponsorsthelargestgoldexchange-tradedfund,theSPDRGoldShares,andprovidesdailyinformationonhowmuchgoldisheldbythefund.TheWorldGoldCouncilworkscloselywithLondon-basedconsultingfirm

GFMSLtd.topublishresearch.CPMalsopublishesbooksongold,whichcontainhard-to-obtainhistoricaldataaswellasmarketcommentary.TheLondonBullionMarketAssociation,LBMA.org.uk,dominatesthetrade

ingoldandpublishesareferencepriceknownasthe“fix.”Thepriceisn’trigged.ThefixismuchlikethesettlementpriceonU.S.futuresexchanges.AlsocheckoutKitco.com,thewebsiteoftheMontreal-basedgolddealer.

Whattowatchfor:Changesinpricesandquantitiesindicatingthatsupplyand/ordemandforgoldisshifting.

Whatitmeans:Whendemandforgoldincreases,investorsfearinflation,eveneconomicimplosion,orgeopoliticalinstability.

Whatstepstotake:Buy(short)goldonthefirsthintofinflationorcatastrophe,man-madeornatural(signsoflong-termpricelevelandfinancialsystemstability).

Risklevel:High.


Chapter42MiseryIndex

W

CoincidenttoLeading

HENTHEECONOMICSGODSaresmiling,weseeourpaychecksgetfatterandthegoodswebuygetcheaper.Don’tlaugh.It’sbeenknowntohappen.But

sometimeswegettheopposite.Weseeourpaychecksdisappear(loseourjobs)andthecostsofeverythingweneedtobuyskyrockets(inflation).That’seconomicmisery.Wecan’tbesurebecausehe’snotalivetoask,buteconomicandsocialmisery

werelikelyattheforefrontofeconomistArthurOkun’smindwhenhedevelopedtheMiseryIndex(MI).Likesomanybrilliantideas,theMIissimple.Itjustaddstheunemploymentratetogetherwiththeinflationrate.Thehigherthefigure,themoremiserysocietyhastodealwith.“TheMiseryIndexcapturesthepainthroughouttheeconomy,”saysPeter

Rodriguez,professorofeconomicsattheDardenBusinessSchool,UniversityofVirginia.“It’smostacuteamongthelowestrungsontheeconomicladder.”ItmakessensethattheMIwasdevelopedinthe1970s,whenforthefirsttime

sincethe1860sthegovernment’s(orthegoldstandard’s)tightholdoninflationcameunstuck,explainsRodriguez.DuringthatsamedreadfuldecadecamelevelsofunemploymentnotseensincetheGreatDepressionofthe1930s.Undertheeconomictheoriesprevailingintheseventies,highinflationandhighunemploymentwereincompatible;theformerwouldautomaticallycreatejobsandthelatterwouldnaturallykeeppricesdown.However,thetheorieswerewrong.“Thisphenomenonofhighunemploymentandrisinginflationwasanewthing

altogetherandwehadthe‘dismalscience’turningintothe‘miserablescience,’”saysRodriguez.AsimilarindexinventedbyeconomistRobertBarro,theBarroMiseryIndex,alsousesinflationandunemploymentbutaddsinothervariablestoo.

InvestmentStrategy

“Forthemostpartthisisaveryblue-collarindex,”saysRodriguez.However,thatisnottosaythatthosehigheruptheladderdon’tfeelsomethingalso,headds.Becauseofthewayeconomicpainisfelt,wecanusetheMiseryIndexasa

crudemetrictohelpreadtheelectoraltealeaves.Ormoresimplyput,whentheMiseryIndexishighandrising,thenyoucanexpectthegeneralpopulacetobehoppingmad.Andsometimestheyhopmadlytothepollingplace,wheretheytakeouttheir

frustrationsonincumbents,aswhentheyoustedDemocraticpresidentJimmyCarter.WhenCartertookoffice,theMiseryIndexwasafairlyelevated12.7,butclosetothelowofhisone-termpresidency.Itjumpedtotherecordhigh(ofanypresidency)ofabout22inJune1980.Needlesstosay,CarterlosttoRonaldReaganinaRepublicanlandslide.ThosepresidentswhosomehowmanagedtoseetheMiseryIndexdroporstay

relativelyflattendedtomakeitthroughtwoterms—GeorgeW.BushandBillClintonaretwoexamples.“Eitherthepresidentmustimprovetheoveralleconomicconditionsorhe

won’tgetasecondchance,”saysRodriguez.TheMiseryIndexalsotellsushowwelltheFederalReserveisdoing.

RodriguezpointsouttheFed,unlikeothercentralbanks,hasadoublemandateoflowinflationandlowunemployment.SothehighertheMiseryIndex,theworsethejobtheFedisdoing.WhatinvestorscandowiththeMIisatricky,contextualquestion.Theymight

usetheMItopredict“gridlock”inWashington,whichmightbebullishforstocks.Ortheymightuseittohelpreadtheinterestratetealeaves.TheFedisprettyindependentfromthepoliticalprocess,butitisnotcompletelyimmuneasitenjoysnoconstitutionalprotection.

EXECSUMMARY:MISERYINDEX

Whentolook:Wheneverinflationorunemploymentrateschange.

Wheretolook:YoucangetthecomponentsoftheMiseryIndex—theunemploymentrateandtheCPIinflationrate—yourselfbygoingtoTheWallStreetJournalonline’s“MarketDataCenter”www.WSJMarkets.com.ThesamedataisalsoavailableattheBureauofLaborStatisticswebsite,

www.bls.gov.Alternatively,youcangetyourdataalreadydownloadedalongwithdetailsof

whowasintheWhiteHouseatthattimeatwww.MiseryIndex.us/.

Whattowatchfor:Arising(falling)MiseryIndex.

Whatitmeans:Incumbentpoliticiansareindeepdoo-doo(haveitmadeintheshade)andFedbashingwillbeontherise(decline).

Whatstepstotake:Lookforchanges(thestatusquo)inWashingtonandattheFed.

Risklevel:ThatdependsonwhatyoudowiththeMI.Ifyoubetamillionbucksevenmoneyonthenextpresidentialelectionwe’dconsiderthatprettyrisky.Ifyouusetheindexinconjunctionwiththeotherforty-ninediscussedinthisbooktoplacesmallbets,thenwe’dsaythatitisprettylow.

Profitpossibility:$to$$$$

I

Chapter43ProducerPriceIndex

LeadingintoRecessions,CoincidentintoExpansions(SeealsoGDPDeflator,GoldPrices,TIPSSpreads)

NFLATIONISN’TBORNINthesupermarket.Ratherstoresinherititasthepricesofgoodstheybuyfromtheirsuppliersrise.That’swhylookingatthepricesof

thethingsthatproducerssellgivesusaspecialwindowintowhereconsumerpricesmightbegoing.ForthatwegototheaptlynamedProducerPriceIndexorPPI.ThePPIisameasureofinflationthatismuchlessfamousthanitscousin,the

CPIorConsumerPriceIndex.InsteadofmeasuringhowmuchabasketofgoodsandservicescostsindividualconsumersastheCPIdoes,thePPImeasureshowmuchdomesticproducersreceivefortheiroutputsor,lookedatfromtheotherside,howmuchretailerspayforthegoodstheysell.“PPItellsusaboutbusinesscosts,”saysPeterRodriguez,professorofeconomicsattheDardenBusinessSchool,UniversityofVirginia.“Whentheeconomyadjusts,someofthefirstindicationsofthatchangewillbeseeninproducers’prices.”Inrecessionarytimesproducersareunderstresstosurvive,sotheywilllower

theircostsandcutpricesorwages.Also,inordertokeeptheircustomershappytheywilloftentrytocushionpriceincreasesfromthefinalconsumers.Butwhentimesaregood,pricesgetpassedontoconsumersimmediately.

InvestmentStrategy

ThePPIincludesanumberofdifferentcomponentsincludingtwoveryvolatileelements:foodandenergy.Thatinstabilitymakeslookingattheoverallfigurerathertrickyforeconomistsandinvestors.Sotomakethingseasiertheystripoutthefoodandenergypricesandlookattheso-calledcorerate.Theideahereisthatit’seasiertospottrendswhenthereislessvolatilityintheindex.AndtrendsaretherealkeywiththePPI.Rodriguezsays,“Lookfor

multimonthtrends.”Morespecificallyhesaysit’sworthlookingatthe“highestfrequencymovingaverages,”likeanaverageofthelastthreeorfivemonths.Whenyouplotthoseaverages,thenyoucanlookfortrendswithinthoseaverages.Specificallytrythis:Overtimetakeanaverageofthepriorthreemonths

annualizedPPIrateandplotitonachart.Theseso-calledrollingaveragesironoutthevolatilityinthemonth-to-monthdata.Ifyoucanseeacleartrend,thenyoucanstarttodrawconclusions.Forinstance,iftheaverageinflationforthepriorthreemonthsrisesfrom1%

to2%,then3%overtheperiodofJune,July,andAugust,thenthereisclearlyatrendofrisinginflation.Whereasifthethree-monthmovingaveragewas4%inonemonthfollowedbyadeclineof2%andthenariseof1%,itwouldbehardtoarguethatinflationisbecomingaproblem.Anupwardtrendcouldmeaninflationattheretaillevelcomingdownthe

road.Oriftheeconomyisweakitcouldmeantheprofitmarginsofretailersandproducersalikewillbesqueezed.Fallingpricesaretrickiertoanalyze.Theymightfallduetoaweakeconomy

oritmightbebecauseofefficiencygainsatthemanufacturinglevel,saysRodriguez.RodriguezsaysTreasuryInflation-ProtectedSecurities(TIPS)areagoodway

tobeatinflationrelativetoregularbonds.Regularbondspayinterestandprincipalonlyonthe“nominal”facevalueofthesecurityratherthanthespendingpoweroftheoriginalbond.IfTIPSdon’tappeal,hesaysyoumightchoosetoholdyourassetsinaless

inflationarycurrency.Healsopointstogoldasauseful,albeitvolatile,hedge.

