Economic indicators are valuable tools for investors, but just how weight should we give them? In this episode of The Agent of Wealth Podcast, host Marc Bautis is joined by Financial Planner Kayla Waller to discuss everything you need to know about economic indicators. While there is valuable information in metrics such as the monthly jobs reports and the US treasury yield curve, understanding their relative strengths and limitations will improve your decision making as an investor.
In this episode, you will learn:
- What indicators are, and how leading indicators are used in the financial industry.
- An overview of the key leading indicators used by investors; how they are calculated, what they can tell you, how accurate they have been in the past, etc.
- What you have to watch out for when using leading indicators.
- And more!
Disclosure: The transcript below has been lightly edited for clarity and content. It is not a direct transcription of the full conversation, which can be listened to above.
Today, we’re going to talk about financial indicators. A lot of investors are in search of a crystal ball that will tell them what’s going to happen to the economy in the future. Because if they can see into the future, perhaps they can predict the markets and see big returns.
When this topic comes up, I always think about the scene in the movie “Back to the Future,” when Michael J. Fox – or Marty McFly – gets his hands on an almanac and is debating on whether he should use it to see who wins sporting events in the future. I think a lot of investors are in search of that almanac.
What we’re going to do in this episode is talk about what indicators are – specifically leading indicators – and then more importantly, get to the bottom of whether or not they can be used to predict what will happen in the markets. Kayla, can you start us off by giving us some background information on what an indicator is and the different types of indicators?
What is an Indicator?
An indicator is a measurement used to draw some conclusion about how the overall economy is doing. There are three different types:
- Leading indicators are considered to point toward future economic events and trends.
- Lagging indicators are seen as confirming a pattern that is in progress.
- Coincident indicators occur in real-time and clarify the current state of the economy.
Okay, we’ll skip over lagging and coincident indicators, because in the landscape of investing, people are primarily focused on leading indicators. So let’s talk about some of the popular ones.
Leading Indicator 1: Monthly Jobs Report
One leading indicator that gets a lot of press is jobs. Monthly job metrics that investors seem to care the most about are new jobs added and initial jobless claims (people filing for unemployment insurance). These statistics are released in the monthly Jobs Report by the Bureau of Labor Statistics, and September’s Jobs Report just came out today. So Kayla, what does the Jobs Report tell us?
The monthly Jobs Report gives a picture into how many people are entering and exiting the workforce. In it, the Bureau of Labor Statistics estimates the U.S. unemployment rate, the monthly change in nonfarm payrolls, the average earnings and hours worked, and more.
The September 2022 Jobs Report shows that September was the 21st month of consecutive job growth, but it’s slowed down a little bit from the peak.
Yeah. So if you look at the report, it reveals that there were 263,000 jobs added to the economy last month. Normally you would think that the addition of jobs to the economy is a good thing, and that it would predict a strong economy. However, the stock market didn’t like the news.
With each leading indicator, investors read or digest the information and then react to it. But the reaction to it can be mixed, or surprising. Today, when theoretically a strong report from the Bureau of Labor Statistics came out, investors didn’t like it and the market reacted negatively.
In this instance, it’s because investors are concerned about other things in the economy besides jobs. To investors, the strong September 2022 Jobs Report signified that the Fed has more ammunition to continue raising interest rates, as we’re in this inflationary period.
Right now, the market has been primarily focused on inflation data and the Fed’s rate hikes. Investors, and the market, currently think that interest rates will continue to rise and the environment that creates will preempt any strong job growth.
So not only is it interesting to understand our economy’s leading indicators, but it’s also interesting to see how investors and the market react to the leading indicators.
Leading Indicator 2: US Treasury Yield Curve
Another leading indicator that gets a lot of publicity is the yield curve. Kayla, can you explain what the yield curve is and what it’s showing now?
A yield curve shows the different maturity points in yield for a specific security. It’s usually talked about with treasury spreads. A spread is just the difference between the two fixed income instruments of different maturities. So a common one that people look at is the 10 year, two year spread, or the 10 year, three month spread.
