The Importance of Key Economic Indicators

by: Elliott Gue

Years ago, when I first started investing in and trading stocks, my biggest enemy was emotion and information paralysis.

By nature, I’ve always enjoyed detailed research and have always sought to understand an industry from multiple angles. I still read dozens of research papers and articles each week and listen to around 50 conference calls every quarter. And those who edit The Energy Strategist and weekly issues of The Energy Letter would undoubtedly attest I tend to err on the side of “too much” when it comes to article length and detail.

Detail is great when it comes to picking stocks and understanding trends, but when it comes to actual buy and sell decisions there’s a danger of too much information. In my experience, trying to process a mountain of data and statistics either leads to an unwillingness to act at all or, ironically, to falling back on gut feelings and emotion. Neither is a profitable strategy.

Even the best investors will occasionally be “wrong,” there is no guaranteed route to profit, and there are no crystal balls. In my view, the solution is discipline. Investors should try to understand all of the forces influencing a stock and risks but realize that there’s never a perfect buy point. If you do enough research, you’ll never find an investment where all of the stars are aligned perfectly.

And, as I’ve written before, knowing when and what to buy is far less important to your bottom line than knowing when to sell. It’s an imperfect world, and if you buy stocks you’ll occasionally be wrong. Although you shouldn’t panic about every twist and turn in a stock’s price, you need to take a dispassionate view when fundamentals change and be willing to take a few losses along the way.

Equally important, you can’t be greedy. It’s a good idea to let profits run, but whenever I see stocks up big and nothing but seemingly bullish news hitting the wires, I get worried. I always get far more negative e-mail when recommending that subscribers sell a big winner than when I recommend a new buy; it’s an all-too-common problem for investors to fall in love with their best holdings.

Of course, all of this is easier said than done. But here’s one practical bit of advice: Put a few key indicators in your quiver that you trust and follow them consistently. These indicators will undoubtedly be incorrect from time to time, but when they don’t line up with your market positioning, you should be extremely careful and look to reduce risk.

As regular readers know, I follow the Conference Board’s Leading Economic Index (LEI) and review the indicator and its constituents every month. For those unfamiliar with the LEI, I wrote a detailed report on it in Follow the Economy’s Lead.

The LEI is clearly not the only economic indicator I follow; I look at dozens of data points released in the US and abroad every week to gauge the health of the global economy. But I make a point of not ignoring the signals generated by the LEI, and if the LEI tells me the economy’s in trouble, I take steps to reduce risk.

Equally important, when the LEI indicates that the environment is improving, I’m inclined to be bullish, and I try not to fall into the bearish trap of scouring the investment landscape looking for reasons for negativity.

This monthly analysis of the LEI has become popular with readers; I know this because if I fail to produce the issue in a timely manner, I receive e-mails from scores of subscribers reminding me to do so.

Of course, I also receive plenty of e-mails from those who believe the LEI is flawed and that there are a large number of long-term headwinds facing the US economy; many argue that the big improvement in the LEI in recent months can’t possibly forecast a recovery for the US economy.

I agree with some of those points. The LEI is, like all indicators, imperfect. Moreover, the US faces some long-term, massive challenges that make this cycle different. However, the LEI has proven its worth in forecasting shifts in the business cycle over many decades so I believe it can’t be ignored.

And, as American novelist Mark Twain once quipped, history doesn’t repeat, but it does rhyme. No two business cycles are exactly alike, and you can always find differences. But the basic patterns of human psychology and market action don’t change.

Perhaps the LEI doesn’t fit your style, and that’s perfectly fine. But I’ve found it useful. And what’s more important than the indicator used is that you have some yardstick that’s constant and dispassionate. If you’re constantly changing the indicators and signals you watch, it’s next to impossible to separate emotion from your portfolio. That’s the only truly deadly mistake I know of.

In that light, the LEI continues to point to a US economic recovery. In fact, the patterns in the LEI suggest that the US could well surprise to the upside this year, generating stronger and steadier growth than the consensus expects through 2010. The LEI was up 1.1 percent in December 2009, well above expectations for a gain of around 0.7 percent. In addition, the November number was revised higher from up 0.9 percent to up 1.0 percent.

This is the ninth consecutive monthly increase in the LEI. And eight of the 10 constituent indicators contributed to the upside. And both of the remaining two indicators were simply flat for the month; this represents one of the broadest-based gains yet for the LEI for this cycle.

Click to enlarge

Source: Bloomberg

Meanwhile, the Conference Board’s Coincident Economic Index (CEI) -- an index of four indicators that tend to turn at roughly the same time as the economy -- increased 0.1 percent in December, its third consecutive monthly gain. That index is now up about 0.6 percent over the past month, and three of the four indicators improved in the most recent data.

This is the typical pattern as the economy emerges from recession: The LEI turns first followed by the CEI a few months later. The market as a whole tends to lead the economy by four to six months. This is all playing out to suggest that the US economy exited recession in the summer of 2009, and that the recovery is likely to strengthen in early 2009. Although this doesn’t preclude a pullback--and such a move may already be underway--it does strongly indicate that the market will be positive overall this year.

The big news of the week was, of course, political rather than economic. Specifically, Republican Scott Brown won the Massachusetts Senate seat long held by the late Ted Kennedy. This doesn’t give the Republicans a majority in either the Senate or the House of Representatives. But it eliminates the so-called supermajority in the Senate, making it far tougher to pass controversial legislation. Given the looming mid-term elections, this shocking win also makes legislators less likely to take a stand on controversial legislation and risk their seats.

Generally speaking, divided government is a positive for the stock market because it makes it more likely we’ll see gridlock and stability. Change means uncertainty, and the market loathes uncertainty.

In this case, the loss of the supermajority in the Senate has also been positive for the US dollar, a trend that was already underway. I suspect this strength will continue for a while longer. The argument goes that a divided government is likely to spend less money; smaller deficits and reduced spending are generally positive for the currency.

Disclosure: "No Positions"