EXECSUMMARY:PRODUCERPRICEINDEX

Whentolook:At8:30a.m.ETaroundthemiddleofthemonth.

Wheretolook:EditorsandwritersatTheWallStreetJournalwatchthePPIclosely.Asnewsaboutitisreleased,JournalreportersfilebreakingnewsstoriesforpublicationonWSJ.com.Ifit’sjustthedatayouarelookingfor,gotoTheWallStreetJournalonline’s

“MarketDataCenter”atwww.WSJMarkets.com.You’llneedtolookunderthe“Calendars&Economy”tabfor“U.S.EconomicEvents”andfind“ProducerPriceIndex.”Alternatively,youcouldgotothesource:theBureauofLaborStatistics,

whichcomputesthePPI.Seewww.bls.gov/pPI/.HistoricaldataisavailableontheFREDdatabaseathttp://research.stlouisfed.org/fred2/series/PPIACO?cid=31.Briefing.comalsohastheinformationreadilyavailableinitsfree“Investor”

sectiononitswebsite.

Whattowatchfor:Unexpectedincreases(decreases)inthecorePPIthree-orfive-monthmovingaverage.

Whatitmeans:Inflationmaybeabouttogowild(remaintame).

Whatstepstotake:Getinto(outof)inflationhedgeslikeTIPS,gold,orlessinflationarycurrencies.

Risklevel:High.


S

Chapter44RetailInvestmentActivity

LeadingintoRecessions,LaggingduringRecoveries

OMEPEOPLEAREJUSTbornunlucky—sounluckyinfactthattheydojusttheoppositeofwhattheyshouldatexactlythewrongtime.Suckers?Maybe.But

inthebusinessofinvesting,thosepeoplehaveaname:retailinvestors.Economistsandinvestorscanlearnalotbywatchingagroupthathas

historicallymadeverypoordecisionswhenputtingtheirownmoneytowork.Specifically,we’retalkingaboutthe“littleguy.”Whenthelittleguysinvestinanyassetclassinabigway,beitstocksorhouses,theeasyprofitsareusuallyalmostover.“Itendtothinkthatretailinvestorswillhearaboutthingswhenit’stoolate,”

saysPeterWelgoss,researchanalystatFinancialResearchCorporation(FRC)inBoston,Massachusetts.“It’soneofthosethingsthathasplaguedsmallinvestorsforalongtime.”FRCcollectsandcollatesdataoninvestmentsinmutualfunds,aproduct

favoredbymostsmallinvestors.Wecangetahandleonwhattheretailinvestorisdoingbyusingthatdataandthenincertaincasesdoingtheexactopposite.Why?Becausethelittleguystendtodotheoppositeofwhatthesavvy

institutionalinvestordoes.Smallinvestorstendtobuyatornearthehighpointsforthemarket,usuallywhenthe“smart”moneyisbailing.Likewiseretailinvestorstendtosellwhenmarketpricesareatorneartheirlows,whenperhapstheyshouldbebuying.“Thatmightjustbeahumannaturepanicbuttoneffect,”explainsWelgoss.

InvestmentStrategy

FRCtrackshowmuchmoneyinvestorsplowintomutualfundseachmonthbyusingsophisticatedtechniquestoestimatehowmuchmoneyeitherflowedintooroutofaparticularfund.FRC’smutualfunddataisimportantbecauseitisolateswhatretailinvestors

aredoing.Professionalinvestorstendnottoinvestinmutualfunds.Insteadtheymightuseexchange-tradedfundsforstockmarketinvestments,orbuyindividualbondsinthefixedincomemarket.Richindividualsalsotendnottobuymutualfunds.Insteadtheyemploymoneymanagerstotailoraportfoliospecificallyfortheirneeds.Ofcoursethereareexceptionstotheserules.Butingeneraltheyholdtrue

enoughforustousetheflowsofmoneyintoandoutofmutualfundsasaproxyforretailinvestorsentiment.Becausethemutualfundsaretypicallycategorizedbythetypeofassetthey

investin—stocks,bonds,cash,preciousmetals,domesticorinternational—wecanseewhichcategoriesoffundssawthebiggestinflowandwhichsawthebiggestoutflow.Thatmeansyoucanseewhichassettypessmallinvestorswentcrazyforandwhichtheyfled.Ifwecombinethatwithinformationabouttheperformanceofcertainassets,

wecangetanideaofwhetheranassettypeiseitherenteringabubbleorwhetheritisunfairlybeingdumped.Forinstance,ifreturnsonbondfundshavebeenhealthyandyouseeretail

investorspilinginathistoricallyhighlevels,thenitmightbeworthevaluatingwhetheritmakessensetofollowtheherdortogoinadifferentdirection.Sometimestheflowofmoneyintoaparticularfundistheresultofan

advertisingcampaignthathaslittletodowithconsumersentimentforaparticularasset.So,asalways,youneedtodocarefulresearch.

EXECSUMMARY:RETAILINVESTMENTACTIVITY

Whentolook:Catchascatchcan.

Wheretolook:FRCdoesn’tprovidethefundsflowdatatojustanyone.You

havetobeabigcorporation.However,theirpressreleasesaboutthemonthlyfundsflowdatatendtogetwrittenupinthebusinessmediaandsodetailsofthefundsflowsareavailableontheWebforthosewillingtodigalittlebit.Inaddition,dataonmostmutualfundsisprovidedbyMorning-star,andit

shouldbepossibletoestimate(roughly)whattheflowsarebylookingattheassetsundermanagementandseeingthedifferenceinvaluebetweenmeasurementperiods.(You’llneedtomakeslightadjustmentstoaccountfortheunderlyingperformanceofthefund.)

Whattowatchfor:Changesinretailinvestorsentimentasmeasuredbyinvestmentflowsinto(outof)differenttypesofmutualfunds.Morespecifically,lookforrecordflowsoffundsinto(oroutof)differentassetclasses.

Whatitmeans:Arecordoutflow(inflow)offundsfromacertainassetcouldsignalthattheendofabear(bull)marketisnear.

Whatstepstotake:Buywhenthe“littleguy”sellsandsellwhenhebuys,especiallywhenthatistheoppositeofwhatprofessionalinvestorsaredoing.

Risklevel:Medium.


T

Chapter45CreditSpreads:TheRiskStructureofInterestRates

Leading(SeealsoTedSpread)

AKINGRISKSISATtheheartofAmerican-stylecapitalism.Thatdoesn’tmeanyoushouldtakeinsane,swashbucklingriskslikethosetakenbynuttythrill

seekersorberserkwarriors.Rather,itistakingrisksforaprofitthatisthetrueessenceofgoodbusiness.NowhereisthismorequantifiablethaninthebondmarketwherebigpubliclytradedcompaniesgotoborrowmoneybysellingIOUs.Insimpleterms,riskiercompaniespaymoretoborrowmoneythanlessrisky

ones.Itmakessense.Youwouldn’tlendtoariskiercompanyifyou’dmakethesamemoneylendingtoasaferone.You’dwantmorereturnfortheincreasedrisk.Thisdifferenceinthecostofborrowingiscalledthecreditspread.Itis

measuredinmanyways,butherewefocusonthedifferencebetweentheinterestratespaidontheabsolutehighestgradeoftradeddebt(thatratedAAA)andthatofagradeslightlybetterthanjunkbonds(ratedBBB).(Ostensibly,specializedratingagenciesratedebtbasedonthecreditworthinessoftheborrower.)Thesizeofthiscreditspreadalsochangesovertime,narrowingaheadofan

economicrecoveryandthenwideningbeforeaneconomicslowdown.Theeconomicsbehindthischangingrelationshipisquitesimple,andthey’realsobehindthepredictivequalitiesofthisindicator.“Capitalbeingputtoworkmakestheworldgoround,economically

speaking,”saysDavidRanson,headofresearchattheBeverlyFarms,Massachusetts–basedeconomicsconsultingfirmH.C.Wainwright&Co.EconomicsInc.Asthecreditspreadswiden,itmeansinvestorsarepricinginahigherlevelofrisk.Thatincreasedperceptionofrisktendstoslowtheflowof

capitalthroughtheeconomy.Withoutenoughcapital,economicgrowthischokedoff.“ThisiswhathappenedinOctober2008,”whenspreadswidenedandcapital

stoppedflowing,saysRanson.“Hence,yougotarecession.”Thegoodnewsisthatthesamethinghappensinreverse.Whencreditspreads

narrow,it’sanindicationthatcapitalisflowingmorefreelythroughtheeconomy.Bydoingsoitfuelseconomicgrowth.

