TECHNIQUES

Given the important role thot economic data plays in the behavior of the financial markets, it is crucial for investors to have an understanding of how to read these reports and how to use that data.

Reading economic reports

BY ANTHONY CRESCENZl
ost retail traders would be sijipri-sed at how liiile niiiny professional rraders on Wall Street know about economic reports. Wilh a litrlc work, anyone can take their knowledge ro a level thar many on Wall Street take years ro ohtaiii and thar some never achieve. The frequency of economic releases makes It easy to understand economic data and how it affects the markets. The frequenr releases also make it easy to spot parrems in rhe way the data behaves and thus draw connections from one economic indicator to the nexr because they are all, ultimately, intertwined. Expert knowledge of economic reports can provide greater personal reward rhan theoretical academic work because it ciin be applied. There's no substitute for knowledge rhat has application value. In tbis case, we are talking about making you a better investor through a grearer understanding of how ro use ecotiomic reports.
MONTH TO MONTH

Look closely at economic calendars

from one month ro tbe next and you'll see rhat rhey look alike, wirh most economic reports released around rhe same date each month (see Dateline, page 66), Also notable is the large role that manufacturing-related data play in the calendar, This might surprise some, given that the U.S. economy is largely a ser\'ice-orienred economy, witb factory activity accounting for only around 15% of activity, and the service sector accounting for about 65%. Tbere are a couple of reasons for the calendar makeup. For one, the government has been skiw to respond tci the secular decline in the U.S. tactor>' sector. In fact, the or\Jy major service-related economic report is the non manufacturing index released monthly by the Institute for Supply Management, a private organization. The government is failing rhe markers in rhis respect. Second, activity in the service sector is much more difficult to measure. It's easier, for example, to measure the monthly output of automobiles rhan to track the activity of land.scapers, repairman, lawyers, hair and nail salons, and so on.

Most times, the focus on factory activity is appropriate because it is represemadve of the overall econotny: the many factors that impact the factory sector also impact ibe service sector, tor example. Still, there have been plenty of occasions when rhe factory sector sent misleading .signals on the state of the overall economy. Nevertheless, due to the makeup of rhe economic calendar, the lx)nd market Is heavily influenced by the factorysector, which is why it is so important to get a grip on factory activity most of all.
NUMBERS DONT LIE

LX'vising a gixxJ forecast on the economy is challenging, but the task is made easier when you ler instincts and facts guide your forecasts. Many economic forecasters approach forecasting far ttxi conservatively and rarely think outside of the box, clustering their forecasts aniund a safe place: the consensus. Hence, they miss making great calls. They are more comfortable knowing rhey will be less open ro criticism il their peers are also wrong. The conservative tiature of forecasters Is similar to the reticence shown by equi-

4 6 FUTURE5 I January 2007

ry analysts before the ecitiity bubble burst in 2000. Analysts staxl by rosy forecasts on stocks and were reluctant to issue sell recommenLl;iti(ms when the environment clearly called tor it. In tact, less than 1 % of analyst stock recoinmendarioas at that time were sells. As a trader with ytuir own money on t\e line you need to be willing to make forecasts that are sometimes far removed trom the ctmsensus. Don't buck the trend just tor the sake of doing so, but lei your forecasts be dictatetl by numbers; numbers don't lie. In doing so, you will find yourself delivering accurate f(iri;casts wben the crowd is wrong. When making :in economic forecast, think like a detective who is on a mission to collect as many relevant facts as p<ssible. An example would Ix' driving to the itKal shopping mall just to look at tbe fullness of rhe parking lotforclues on ijomunier spending. You can never have too mttch data when you are trying to forecast the economy, and the information age helps a great deal. Web sites by trade associations and specialised journals contain a lot of information about specific sectors of rhe economy. Once you've assembled as many relevant tacts as you can, it's vital to let them guide your forecasts and to have conviction. You must remain open minded, but there are many situations where your forecast might seem at odds with what might be guiding other forecasters. In the second half of 2001, for example, a torecast tor weakness in the hoiLsiny market was counterintuitive given that interest rates had fallen sharply, but some important numbers pointed ant.)ther way. Lumber prices were near a nine-year low, mortgage applications were slipping, consumer confidence was down and home btiilders' ctinfidence was down. Despite low interest rates suggesting otherwise, housing slowed.