If you look at those yield curves over the past year, you can see that in March, the 10 year, two year spread inverted and it’s been like that for most of the year. People generally consider this a warning sign because you’re getting more yield on the earlier maturity than you are on the later one, which signifies that you feel weaker about your future outlook.
Normally, when someone invests in a fixed income bond, or in this case a treasury, you would usually get a higher interest rate the longer the maturity of that bond is. And that not just across treasuries or bonds, but think mortgages, even: the shorter the duration of your mortgage, the lower your interest rate typically is.
Now when the yield curve inverts, you actually would receive a higher interest rate return from a shorter maturity. And we’re seeing that a lot, where the appetite for these one year treasuries is pretty appealing, even though you take into account you’re only having that money tied up for a year versus if you did a 10 year or a 30 year. When that happens, it’s usually because people are bearish.
Has the yield curve been a good predictor of a recession or a pullback in the economy?
The answer is yes and no. If you look at the last 14 recessions since the 1970s, the yield curve has been an accurate leading indicator eight times. So, kind of…
So that’s the thing with indicators. If something is only accurate 50% or 60% of the time, do you think you should base your investment strategy around it? Is it really something that you can put your hat on? The answer is probably no.
Leading Indicator 3: The Stock Market
Another indicator I find interesting is the stock market itself. So, people are trying to use these indicators to predict the stock market, but is the stock market itself a leading indicator?
Yeah, that’s probably the one that people look at first. Stock prices are based in part on what companies are expected to earn. So yes, in that sense, it is a leading indicator. A company’s earnings expectations decreasing could indicate a down market, and then an investor could imply that there’s going to be an upcoming recession. Therefore, many investors believe that large decreases in stock prices are reflective of a future recession, whereas large increases in stock prices suggest future economic growth.
You make an important point when you talk about a company’s earnings increasing or decreasing. When a company’s earnings are positive, a lot of the time, people will look at them and say, “That company had good earnings. I’m going to buy their stock.” On a larger scale, some investors will ask, “I’m hearing that there’s going to be a recession. Should I invest differently or should I change my investments?”
If we look at this year as an example, the stock market is pricing in some sort of future recession or downturn into the market already. So even if there is a recession – say, next year – that doesn’t mean the stock market is going to go down or up. Instead, the stock market’s next step will be based on how severe the recession is… as there are really bad recessions, moderate recessions and so on.
So it’s important for investors to know what the market has already priced that information in. Which, I think, is one of the things that’s really hard to understand about how the stock market itself is a leading indicator.
Leading Indicator 4: Building Permits
One area of the market that I want to talk about is real estate, because the real estate market is huge. Are there any leading indicators in that sector?
Yeah, building permits is a big one. It provides insight into what future real estate supply levels could be. A high volume obviously means that it would be more active. And if you look at the numbers now, they’ve come down a little bit since the Federal Reserve started raising rates this year, but there are still new building permits.
Yeah. New building permits are great because they indicate new construction, which will trickle down into all types of industries or sectors. But, like you mentioned, almost all real estate is tied to interest rates, and rising interest rates hits the sector hard. A lot of people purchase real estate using leverage, or loans, so as interest rates on loans rise, the mortgage applications will decrease.
Leading Indicator 5: Consumer Confidence
So far, a lot of the indicators we’ve talked about are data driven. But one that isn’t is consumer confidence. Kayla, what does that measure?
Consumer confidence measures how people feel about the economy and where it’s going. In September, consumer confidence increased for the second consecutive month. The baseline is 100, and then anything above 100 is considered good/expansionary. Anything below 100 is considered bearish. But since it did increase for the second month, we can assume that people are still feeling relatively good about the economy.
Yeah, the indicator is actually positive right now. Something that often gets forgotten is that the economy is driven by consumption – people going out and spending money. And people are still spending money… So that’s a bullish sign.
The funny thing about consumer confidence is some investors think positive consumer confidence isn’t bullish, it’s bearish because you want to go against the herd. That’s the contrarian type of view. It’s like what we talked about with the Jobs Reports.
Leading Indicator 6: The Buffer Indicator
Everyone knows Warren Buffett, but you might now know that he has an indicator named after him. Kayla, what is the Buffet indicator?