InvestmentStrategy

Ransonhasstudiedthewaycreditspreadstendtomoveinrelationtotheeconomyallthewaybackto1949.Onaverage,whenevercreditspreadswidenornarrowdramaticallytheeconomyrespondsinamajorway.Broadlyspeaking,amajornarrowinginthespreadresultsinstrongeconomicgrowthshortlythereafter.Awideningofthecreditspreadslowsgrowthdown.Specifically,whathefoundwasthatwhencreditspreadsnarrowbymorethan

3.5percentagepoints(forexample,thedifferenceinborrowingcostsbetweenhigh-qualityborrowersandlower-qualityonesdecreasingfrom6.5%peryearto3%),theneconomicgrowthinthatsamequartertendstojumpbymorethan5%onaverage.Butmoreimportant,threetosixmonthslatereconomicgrowthexplodes,with

annualizedgrowthratesexceeding6%.Incaseyouareinanydoubt,thatcountsassmoking-hotgrowthforarichcountryliketheUnitedStates.RansoncorrectlypredictedthebounceintheU.S.economyinthefourthquarterof2009followingthedramaticnarrowingofcreditspreads—aninsightthatwasnotobvioustomosteconomicobserversatthetime.Hisstudyalsofoundthatawideningofcreditspreadsby3.5percentagepointstendstoleadtoadropineconomicoutputbyabout1.4%inthatsamequarterandalsothreemonthslater.Sohowdoyoumakethisknowledgeworkforyou?Theanswerissimple:You

choosetobuycertainassetclassesthatwilllikelydowellintheapproachingeconomicscenario.Ascreditspreadswidendramatically,it’ssafetoassumethataneconomic

slowdownwillfollowrelativelyshortlythereafter.“Attheonsetofrecession,seekouttheinvestmentsthatoffersafetyratherthanriskinanyform,orcyclicality,”saysRanson.Specifically,hesaysfavorsovereignorgovernmentdebtsuchasU.S.Treasury

bonds—aswellasgoldasasafe-havenasset—andavoidcommoditiesandequitiesofanytype.(Ransonexcludesgoldfromhisdefinitionofcommodities.Insteadhe,likesomeothers,seesitasitsownspecialassetclass.)U.S.TreasuriescanbepurchaseddirectlyfromtheU.S.governmentat

TreasuryDirect.gov.SmallinvestorscangetexposuretothepriceofgoldbullionbyconsideringtheSPDRGoldSharesexchange-tradedfund(GLD),whichholdsbarsofgold.Ascreditspreadsnarrow,itsignalsthattheeconomyis

comingoutofarecession.Sotheoppositeinvestmentadviceapplies.Investorsshould“embracerisk,”saysRanson.Also,emergingmarketsstockscanbegoodtooastheytendtobehavelike

hybridscombiningcommoditiesexposureandequityrisks.Manyemergingmarketscompaniesareengagedincommoditybusinesseslikeminingandagriculture.

EXECSUMMARY:CREDITSPREADS—THERISKSTRUCTUREOFINTERESTRATES


Wheretolook:TheWallStreetJournalonline’s“MarketDataCenter”hassomeinformationoncorporatedebtyields.You’llfindthedatacenteratwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tabandlookforthe“MostActives”incorporatebonds.OtherinterestratedataforcorporatebondsiswidelyavailableontheInternet.

Foreasilysearchedanddownloadedhistoricaldata,oftengoingbackdecades,ourfavoritesiteistheFREDdatabaseathttp://research.stlouisfed.org/fred2/.Also,privateconsultingfirmslikeH.C.Wainwright&Co.Economicscompilesuchdata.

Whattowatchfor:Narrowing(widening)creditspreads.

Whatitmeans:Theeconomyisgoingtogrow(shrink)thatquarterandthenext.

Whatstepstotake:Buystocksandcommodities(buyshort-termbondsandgold,orkeepholdingsincash).

Risklevel:Medium.


F

Chapter46TedSpread

Leading(SeealsoLibor,CreditAvailabilityOscillator)

OLLOWINGTHEGREATCREDITCrunchof2008,itbecamereally,reallyfashionabletohatebanks.However,thereisprobablyamoreprofitableway

toexpressyouranger.That’stofigureouthowbanksfeelaboutmakingloansandthenmakingakilling.Despiteallthebrouhahaandthehating,lendingbybanksiskeytoeconomic

growth.It’sactuallyquiteeasytotellhowbankerscollectivelyfeelaboutlendingbylookingathowtheypricetheriskthatloanswon’tbepaidback.Specifically,thequestionishowmuchmoredothebankspaytolendtoeach

otherthanthegovernmentpaystoborrow?TheU.S.governmentisconsideredtohavezeroriskthatitwon’tpayitsloansback.(Itcantaxandprintmoneyatwill,afterall.)Soanyinterestratechargedoverthegovernment’srateisameasureofcreditrisk.Wecaneasilyanswerthequestionofhowmuchmorebanksneedtopaythan

doesthegovernmentbycalculatingtheTedSpread,thedifferencebetweentheyieldonT-billsandLibor,therateatwhichbankslendtoeachother.“Itrepresentstheoxygenlevelinthefinancialmarkets,”saysDavid

Rosenberg,chiefeconomistandstrategistatToronto-basedwealthmanagementcompanyGluskinSheff.“Itassesseshowconfidentthecommercialbanksareinlendingtooneanother.”Anarrowspreadindicatesconfidence.Awidespread,lessconfidence.Areally

widespread,pandemonium.Thismattersbecausehowmuchbankslendandwhatpricetheychargeto

borrowmoneyhasamajorimpactontheeconomy.Typically,morelendingleadstoeconomicgrowth.Lesslendingleadstoaslowdownorevenarecession.

“Invariablywhathappensinthefinancialarenaendsupintherealsideoftheeconomy,”Rosenbergsays.

InvestmentStrategy

WhentheTedSpreadwidens,theoverallamountoflendingintheeconomycontracts,andthatultimatelyleadsto“avisibleslowingineconomicgrowth,”explainsRosenberg.Likewise,whentheTedSpreadnarrows,itisasignthatlendingisresuming.Orputanotherway,theappetitefortakingonriskierloansbybanksisincreasing.TheTedSpreadwidenedin1987,1990,1998,2000,2008,and2010.

Recessionsdidnotfollowin1987or1998,buttheydidin1990,2000,and2008.SoariseinTedclearlysuggeststhataperiodofslowereconomicgrowthmay

beintheoffing,but,aswheninterpretingotherindicators,it’simportanttolookforasustainedtrendandcorroboratingevidencebeforeacting.Ingeneral,lowerappetiteforlendingbybanksisnotauspiciousforthe

economy,anditdoeschangetherisk-rewardratioinfavorofmakingmorecautiousinvestmentdecisions.“Whenyoustartnoticingthisindicatoriswidening,it’susuallyasigntostep

tothesidelinesandincrementallytakeriskoffthetable,”saysRosenberg.Solooktoinvestinrelativelylow-riskassetslikegovernmentorhigh-rated

corporatebonds.Ifyouwanttostayinstocks,lookatcompaniesthatspecializeinconsumerstapleslikemanufacturersandretailersofsoap,toothpaste,andshampoo.But“don’tdoanythingwholehog,”hewarns,meaningmakechangestoa

portfolioofinvestmentsinsmallincrements.Andthat’sparticularlypertinentgiventhattheTedSpreadcannarrowquickly,indicatingthatthebanksonceagainfeelbetteraboutlending.

EXECSUMMARY:TEDSPREAD


Wheretolook:YoucancalculateyourownTedSpreadbylookingupLiborratesandsubtractingtheT-billrates.Tobeexactyouneedthree-monthT-billratesandthree-monthLiborrates.YoucanfindboththeseratesinTheWallStreetJournalonline’s“MarketData

Center”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”tab.Alternatively,forU.S.Treasuryyields,seetheFREDdatabase.ForLibor,look

atthewebsiteoftheBritishBankers’Associationatwww.bbalibor.com/bba.

Whattowatchfor:Increases(decreases)inTedspreads,thedifferencebetweenTreasuryyieldsandLibor.

Whatitmeans:Bankswillbelendingless(more)inthenearfuture,slowing(stimulating)theeconomy.

Whatstepstotake:Appropriatecyclicalinvestment,i.e.,loweringexposureincrementallytoriskierassetslikestocksasTedspreadswiden.

Risklevel:Medium.


Chapter47Texas“ZombieBank”Ratio

W

Leading

HENTHEDEFINITIVEMOVIEoftheGreatCreditCrunchof2008ismade,itshouldbegiventhesubheading“AttackoftheKillerZombieBanks.”

Zombies,youmayrecall,aretheundead,neitherdeadnoralive.Torturedbythisunnaturalstateofbeing,theywreakhavocamongthelivinguntildestroyed.Thezombiebanksaresimilar.Theycausehavoctoo.Neitheraliveenoughto

makeloans,nordeadenoughtodieorgettakenover,theylingeranddragontheeconomy.Howdoyouknowifyourbankisazombiebank?Youusetheso-calledTexas

Ratio.Itwasinventedintheearly1980sbyGerardCassidyandhiscolleaguesatRBCCapitalMarkets.Inthesimplesttermsitcomparestheratioofbadassetsatabanktoits

availablecapital.Thatavailablecapitalisacushionagainstthefirmgoingbust.“IcoveredtheTexasbanksinthe1980sandwhatIlearnedfromthemwasthat

whentheirTexasRatiobrokethrough100%theywentbust,”saysCassidy,who’sstillwithRBCCapitalMarkets—nowinPortland,Maine—asabankequityanalyst.Thesimplereasonthatthe100%figureissoimportantisthatatthatpointthebank’sreservesorcapitaliswipedoutbymountingbaddebts.TheTexasRatiocanbealittletrickytocalculate.Thebadassetspart,or

numerator,containsthetotalbookvalueofallnonperformingassetsonthebank’sbooks.Thatincludesrealestatethebankhasrepossessed(whichsometimesgoesbythemonikerOREO,orotherrealestateowned)aswellasloansthatareindefaultorarebeingrestructured.Inshort,itincludesthingsthataregoingtocostthebankmoney,saysCassidy.Thedenominatoristhevalueofthebank’sequityorbookvalue,plusits

reservesagainstloanlosses.Intangiblepartsofthebank’sequity,likegoodwill,areexcluded.Thewaytothinkaboutthedenominator(thebank’stangiblecapital)islikethesandbagsonthetopofariverbankthatprotectpeoplelivingnearbyfromextraordinaryfloods,explainsCassidy.Orintheparlanceoffinance,thebank’scapitalisthedefenseagainstbad

loanswipingouteverything.It’slikethelastlineofdefenseagainstanattackoftheundead.BankswithahigherlevelofbaddebtsandahighTexasRatioaresometimesrescuedbystrongerbanks.However,sometimestheyjustlimpalong

likezombies.