!GYVS. THE FED

Despite rising energy prices, the Federal Reserve felt it was safe to continue raising fed funds target throughout 2005 and 2006. 510 290 270 250 230 210 190 170
I' U.S. - all grades (all formulations) retail gasoline prices (c per gallon) Fed funds target 2.0
5.0

4.5 4.0 S.5 3.0 2.5

^^^ 1/3 2/7 3/U 4/18 5/23 6/27 8/1 9/5 10/10 11/14 12/19 1/23 2/27 4/3 5/8 6/12 7/17 8/21 9/25 10/30 2005 2006

Similarly, when energy prices started to climb in 2003 and 2004, personal income data showed that income growth was strong enough to absorb the consumer's increased energy costs. An astute analyst would have remained optimistic about the economic expansion and bet on Fed rate hikes into early 2006 when energy was still rising (see "Energy vs. the Fed," above). That proved to be the right call. It is important to stand by your numbers, especially if they make a compelling case.
BE FLEXIBLE

The bond market's focus on economic data is intense, but rhe specific economic reports that get the most attention vary. For example, die monthly employment report tends ro be a big market mover most times, but it is otten downgraded in importance and viewed as a lagging indicator. It's therefore important to be open-minded and tlexibie when weighing the potential impact of a set of economic reports. With tbe market's focus on data changing frequently, you should look several steps ahead and consider the

chain of events that could affect the economy and perceptions about it in the financial markets. Given how Wall Street works, kioking at the present is Itxiking in the past. Successful investtjts must first itientify eitlier the economy's key problems or its major underpintiings and then try to envision the chain of events that could alter its direction. The best way to accomplish this us to recognize that behind each economic event is a series of other events. For example, by following weekly data on mortgage applications, you can quickly drum up a view on the housing market. This is a major element in forecasting the economy and perceptions about it, especially given the intense focu,s on housing these days. From there, it's especially important to relate developments in the economy to the markets; you can't put being right in the bank. You must apply your sense of the data to the markets in order to benetit.
METHODOLOGIES MATTER Once ytiu've got a good sense of how the economy works and you feel comfortable making economic forecasts, you

Knowing the survey methodology makes it less likely you will be fooled by economic reports and you can better spot trading opportunities.
www.fulu resmaQ.com | January 2007 47

Trading Techniques
can signiticantly enhance your forecasting ability by teaming more about the survey methodology for the economic reports. This will give you an edge on other market participants who often have scant knowledge about the data. An important premise to remember is that actual economic data can differ greatly from the reported data. Statisticians see to it that raw data are altered to smooth out seasonal fluctuations. Coasider the sale of Christmas trees, tor example. Sales increase substantially in December before nose-diving in January. Statisticians attempt to "smiX)th," or seastmally adjust, the fluctuations by adjusting the December data downward and the January data upward. Who, after all, wants to hear that sates ruse 4OO'X. in December but fell 400% in January? By recognising how data are altered, you can find situations where the adjustments might be ttio much or too little under various circumstances. Track also how economic data are collected; specifically tbe survey cutoft dates because most are not at montli's end. In January, for example, a snowst<,)rm that occurs late in the month will affect some economic reports for January but not others. Knowing the survey methodology makes it less likely you will he ftxiled by economic reports and you can better spot trading opportunities. Pl/TTINGTT TOGETHER Few di)ubt that economic reports are at the root of most Kind market volatility. Recognizing this is the first step to using this simple notion to your advantage. Tbe next step is to take advantage of rhe repetitiveness of the monthly releases to learn them inside and out. From there, increase your understanding of the economy and the data enough to envision the series of events that could follow different sets of economic data imd how the markets might re.spond to the events. Finally, get an extra edge hy learning more about how economic reports are put together: the survey methodology. Try all of these things while remembering that in the economy, everything is connected in one way or another. In the economy, there's certainly truth to tbe notion that for every action there's a reaction. As a trader, your ability to anticipate these series of reactions will separate yini from the pack. ! FM

Anthony Crescenzi is a bond market strategist at Miller Tabak + Co. and author of The Money Waricet and The Strategic Bond Investor. He can be reached atacrescenzi@millertakak.com.

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