The Buffet indicator measures the ratio of all US stocks in their combined market cap to the US GDP. Warren Buffet once called this the best single measure of where valuations stand at any given moment, which is why it’s named after him. A ratio of one to one or just 100% means that the market’s fairly valued. When the US market cap surpasses GDP, the indicator means that things are overvalued. And the Buffett indicator has proved to be a good warning for seven out of the past 14 market declines since 1971. So, about half of them.
Again, only about half the time… Yeah, I mean it’s interesting to look at. A lot of the time, whe people are trying to determine if stocks are overvalued, they’ll look at a measure called price to earnings, or PE ratio. But the Buffet indicator takes it to a larger scale by looking at the market cap.
The market cap is the number of outstanding shares times the stock price. You tally that up for all the public companies and then you compare it to the gross domestic product, which is the value of all goods and services that are created in the U.S. Like you said, Kayla, when that ratio is over one, this indicator starts to signify that things are overpriced.
One of the things that this indicator doesn’t consider is that if you go back into the 1940s or 1950s, stock prices have risen faster than GDP has. So I don’t know if consistently holding it and saying, “Oh, if the threshold is one,” is really relevant because the top part of that US market cap has risen faster than stock prices have.
Right now, the Buffett indicator shows things are historically high, but again, the Buffet indicator has only predicted seven out of the last 14 recessions. So, seven times it was right, seven times it wasn’t.
Yeah. Another thing with it is it’s been above 120% since 2016. So if you followed the Buffet indicator only, you would’ve believed things have been overvalued for the past six years.
Exactly, and then you would’ve missed out on a lot of the market returns over the past six years.
Leading Indicator 7: The Baltic Dry Goods Shipping Index
The last indicator I want to talk about is called the Baltic Dry Goods Shipping Index. I find it funny because Baltic always reminds me of Monopoly, but this measures goods that are being transported to different areas. And that’s important because theoretically, those goods are going to go somewhere to be used to build some product that’s going to add to the economy. Kayla, what is going on in the manufacturing sector now and what are those indicators showing?
A big theme this year has been the supply chain and manufacturing issues. It eventually will influence GDP and it’s been contracting a little bit this year. Right now, these indicators are at a high level, in terms of what they’re measuring. It’s usually at a broad scale. But sometimes we’ve seen where a specific company comes out with information and the market reacts to that.
One example is FedEx. A couple of weeks ago, FedEx released their earnings and they had soft projections. As a result, the overall market took a hit, because a company like FedEx or Amazon acts as an indicator of the entire market. If people are shipping less things via FedEx, or if people are buying less things on Amazon, that probably means that consumers are spending less.
So, as you see, indicators don’t always have to be these broad measurements. A company like FedEx can foreshadow what’s going to happen to the economy.
Should You Invest Using Indicators?
So, we talked a lot about these different types of leading indicators. Kayla, what’s the takeaway from this? Are they 100% accurate in predicting what’s going to happen in the future of the economy?
No. But it would be nice if it was the case. I think the takeaway is that leading indicators need to be considered in conjunction with the other indicators. If they’re all signaling a warning sign of a recession, then you can draw a more legitimate opinion. But I don’t think it’s plausible to just relying on one indicator. For example, if an investor just relied on the Buffett index, and they took their money out of the market in 2016, they would’ve missed a 10% annualized return in the S&P 500 Index over all of those years.
Yeah, I agree with you. If all of these indicators are in sync – all pointing in the same direction – that’s a different story. One of the biggest takeaways I want listeners to understand is that the stock market itself is a leading indicator. If the stock market was a lagging indicator, then you might be able to look at some of the other leading indicators to determine how to invest in the stock market. But there’s no crystal ball out there.
Alright, we’re just about out of time. Kayla, thank you for joining me today. You provided some great insight on indicators. And thank you to everyone who tuned into today’s episode. Don’t forget to follow The Agent of Wealth on the platform you listen from and leave us a review of the show. We are currently accepting new clients, if you’d like to schedule a 1-on-1 consultation with our advisors, please do so below.