InvestmentStrategy

“AbankwithaTexasRatioover100%isindirestraits,”saysCassidy.“It’slikedrivingacarwiththetachometerintheredzone,”hesays.“Ifyoukeepdoingthat,eventuallythecarwillblowuponyou.”ThebiggestproblemmostpeoplehavewhentryingtousetheTexasRatiois

thattheyforgettotakeoutintangibleequity—suchasgoodwill,tradesecrets,copyrights,patents,andtrademarks—fromthedenominator,saysCassidy.“Whenyouseeabankhavingtroubles,thengoodwillandintangiblesareusuallyworthless,”hesays.

EXECSUMMARY:TEXAS“ZOMBIEBANK”RATIO

Whentolook:Daily.

Wheretolook:TheFederalDepositInsuranceCorporation(FDIC)hasthenecessarydatatocalculateyourownTexasRatiosforeachbankatwww.fdic.gov/bank/statistical/.SomedatacanalsobegleanedfromtheOfficeoftheComptrolleroftheCurrencyatwww.occ.treas.gov/pubinf.htm.Alternatively,forbanksthathavepubliclytradedstock,aninvestorcanglean

informationfromthequarterlyearningsreleaseknownasthe10Q,ortheannualreleaseknownasthe10K.

Whattowatchfor:Increases(decreases)intheTexasRatio(nonperformingassets/tangiblecapital).

Whatitmeans:Thebankorbankingsectorismore(less)likelytofail.

Whatstepstotake:Sell(buy)thebankorsectorespeciallyastheratioapproachesthezombielandof100%.

Risklevel:Medium.


T

Chapter48TIPSSpread

Leading(SeealsoPCEDeflator,RealInterestRate)

HEWORDSOFWALLStreetforecastersareoftencheap.Sowhenyoureallywanttoknowwhatpeoplearethinkingaboutthefutureyoushouldwatch

whattheydo,notwhattheysay.Morespecifically,bylookingattheactionsofinvestorsintwodifferentparts

oftheU.S.governmentbondmarket,wecancalculateexpectationsoffutureinflation.Wederivetheanswernotbywhatpeoplesay,butratherbyhowmuchtheaverageinvestoriswillingtopayforthebondsinquestion.Thetwotypesofbondstocomparearegovernment-issuedinflation-indexed

securities,commonlyknownasTIPS,andstandardtermdebtsoldbytheU.S.Treasury.TIPSstandsforTreasuryInflationProtectedSecurities,atypeofbondthatcompensatesinvestorswheninflationincreases.Withregularbonds,bycontrast,holdersarehurtasinflationrisesbecausethepurchasingpowerofthenominallyfixedinterestpaymentsandtheprincipaldeclinesovertime.TreasuriestypicallyofferahighernominalinterestratethanTIPSdo.Inother

words,theypromisetopaymoredollarsofinterestperonehundreddollarsinvested.ButtheactualinterestpaymentoftheTIPSisadjustedinthefuturefortheeffectsofinflation.Thedifferencebetweentheyieldsofthetwotypesofsecuritiesistheexpectedfuturerateofinflationatthatpointintime.It’sknownastheTIPSspread,ortheTIPSbreakeven.Here’sanexample:Iften-yearTreasuriesareyielding4%andTIPS1%,then

thefutureinflationrateisexpectedtobe3%ayearforthenexttenyears.Thedifference,orspread,betweentheyieldschangeseverydaybasedonchangesinthepricesofthetwotypesofbond.Investorstendtoputalotofweightonthismetricbecauseitgivestheman

insightintobondmarketinvestors’inflationexpectations.Unlikeinsomemarkets,tradingingovernmentbondsisalmostentirelycarriedoutbysophisticatedinvestorswhotendtoactrationally.(That’squiteunlikethestockmarket,whichhasasizableportionofretailinvestorswhohaveactedquiteirrationallyattimes.)

InvestmentStrategy

TheTIPSspreadmattersbecauseittellsyouwhatlevelofinflationaverysavvypartofthemarketisexpecting.Expectationsarekeywithinflationbecausetheycanbeself-fulfilling.Ifyou

andeveryonearoundyouthinkpricesofgoodsandservicesaregoingtorise,thenpriceshaveaworrisometendencytodoso.Becauseofthisself-fulfillingproblemwithinflationexpectations,theFedkeepsacloseeyeonthispartofthebondmarket.Accordingly,wecanalsogetareadonwhentheFederalReservemight

changethecostofborrowing,explainsbondmarketveteranandheadofNewJersey–basedresearchoutfitMartaontheMarkets,T.J.Marta.“Twopercentseemstobethedividinglinebetweenhikingandeasing,”explainsMarta.Whathemeansisthatwheninflationexpectationsareabove2%ayear,theFedwilllikelyraisethecostofborrowing.Inthiscase,long-termbondsmaybeinforarally,hesays.“ThatisseenastheFedbringinginflationundercontrolandsoyieldscomedown[andpricesofbondsgoup],”hesays.Whenexpectationsareforinflationlowerthan2%ayear,theFedwilllikely

notraiseshort-terminterestrates.Asaresult,theshort-termcostofborrowingwillstaylowandthattendstobegoodforcommodities,explainsMarta.Healsosaysequitiescandowellinthatscenariotoo.Martapointsout,however,thattheTIPSspreadsometimestemporarilyjumps

above2%,so,aswithallindicators,it’simportanttoseethatasustainabletrenddevelopsbeforeleapingintoaction.

EXECSUMMARY:TIPSSPREAD

Whentolook:Daily.

Wheretolook:DataonTIPSyieldsandTreasuryyieldsareavailableinTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,you’llneedtogotothe“Bonds,Rates&CreditMarkets”section.Alternatively,theFREDdatabasehasyieldsonbothTIPSandregular

Treasuries.TheU.S.Treasury’swebsite,www.treasurydirect.gov/,alsohas

informationonTIPS.

Whattowatchfor:Sustainedinflationexpectationsgreaterthan(lessthan)2%asmeasuredbytheTIPSspread.

Whatitmeans:TheFedwilllikelyraise(notraise)interestrates.

Whatstepstotake:Appropriatecyclicalinvestments.Forexample,whentheTIPSspreadpointstomonetarypolicytighteningbytheFed,considerbuyinglessriskyassets,likehighgradecorporatebonds,andsellingriskierones,likestocks.

Risklevel:Medium.


Chapter49CBOEVolatilityIndex(VIX)

D

Leading

OGS,THEYSAY,CANsmellfear.Well,youcantoo,inanentirelyobjectivemanner.That’simportantbecausefearandgreedarewhatdrivetheactionon

WallStreet.Whilewecan’tmeasuregreedverywell—it’sjusttoosubjective—wecaneasilymeasurefear.It’sdoneusingtheVIX,ortheCBOEVolatilityIndex:ThehighertheVIX,the

greaterthelevelofanxietyamonginvestors.Ifevertherewasa“tell”onWallStreet,thisisit.Inthesimplestterms,theVIXmeasuresthecosttobuyprotectionagainstthe

broadstockmarketfalling.Themoreinvestorsarewillingtopayforthis“insurance,”themoreanxioustheyareoverall.Sowhileitstillwon’tletyouseethroughthetoughemotionalshellofaninvestmentbanker,itwillgiveyouanideaofhowscaredtheyareasagroup.TheVIXisarelativemeasureofthecostofbuyingoptionsontheS&P500

Index,themostpopularbroadmeasureoftheU.S.stockmarket.TradedontheChicagoBoardOptionsExchange,theseoptions5actlikeinsuranceprotectionfromunforeseenstockmarketcrasheslikein1929,1987,or2008.Themoreuncertaininvestorsfeelaboutfutureevents,themoretheyarewillingtopayforthatinsurance,sotheybidupthepriceoftheoptions.Thetheoreticalvalueofoptionsismostfrequentlydeterminedusingthe

Black-Scholesformula,namedafterthetwocannyeconomistswhoinventeditinthe1970s.Theformulausesanumberofdifferentinputs,includinginterestrates,lengthoftheoptioncontract,therelativepricesoftheindex,andlastbutnotleast,volatility.Thekeythingtoknowisthatatanypointintimeeveryvariableexceptvolatilityisalreadydetermined.Traderslookatthemarketpriceoftheoptionandsolveforthevolatilityvariable.Theycalltheresult“impliedvolatility.”That’spreciselywhattheVIXis:impliedvolatility.

