Economics, often referred to as the "dismal science" since Thomas Carlyle coined the term in the nineteenth century, are really the study of how society behaves in the struggle between unlimited wants and limited resources. Today, an entire industry thrives on the creation, monitoring, reporting and interpretation of a multitude of economic indicators such as employment, consumer sentiment, inflation, interest rates, inventories, price of raw materials food or energy, trade deficits and many more. The Commerce Department, the Labor Department, academic institutions and numerous think tanks crank out an endless stream of numbers. Econometrics then applies statistical theories to economic ones for the purpose of forecasting future trends. While much of this is way above our heads, the complex web of causes and effects between the multitudes of variables in society is backed by much research and for the most part seems quite logical. Most of us can follow simple scenarios such as growing unemployment negatively affects consumer sentiment, which in turn reduces their level of spending causing increased inventories. The reduced demand for goods causes prices to drop and manufacturers to slow down production and so on and so forth.

The disconnect occurs when trying to interpret all of this data in order to issue stock market forecasts. As with all market interpretations the result is highly dependent on the interpreter's point of view, the market context, and the then prevailing investor psychology. Depending on these conditions the same set of economic data can lead to diametrically opposed conclusions, which helps explain why so many respected expert forecasts are dead wrong. This is best illustrated with practical examples.

Example 1: Higher interest rates are bad news for the stock market
Or are they? This week the Federal Open Market Committee (FOMC) decided to raise its target for the federal funds rate by 25 basis points to 1-1/2 percent and gave a perfect opportunity for highly regarded economists and pundits to contradict themselves. In the first analysis, increasing rates and talk of a resumption of economic growth during the second half signals more rate hikes down the road (bad for stocks). The market rallies on the news. The next day more economists rationalize that, in this politically charged election year, if the Fed held rates steady instead of increasing them it would have signaled an economy that is actually weaker than they want us to believe, and therefore the rate increase had to occur to meet expectations. On this news the market tanks. One economic event with numerous interpretations. Sometimes, what Alan Greenspan says or does not say is more important than what he does.

Example 2: War is good for the economy and the stock market
While this theory has long ago been proven to be fundamentally flawed by economists, investors and politicians hold on to the myth. The simplest way to explain this one is with the "Broken Window Fallacy". The story goes something like this: a punk throws a rock through a storefront window which has a visible set of consequences. The shop owner has to pay the glass maker $1,000 to fix it. This $1,000 causes the glazier to purchase more raw materials from other merchants and hire employees to make the window, who in turn can spend their new earnings. The logical conclusion is that the punk, far from being a vandal, is actually an economic benefactor to society. Economists then like to point out that he has actually caused a net decline in the economy. Instead of having a window and $1,000 the store owner now only has a window. He could have spent the $1,000 to buy a suit, so he would have a window and a suit, and the $1,000 he paid for the suit would have generated the same economic boon as when he paid the glass maker.
In similar fashion the war has to be funded by a combination of reduced spending elsewhere, higher taxes and/or higher debt, all of which are bad for the stock market.

Example 3: Rising unemployment is bad news for the stock market
Or is it? Research tells us that it depends on which phase of the economic cycle we are in. Announcements of rising unemployment tend to be good news in economic expansions during which investors worry more about interest rates. News about higher unemployment reduces the risk that the Fed will increase interest rates. The same exact news will on average be perceived as bad news during an economic contraction during which investors tend to be more worried about corporate dividends and equity risk premiums which can be negatively affected by layoffs.

Now that we better appreciate the difficulty in using economic leading indicators to forecast the stock market we can also point out that in fact the stock market itself just happens to be one of the most reliable leading indicators of the economy's future direction. Not the other way around. In mysterious ways the stock market anticipates what is coming. A bear market always reaches its bottom while the recession is still worsening, well before economic recovery begins. The falling interest rates and prices provide the consumer a glimmer of hope which in turn triggers the next bull market cycle and in turn a recovery begins. As the economic recovery gains steam, prices start inching up, the Fed raises interest rates all over, and consumer expectations start declining as the stock market peaks. And so on.

As Trend Timers we prefer to watch the market itself for clues of what it is doing. Following the market trend is much simpler and more reliable than reading economic tea leaves.

Warm wishes and until next week.

The TimingCube Staff