InvestmentStrategy

Someoneelse’sfearcanhelpyoumakemoneyonWallStreet.Butfirstyouneedtoavoidsomehighlyriskystrategies.Mostnotably,someinvestorsusechangesintheleveloftheVIXtobuyorsell

options.Thatmayworkforthem,butbeforeyoutryit,considerthis:“Buyingoptionsisawaytoloselotsofmoneyreally,reallyquickly.”That’swhatoneveteraninvestoradvisedoneoftheauthors.Thisisespeciallysoforthenoviceinvestor,soifthat’syou,avoidoptions.Ofcoursethatdoesn’tmeantheVIXisuseless.Ontopofjustageneralsense

ofcollectiveanxietyonWallStreet,therearewaystosnagsomeprofits.JamesAltucher,managingdirectorofNewYork–basedalternativeasset

managementfirmFormulaCapital,sayshe’sfoundagenerallywinningtradeusingtheVIXasanindicator.“WhentheVIXspikesupover20%inaday,it’softenaverygoodtimetobuy

themarket,regardlessofwhetherweareinabullorbearmarket,”hesays,notingthatsuchajumpintheVIXistypicalofagutreactiontofallingstocks.However,thereisfrequentlyabouncebackinstocksthenextday.Specifically,hesays,afterthe20%spikeintheVIX“buySPYthenext

morningandsellattheendofthatday’strading.”Theso-calledSPYistheSPDRS&P500(SPY)exchange-tradedfund,which

tracksthevalueofthewidelyfollowedS&P500Indexof500leadingpubliclytradedcompanies.Theresultisanaveragegainof0.97%,basedonAltucher’sanalysisofdata

goingbackto1993throughmid-2010.The20%-plusjumpintheVIXhappenedonlythirtytimes,butthesuggestedtradewouldhavebeenprofitableintwenty-twocasesor73%ofthetime.Theaveragereturnofnearly1%is“enormous”foraone-daytrade,says

Altucher.It’sroughlyequivalenttoover200%inannualizedreturns.Henotesthattransactionscosts,ataboutonecentashare,areminimalwiththistrade,andthatthedayswhenthetradedidn’twinsawonlymodestlosses.“Inthepastseventeenyears,doingthesystemdescribedabovebutholdingfor

amonthinsteadofadaywould’veresultedinanaveragereturnof–0.64%pertrade,”hesays,notingtheworstyearwas2008.Excludingthedatafrom2008,

themonthlongtradewouldhaveseenprofitsonaverage.

EXECSUMMARY:CBOEVOLATILITYINDEX(VIX)


Wheretolook:DataontheVIXisavailableatthemainpageofTheWallStreetJournalonline’s“MarketDataCenter”atwww.WSJMarkets.com.Whenyouarethere,lookfor“CBOEVolatilityVIX.”Alternatively,dataontheVIXcanbefoundatYahoo!Financeat

www.finance.yahoo.comandtheChicagoBoardOptionsExchangeatwww.cboe.org.

Whattowatchfor:AnupwarddailyspikeintheVIXof20%ormore.

Whatitmeans:Theremaybeexcessfearinthemarket,makingitripeforabounce.

Whatstepstotake:BuyabroadmarketETFlikeSPYthemorningafterthespikeandsellitattheendofthatsameday.



Chapter50VixenIndex

T

Coincident

HEVIXENISOTHERWISEknownastheHotWaitressIndex.Theideaisthatwhenthewaitressesatyourlocaleateriesandbarslooksmokinghot,thenit’s

asurefireguaranteethattheeconomyisinthedoldrums.Thisindicatorfirstcametolightin2009inthedepthsoftheeconomiccrisis

whenHugoLindgren,theneditorialdirectorforNewYorkmagazine,wroteapieceaboutitforhismagazine.Apparentlythiswasn’tjustadesperateattemptto“fillspace”insidetheadvert-heavyglossypublication.Believeitornot,thereissomeseriouseconomictheorybehindthisindex,and

itallrelatestoemploymentopportunities.“There’reawholelotofbusinessesthatareinterestedinhiringattractive

people,”saysLindgren.“That’strueforbothmenandwomen.”ButLindgrenpointsoutthatbeautifulwomenarevaluedmorebybusinesses

thanattractivemen.That’swhythisiscalledtheVixen,andnottheStud,indicator.Ingeneral,employers—particularlythoseintheserviceeconomy—generally

placeapremiumongood-lookingpeople.That’snotjustinrunwaymodeling,butalsoforallmannerofsocial/commercialevents.AcompanyinNewYorkcalledBarCandy,forexample,specializesinprovidingattractivebartendersforfancyevents.Whentheeconomybooms,“beautifulpeople”snagthesebetter-paidgigs.

Theydon’ttendtoworkatthelocalgreasyspoon.Butasthingsgetroughintheeconomyandthewell-paidjobsdryup,theymaytaketheregularrestaurantpositions.Sonexttimeyounoticethatthewaitstaffatyourlocaldinerisdrop-dead

gorgeous,thenyoucanrightfullysuspectthattheeconomyisincrisismode.EitherthatoryouarelivinginLosAngeles.

InvestmentStrategy

It’salittletrickytoapplythisindicator.That’sbecauseyourviewofwhatisattractiveisunlikelytobeexactlythesameasanyoneelse’s.Forthatreasonyouhavetocollectyourdatayourself,notfromothers.Andyoushouldtrytoensurethatyouareinthesamestateofmindeachtime.Togetanaccuratereadonthisindicatorsomeseriousstudyisinorder.Yep,

yourhomeworkassignmentistocheckoutthewaitstaffatyourlocaleatery.Onetripwillnotsuffice.You’llneedtotakenotesandtodosoeachtimeyouvisittheeaterybecause

thekeytothisindicatorisestablishingatrend.Itisnotreallyabouttheabsolutelevelofcuteness.Forinstance,isthebeautyofthewaitressesimprovingovertime?Ifitis,then

perhapsthatmarksasignthattheeconomyissouring.If,ontheotherhand,thelocalcoffeeshopsarestaffedbythehideousandunattractive,thenyoucanbesurethingsarelookingup.It’sworthnotingthatoneofthereasonsLindgrenwrotehispiecewasto

promptpeopletothinkforthemselves.“Itwasafunstorytowriteasameanstohelpotherscomeupwiththeirown

indexes,”saysLindgren.Orinotherwords,don’trelysolelyonthedataprovidedbygovernmentagencies.Insteadwould-beforecastersshouldcomeupwiththeirownideas.FormerFederalReservechairmanAlanGreenspanissaidtofavorwatchingscrapmetalpricesandunderwearsales,saysLindgren.Meanwhile,otherpeoplesaythetimeittakesyoutohailacabonaNewYork

Citystreetisafairindicationofhowstrappedconsumersarefeeling.The“taxiindicator”hasalotofmerit.That’sbecausethenumberofcabsonthestreetisbasicallyfixed.Whatisn’tfixedisthedemandforthosecabs.Thespendingontaxiswaxesandwaneswiththerelativestrengthoftheeconomy.Aspeoplehailmorecabs,therearelessfreeonesavailableforyousoittakes

youlongertocatchone.Inshort,ifyoucanconsistentlygetacabinstantlyatrushhourinMidtownManhattan,thentheeconomymustsuck.Likewise,ifyoucan’tgetoneeasilyevenintheoff-peakhours,thenthingsmustbelookingup.Andifyourunintoastringofattractivecabbies,headforthehills!

EXECSUMMARY:VIXENINDEX

Whentolook:Wheneveryouvisitarestaurant.Wheretolook:BecauseTheWallStreetJournalisafamilypublicationyou

won’tfindtoomanyhotwaitressesinitspages.Thatmeansyouarekindofonyourownwiththisindicator.Butifyouhavereadthisfarinthisbook,youarewellonyourwaytobeingabletoactonyourown.Youmightbereadingthisinacoffeeshoprightnow.Ifso,makenoteoftheattractivenessofthestaff.Writeitdown(maybeevenonthispage)alongwiththelocationandthedateandthendothesameagainandagainandagain.Prettysoonyou’llhaveenoughdatatoworkwith.ButmorethanjustdevelopingtheVixen,doasHugoLindgrensuggestsand

thinkofyourownindicators.Trythemout.Iftheywork,keepusingthem.Ifnot,discardthem.Butmostofallhavefunandnever,evermakebigmoneydecisionsonthebasisofanyoneindicator,nomatterhowattractiveitmayseem.

Whattowatchfor:Anincreaseintheattractivenessoflocalwaitstaff.

Whatitmeans:Well-paidjobswherebeautyisrequiredarescarce.Theeconomyissofterthanthepuddingyoujustordered.

Whatstepstotake:Askthehotwaitressout,thenbuydefensivestockslikeutilities,foodretailers,andpharmaceuticalcompanies.



I

ConclusionPuttingItAlltogether

FYOU’VEREADANDthenrereadourFantastic50,youarenowinapositiontostartputtingitalltogether.Asyoudothat,rememberthateconomic

forecastingismoreartthanscience.Farmore!Hereareafewtips,innoparticularorder:First,bemorethanalittlewaryofmathematicalmodelsbecausetheygivea

falsesenseofprecisionandhencesecurity.Sayingtheeconomywillgrow2.3422674%nextyearisanabsurdstatement.Bewaryofanyonewhosaysotherwise.Likewise,numbersfromofficialsourcescangiveafalsesenseofaccuracy.

Whenthegovernmentsaystheunemploymentrateis9.6%,rememberthatitisanestimatedfigurebasedonasmallsampleofhouseholds.Bettertosayit’sbroadly10%.Betterstilltonotewhetherit’sfallingorrisingmonthtomonth.That’sfarmoretelling.Insteadoflookingforexactnessinnumbers,looktogainexperienceand

improvejudgmentbyunderstandingsomebasicmodelsofeconomiccausation.Theyarefarsuperior,andfarmoreflexiblethanjustfigures.WeoutlinedsomebasicideasintheindividualeconomicchaptersoftheFantastic50.Still,whileyoulookatthosemodels,rememberthatforecastingisamoving

target.Statisticalrelationshipsbetweenvariablesthatheldlastdecade,lastyear,orevenlastweekmaynolongerringtrue.Thatiswhydataimmersion,thoughitwillstrikemanyasredundant,issoimportant.Andthatisalsowhywepackedmultipleindicatorsintothesectionscoveringthedifferentpartsoftheeconomy(withoneexception:thegovernment,wherewefeltonewassufficient).Afterall,considerthis:SayX,Y,andZalltraditionallymoveinlockstepand

typicallyprecedeA.YoumightconcludethatyoucanjusttrackXandforgetaboutYandZ.Butthenyou’llmissastructuralchangeintheeconomicbeastthatmakesYalonepresageAwhileXandZheadoffintheoppositedirection.Aninvestorintunewithallthreeseries,bycontrast,willnotetheanomalyand

treadcautiously.Thatwayyoudon’tloseyourshirt.FormerFederalReserve

chairmanAlanGreenspanwasanadvocateofimmersion,poringoverreamsandreamsofdatabeforemakingthepredictionsuponwhichhebasedU.S.monetarypolicy.Hedidn’talwaysgetitrightbuthehadafarbetterrecordthanmost!Asinformationflowsfaster,therearepressurestoforecastevermorequickly

andaccurately.Ifyouarefeelingthatpressure,youmaybetemptedtoconcentrateonafewbroadindicatorsratherthanthefiftywespecify.Don’t!Why?Becausedoingsowillgiveyoumajorproblems.Thebroaderan

economicindicatoris,thelessaccurateitis.Orputanotherway,metricsthatlookatoveralleconomicactivitytendtobecrudeatmeasuring.Thatinsightisjustanapplicationoftherisk-returntradeoffwellknowntoinvestors.Aquickreadofindicatorsusedtomakeinvestmentdecisionssometimesmayworkbutoftenwillbackfire.Attheotherextreme,youcouldwaituntiltheNBERcompletesitsextensive

(butbackward-looking)evaluationofmanydifferentmeasuresoftheeconomythatdefinewhenthebusinesscyclestartsandfinishes.Theproblemwithdoingso:You’llmisstheboateverytime.That’sbecausebythetimeNBERcallsarecessionorexpansiontheactualeventislonggone—solonggonethatit’salmostahistoricalevent!Bythattimetherelevantinvestmentopportunitiesarehistorytoo.Whatyouneedtodoislookatavarietyofindicatorsthatcoveralltheareasof

theeconomyandlearntomakedecisionsoninvestmentswhilethereisstillsomeuncertainty.Indeed,youmaybeaheadofthepackcomparedtothosewhohaven’tstudiedtheFantastic50andmayhearfromfriendsthattheeconomyisgreatwhenyouseemultiplesignsthatit’sheadingforaslump.Learnthroughexperiencetotrustyourjudgment.

ChoosingIndicatorsWisely

Beforeusinganyindicator,itiscruciallyimportanttounderstandthedifferencebetweencyclicalandstructuralchanges.Cyclicaliswhathappensduringthebusinesscycle—recessionfollowedbyexpansionandthenrecessionagain.Structuralchangeshappenwhenthingsfundamentallychangeintheeconomy,liketheadventoftheautomobileintheearlytwentiethcentury.ArecentexamplehappenedintheUnitedKingdom.Thenumberofitems

mailedinBritainwaslonganeconomicindicator.Whentheeconomygrewbriskly,therewasmoreneedtousethepostforadvertising,magazinesubscriptions,contracts,checks,etc.,sotheRoyalMail’svolumeincreasedcommensurately.Startingaround1999–2000,however,useofthemailservicedroppedevenwhileBritain’seconomyexpanded.DuringtheGreatRecession,thevolumeoflettersdroppedmanytimesfasterthantherateofeconomicactivity.TousetheRoyalMail’sdeclineasanindicatoroftheimminentdemiseoftheBritisheconomywasfalse.Thesteepdeclineinpostalvolumehasmoretodowithtechnology(e-mail,websites,electronicsignatures,etc.)thanwiththelevelofeconomicactivityinBritain.Similarly,aswementionedearlierinthebook,investorsoncebelievedthat

whatwasgoodforGeneralMotorswasgoodforAmerica,andviceversa.IfGM’searningswerepoor,they’dtakethatasasignofaneconomicdownturn.Thatmighthavemadesenseinthe1950s.ButovertimethecorrelationbetweenGM’sfortunesandthoseofthenationhavegrownweaker.Today,aninvestormightevenseesaggingGMsalesasasignofastrongereconomytocome,ifonlythegovernmentwouldlettheonce-behemothcompanyfail,thusallowinghundredsofmoreinnovativecompaniestospringforthfromthenutrients(engineers,robots,unusedfactories,etc.)providedbyitsgiant,rottingcorpse.Atthetimeofthiswriting,GMwaspartiallygovernmentowned,followingamassivebailout.That’ssomethingtheauthorsthinknevershouldhavehappened.Someforecastersusethenumberofpatentsgrantedannuallyasameasureof

economicactivity.Butit’strickytousethatfigurebecauseitmaybebothacoincidentindicator(thatdutifullyfellduringtheGreatDepressionandthe1970s)andafarsightedleadingindicatorthatmeasuresfutureproductivitygrowth.Patentsgrantedtoday,inotherwords,willallowustoproducemoretomorrow.Peoplespendgoodtimeandmoneyinventingstuffandprotectingit

withapatent,sotheymustexpectittobevaluable.Right?Right!However,inmanyplaces,includingtheUnitedStates,obtainingand

maintainingapatentisprettycheapintheschemeofthings.So,whilewemightstipulatethatallpatentshavepositiveexpectedvalue(expectedprofitsexceedthecostsofpatenting),allpatentsarenotequallyimportant.Thedifferenceineconomicimpact,bothinprofitsandinspillovereffects,betweenthefirstcomputerchipandthefirstholywaterdispenser,forexample,wasundoubtedlyhuge.Butit’shardtotellhowmuchmore.Qualitymattersherebigtime,inotherwords,butit’strickytomeasureaheadoftime.Evenmoretroubling,thenumberofpatentsgrantedisfarfromaclean

measureduetochangesinpatentofficerulesandefficiency.Some,most,orevenalloftheapparentfalloffinpatentingactivityinthe1970s,forexample,wasduetoasmallerpercentageofpatentapplicationsbeingacceptedandalongbacklogofcasesawaitingreviewduetogovernmentstaffcuts.Anotherclassicerrorinforecastingistosimplygobytheideathatifan

expansionorarecessionlastslongerthanaverage,thenaturningpointisimminent.Thereisnoreasonwhyarecessioncan’tlasthalfacentury—justasksomebodyfromCubaorNorthKorea—andnoreasonwhyanexpansioncan’tlastmuchlongerthan“average,”whichofcoursewillbehighlysensitivetostartandenddates.AccordingtotheNBER,forexample,theaverageexpansionsince1854hasbeenthirty-eightmonths,yetsevenexpansionssincethenhavelastedfiftyormoremonths,i.e.,afullyearormorepasttheaveragedate.Investorsalsoneedtobecarefulthattheydon’treadtoomuchintocomplex

indicatorslikethenumberofMexicanscomingillegallytotheUnitedStatesforwork(evenifthatfigureispossibletomeasure).AstheComedyCentralTVcartoonseriesSouthParkshowedbrilliantlyinits2004episode“Goobacks,”thelevelofMexicanimmigrationisafunctionoftherelativehealthoftheMexicanandU.S.economies,notsolelyabarometeroftheAmericaneconomy.Sowhiletheestimatednumberofimmigrantsin2009waswelloffitspeakofover1.5millionin2000,immigrationactuallybegantoslidein2005–6,wellbeforetheGreatRecession.ItwasnotthatpotentialMexicanimmigrantswereparticularlyprescientandfore-sawthefinancialcrisis;itwasthattheMexicaneconomyimprovedvis-à-vistheU.S.economyatthattimeandcontinuedtodosothrough2009.Thefinancialmarketsareforwardlooking,soinvestorsneedtobetoo.The

earlybirddoesn’tnecessarilygetthewormasitmightmisshoursofsleeponly

toarriveinthewrong,wormlessplace.Likeabove-marketreturns,wormsareelusivecreaturesthatdonotoftenappearinthesameplacetwice,atleastonsuccessivedays,soitisthesmartbird,thepredictiveone,thatwillgetthewormanddosowithminimalcost.Likewiseforinvestors,youmustbesomewhatanticipatoryinordertoprofit.

OurMagicBullets

InadditiontotellingyoualittleabouttheFantastic50indicators,wehavetriedtoestablishthefollowingpoints:

•Successfulinvestingmeansmakingandkeepingabove-marketreturnsateachstageofthebusinesscycle.•Investorsmustcorrectlyforecastthebusinesscyclebeforetheycanknowwhichtypesofspecificinvestments(bonds,equities,commodities,realestate)arelikelytogeneratesuperiorreturns.•Investingisnotaone-offevent.Itisalearningprocess,alifetimecommitmenttounderstandingtheeconomyinallitsgloriouscomplexity.•Forecasting,likeinvestmentmoregenerally,ismoreartthanscience.Correctreasoningandbig-picturepresciencetrumpquantitativeandmathematicalprecisionbasedondubiousassumptions.•Yourcapacitytoaccuratelypredictstemsfromacombinationofsoundhistoricaltrenddataandamodelthatcorrectlyidentifiescausalagentsratherthanmerestatisticalcorrelations.•Economicindicatorsmaylead,coincidewith,orlagactualeconomicconditions,asmeasuredbypercapitaoutputorGDP,whichisthesumofconsumption,investment,governmentexpenditures,andnetexports(C+I+G+NX).•Themoreindicatorsaninvestortracks,thebetterfeelfortheeconomyshewilldevelopandthemoreconfidentshecanbethatchangesinthebusinesscycleareintheoffing.•Thefiftyindicatorsdescribedinthisbookarethebestbecausetheyarethemosttimely,accurate,andrelevanttotherealeconomyandalsorelativelyunknown.•Whilelaggingandcoincidentindicatorsareimportanttofollowinordertounderstandtheeconomyinallitscomplexity,leadingindicatorsarethemostimportanttoinvestors.•Occasionally,though,thecomponentpiecesofacoincidentindicator

aretimelyandprovideaglimpseofthefutureandcanthereforebeasusefulasleadingindicators.

Readingabookexplainingtheseeconomicindicators—andhowyoucanprofitusingthem—onceisonething.Actuallyapplyingitisquiteanother.Sohowdoyouputthisknowledgeintopractice?Whatyouneedisaplantoreallymasterthematerial.First,startbysetting

asideaperiodeachdaytostudyjustacoupleoftheindicators.Thebestwaytochoosewhichonestostudyandwhenistomarkacalendarwheneachnewsetofdataoneachindicatoriscomingout.Mostoftheindicatorshavespecificandpredictablereleasedatesandtimes.CurrentreleasedatesarelistedinourExecSummaries.TheWallStreetJournalhasacalendaronline:http://online.wsj.com/mdc/public/page/2_3063-economicCalendar.html?mod=topnav_2_3000.Also,Briefing.commaintainsacalendarofeconomicdatareleasedatesandtimesatwww.briefing.com/Investor/Public/Calendars/EconomicCalendar.htm.BecausemostdatacomesoutinthemorningNewYorktime,wesuggest

dedicatingsometimetheeveningbeforeitistobereleasedtorereadthechapterontheindicator(s)inquestion.Whenyou’vereadandrereadthechapter,alsoreadthefinancialpress.Therearefrequentlyarticlesthatoutlinewhatinvestorsareexpectingfromthenewdataandwhatitmightmeanifvariousscenariosoccur.Inthemorninggetupearlytoseewhatthedatasays.Alsoatthattimeitwill

payofftoreadwhatthefinancialpressactuallysaysaboutthenewdata.Mostdaysofthemonth(therearetwenty-twoworkdaysinanaveragemonth)havesomeeconomicdatareported.Soyoucouldsetupastudycalendararoundthatschedule.Thatsaid,someoftheindicatorswefeaturedareprivatelypublished(e.g.,the

CreditAvailabilityOscillator)ordon’thaveregularreleasedates(VIX,Vixen,TexasRatio,etc.).Thismakeslifeatadtrickier.Butthisiswhereyourregularperusalofthebusinesspresswillpayback.You’lldevelopwaystofindtheinformationyouneedtofollowthoseindicators.Wheneveryoucomeacrosstheinformationyouneedforthesenonpublicorqualitativeindicatorsrereadtherelevantchapters.Followthatstudyscheduleofreadingthechapterthenightbeforeandthen

analyzingtheactualdatathenextdayforatleasttwomonths.Atthattimeyou

maybereadytostartkeepinganinvestingdiary.Thisiswhereyoumake“papertrades.”Inotherwords,you“buyandsell”

assetsbasedonwhatyouarelearningabouttheeconomy.Buthere’sthekey:Thetradesareonlyonpaper.Noactualmoneyshouldbeusedatthisstage.Theideahereistotryouttheknowledgeyouarelearningbutinasafeandcost-freeway.Foreaseofcalculation,useclosingpricesofthesecuritiesorassetsyou“buy”and“sell”foryourphantom“account.”Usethispaperaccountforatleastsixmonths,possiblylonger.Whenyoufeel

ready,startmakinginvestmentswithrealmoney.Atfirstyoushouldbecautiousbecauseyouwillundoubtedlystillmakemistakes.However,byusingtheknowledgeyou’vegainedinthisbookandinyourstudies,theseinvestingmisstepswillhopefullybefewerandlessdamagingthanbefore.Andthatcanleadtosomethingallinvestorsarelookingfor:biggerprofitsandlessstress.

AppendixUsefulEconomicIndicatorsWebsites

GENERAL

Briefing.com:www.briefing.comhasafree“Investor”sectionandaneconomiccalendar.

CONSUMPTION

BureauofLaborStatistics:www.BLS.govhasaplethoraofinformationaboutunemployment,efficiency,andthemakeupoftheU.S.work-force,aswellasproducerpricesandlotsofotherdata.

BureauofTransportation:www.bts.gov/publications/national_transportation_statistics/Statisticshasdetailsofcarsales.

ConferenceBoard:www.conference-board.orgprovidesdetailsonconsumersentiment.

RedbookResearchandChainStoreAge:www.chainstoreage.com/industrydata/monthlysales.aspx?menuid=471andwww.redbookresearch.comhavedataonretailsales.

INVESTMENT

EconomicCycleResearchInstitute(ECRI):www.businesscycle.comhasdataontheWLIandtheJoC-ECRIIPI,plusotherindicesandmetrics.

InstituteforSupplyManagement:www.ism.wshasdataontheISMManufacturingSurveyaswellastheISMNon-ManufacturingSurvey.

Kitco:www.Kitco.com,www.kitcometals.com,www.kitcosilver.comprovidedeepresourcesformetalsmarketwatchers.

LondonMetalExchange:www.lme.co.ukhasdetailsofbasemetalspricesaswellasregularreportingonmetalsinventories.

NationalAssociationofRealtors:www.realtor.orghasaslewofdataavailableonthehousingmarket.

NewYorkMercantileExchange(partoftheCMEGroup):www.cmegroup.comprovidesdataonenergyandmetals.

SemiconductorIndustryAssociation:www.SIA.orghasdetailsofthebook-to-billratio.

WorldBureauofMetalsStatistics:www.world-bureau.comhasdetailsoftheglobalmetalsmarkets.

GOVERNMENT

U.S.Treasury:www.treasury.govhasloadsofinformationontheeconomyandtaxes.

WhiteHouse:www.whitehouse.govpublishesdataonthegovernment.

NETEXPORTS

BalticExchange:www.balticexchange.comfortheoceangoingfreightrates.

BankofJapan:www.boj.or.jp/en/fortheTankanSurveyandotherJapan-specificdata.

CentralIntelligenceAgency:www.cia.govhasbasiceconomicdataonmostcountries.

Economist:www.economist.comprovidesdetailsontheBigMacIndexandothereconomicdata.

EnergyInformationAdministration:www.eia.govprovidesdetailsonoilinventories.

InternationalMonetaryFund:www.imf.orghasinformationonalmostallcountriesintheworld.

OrganizationofEconomicCooperationandDevelopment:www.oecd.orghasdataontheworld’srichcountries.

WorldBank:www.worldbank.orghasdataonover1,200economicindicators,fromagriculturetoeducationandtheenvironmenttohealth,forovertwohundrednations.

MULTIPLECOMPONENTS

BritishBankers’Association:www.bbalibor.comforLiborquotes.

BureauofEconomicAnalysis:www.bea.govmaintainsdataonincome,spending,andsavingsaswellasmanyotherdata.

CensusBureau:www.census.govhasinformationondurablegoodsorders,thehousingmarket,andnumerousothereconomicindicators.CentersforDiseaseControl:www.cdc.govprovidesdemographicdata.

FederalReserve:www.federalreserve.govhasdataandresearchreportsonaslewofthingsincludingindustrialproduction,aswellasthefamedBeigeBook.

DailyFinance:www.dailyfinance.comhasdataonshortinterest.

FREDdatabaseattheSt.LouisFed:http://research.stlouisfed.org/fred2/providestimeseriesdataonovertwothousandnationaleconomicvariables,includingbanking,business,prices,employment,exchangerates,output,interestrates,monetaryaggregates,andinternationaltransactions.

OfficeoftheComptrolleroftheCurrency:www.occ.gov/pubinf.htmhasthedataforanalyzingbanks.

PhiladelphiaFed:www.phil.frb.orghasdataontheAruoba-Diebold-Scotti

BusinessConditionsIndexanditsBusinessOutlookSurvey.

TheWallStreetJournal:www.wsj.comhasmassesofnewsandanalysisplusahandy-dandydatacenter.

Yahoo!Finance:finance.yahoo.comhastimeseriesdataonstocks,indices,andexchange-tradedfunds.

INFLATION,FEAR,ANDUNCERTAINTYChicagoBoardOptionsExchange:www.cboe.orghasdataontheVIX.

FederalDepositInsuranceCorporation(FDIC):www.fdic.gov/bank/statistical/hasdataneededtocalculatetheTexasRatio.

LondonBullionMarketAssociation:lbma.org.ukhashistoricaldataongoldandsilverprices.

MiseryIndex:www.miseryindex.ushasdataoninflationandunemploymentthatitcombinesintotheMiseryIndex.

SelectedBibliography

Axilrod,Stephen.InsidetheFed:MonetaryPolicyandItsManagement,MartinthroughGreenspantoBernanke.Cambridge:MITPress,2009.Baumohl,Bernard.TheSecretsofEconomicIndicators:HiddenCluestoFutureEconomicTrendsandInvestmentOpportunities,2nded.Philadelphia:WhartonSchoolPublishing,2008.Birchenhall,Chris,HansJessen,DeniseOsborn,andPaulSimpson.“PredictingU.S.Business-CycleRegimes,”JournalofBusinessandEconomicStatistics17(July1999):313–23.Boldin,Michael.“DatingTurningPointsinEconomicCycles,”JournalofBusiness67(January1994):97–131.Bordo,Michael.“TheLimitsofEconomicForecasting,”CatoJournal12(Spring/Summer1992):44–48.Fleckenstein,WilliamA.andFrederickSheehan.Greenspan’sBubbles:TheAgeofIgnoranceattheFederalReserve.NewYork:McGrawHill,2008.Friedman,Walter.“TheHarvardEconomicServiceandtheProblemsofForecasting,”HistoryofPoliticalEconomy41(2009):57–88.Griliches,Zvi.“PatentStatisticsasEconomicIndicators:ASurvey,”JournalofEconomicLiterature28(December1990):1661–707.Kaufman,Henry.OnMoneyandMarkets:AWallStreetMemoir.NewYork:McGrawHill,2000.McCloskey,Deirdre.“TheArtofForecasting:FromAncienttoModernTimes,”CatoJournal12(Spring/Summer1992):23–43.Rogers,R.Mark.TheCompleteIdiot’sGuidetoEconomicIndicators.NewYork:Alpha,2009.Stock,JamesandMarkWatson.“NewIndexesofCoincidentandLeadingEconomicIndicators,”NBERMacroeconomicsAnnual4(1989):351–94.Wright,RobertE.Fubarnomics:ALighthearted,SeriousLookatAmerica’sEconomicIlls.Buffalo:Prometheus,2010.

Wright,RobertE.andVincenzoQuadrini.MoneyandBanking.Irvington,N.Y.:FlatWorldKnowledge:2009.www.flatworldknowledge.com/printed-book/1634.

Acknowledgments

Nobookcanbecompletedorevenattemptedwithoutthehelpofmanyothers.Inadditiontoallthepeoplequotedinthisbook,thereweremany,manyothers.Inparticular,webothhighlightRoeD’AngeloandMattInmanfortheir

patienceandperseveranceduringtheeditingprocess.Weneversaidwewereeasy!Inaddition,Mr.ConstablesaysthanksdearlytoCourtneyLuttermanwithout

whosemoralsupportthiswouldnothavebeenpossible.ThanksarealsoduetoAlanMurrayandRickStineformakingawholehostofthingspossibleatDowJones.OthersnotablefortheirencouragementinthisprojectincludeNealLipschutz,BrettArends,JulieIannuzzi,ShawnBender,BobBruner,andKenEades.Dr.WrightthanksDavidBackus,MichaelDarda,JanReid,MarkStickle,and

RichardSylla.Finally,weapologizeinadvanceforanyomissions.Youknowwhoyouareevenifweforgottomentionyou!

AbouttheAuthors

SIMONCONSTABLEishostoftheNewsHublivewebshow,whichairsweekdaysat4:00p.m.ETontheWallStreetJournalDigitalNetwork.Healsomakesstand-alonevideosforWSJ.com,MarketWatch,andBarrons.com.HehaswrittenforTheWallStreetJournal,WSJ.com,DowJonesNews-wires,MarketWatch.com,TheStreet.com,theNewYorkPost,theNewYorkSun,andtheSouthChinaMorningPost.HeisalsoafrequentguestonFoxNews,BBC,andABCTV;afill-inhostfortheJohnBatchelorShowonWABCRadio;andwaspreviouslyaseniorcorrespondentforTheStreet.comTV.ConstableholdsanMBAfromtheDardenSchoolofBusinessatthe

UniversityofVirginia.HealsoworkedonWallStreetasanadvisertotopmanagementatsomeofAmerica’smostprestigiouscompanies.HelivesinNewYorkCity.

ROBERTE.WRIGHT(PhDinHistoryfromtheStateUniversityofNewYork–Buffalo,1997)istheNefFamilyChairofPoliticalEconomyandtheDirectoroftheThomasWillingInstitutefortheStudyofFinancialMarkets,Institutions,andRegulationsatAugustanaCollegeinSiouxFalls,SouthDakota.Hehasauthoredorcoauthoredfourteenbookswithleadinguniversitypressesandcommercialpublishers.HehasalsowrittenforBarron’s,theChronicleofHigherEducation,theLosAngelesTimes,McKinseyQuarterly,andotherprominentpublicationsandhasappearedonNPR,C-SPAN,FoxNews,theBBC,BNN,MSNBC,variouslocalTVnewsstations,andadozennationallysyndicatedradioprograms.WrightalsositsontheeditorialboardoftheMuseumofAmericanFinance’sFinancialHistorymagazine.

Visitwww.AuthorTracker.comforexclusiveinformationonyourfavoriteHarperCollinsauthors.

AuthorphotoofSimonConstablecourtesyofTheWallStreetJournal

AuthorphotoofRobertE.WrightbySamStern

Copyright

THEWALLSTREETJOURNALGUIDETOTHE50ECONOMICINDICATORSTHATREALLYMATTER.Copyright©2011byDowJonesandCompany.AllrightsreservedunderInternationalandPan-AmericanCopyrightConventions.Bypaymentoftherequiredfees,youhavebeengrantedthenonexclusive,nontransferablerighttoaccessandreadthetextofthise-bookon-screen.Nopartofthistextmaybereproduced,transmitted,downloaded,decompiled,reverse-engineered,orstoredinorintroducedintoanyinformationstorageandretrievalsystem,inanyformorbyanymeans,whetherelectronicormechanical,nowknownorhereinafterinvented,withouttheexpresswrittenpermissionofHarperCollinse-books.

IllustrationsthroughoutthisbookareusedcourtesyofTheWallStreetJournal.

FIRSTEDITION

LibraryofCongressCataloging-in-PublicationDataConstable,Simon,1968–TheWallStreetJournalguidetothe50economicindicatorsthatreallymatter:fromBigMacsto“zombiebanks,”theindicatorssmart

investorswatchtobeatthemarket/bySimonConstableandRobertE.Wright.—1sted.

p.cm.Includesbibliographicalreferences.ISBN-13:978-0-06-200138-2(pbk.)ISBN-10:0-06-200138-8(pbk.)1.Portfoliomanagement.2.Economicindicators.3.Businessforecasting.I.Wright,RobertE.(RobertEric),1969-II.Title.III.Title:Guidetothe50economicindicatorsthatreallymatter.HG4529.5.C6582011339.3—dc22

2010052579

EPubEdition©2011ISBN:97800620497731112131415OV/RRD10987654321

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1Readersshouldnotconfuse“investment”with“businessinvestment.”Businessinvestmentinvolvesbuyingnewmachineryorbuildingnewfactories.Insomecontexts,investmentsareanysumsofmoneyinvestedinfinancialorotherassetsinthehopeofeconomicgain.Buyingequitiesinasecondarymarketisanexampleoffinancialinvestmentnotbusinessinvestment,forexample,becauseitdoesnotrepresentnewnetinvestmentintheeconomy,justachangeofowners.Throughoutthebook,wewilltrytoclearlydifferentiatebetweenthetypeofinvestmentthatreadersmightmakefromthebusinessinvestment(I)usedbyeconomistsinGDPcalculations.

2Ifyouthinknominalinterestratesareheadeddownward—astheytypicallymoveduringarecession—buybonds,becausetheywillincreaseinprice.(Nominalinterestratesandbondpricesareinverselyrelated.Ifyoudidn’tknowthatorotherwisefeelthatyourbasicbackgroundisalittleshaky,readWrightandQuadrini’sMoneyandBankingtextbookfirst.It’sfreeatwww.flatworldknowledge.com/printed-book/1634.Alsoavailablefree,ontheThomasWillingInstitute’swebsite,www.augie.edu/thomaswilling,isanextensiveglossaryoffinancialterms.)Ifyouthinknominalinterestratesareheadedupwardduetoaneconomicexpansionorbecauseinflationisheadedskyward,short(mostsimplysell,orborrowsomebonds,sellthemhigh,andbuymoreofthembackatlowerprices,asdescribedintheshortinterestentrybelow)bonds,becausetheywillbehithard.Usethenewcashtobuygold,realestate,andotherassetsexpectedtoappreciateinlinewith(orbetteryet,fasterthan)thepricesofothergoods.Iftheeconomylookstoheatupwithoutinflationarypressures,pro-cyclicalstocksinthefinancial,industrial,andconstructionsectorsareagoodbet.Whenrecessionlooms,bycontrast,defensivestockslikefoodandutilitiesareprobablythewaytogo.Andifpanicorcrisisappearsimminent,Treasurieswilllikelysoar,justastheydidinSeptember2008.

3Forinstance,afundmanagerwhoexpects,say,abankstocktooutperformitspeergroupmaysellshortanETFthatholdsabroadbasketofbankstocksandthenusetheproceedsoftheshortsaletobuythestockthatisexpectedtooutperform.Thatwayeveniftheentiregroup—includingthefavoredstock—dropsinpricebutthefavoredstockstilldoesbetter,themoneymanagerwillhavemadeaprofit.

4WhileMishkinandEstrellagetmuchofthecreditformodernyieldcurvetheory,Duke’sCamHarveypresagedtheirefforts.Ifyouwanttodelvedeeperintothepredictivepowersofyieldcurvesanddon’tmindalittlemathematics,checkoutCam’s1986UniversityofChicagodissertation“RecoveringExpectationsofConsumptionGrowthfromanEquilibriumModeloftheTermStructureofInterestRates,”his1988JournalofFinancialEconomicsarticle,“TheRealTermStructureandConsumptionGrowth,”orotherworkavailableatwww.duke.edu/~charvey/research_term_structure.htm.

5Optionsarefixed-termcontractsthatgivethepurchaserofthecontracttherighttobuy(orsell,dependingonthecontract)theindexatapredeterminedprice.Profitsorlossesaremadefromthedifferencebetweenthecontractpriceandthemarketpriceoftheindexattheexpirationoftheoptioncontract.

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