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Reading Economic Reports for Bullish Signs


And making sense of forecasts as a whole.

A "sense" of something is not the best way to make investment decisions. Gut feelings are all well and good, but they're hardly the primary basis upon which investment decisions should be made. Yet, a sense of where the economy -- and therefore earnings and stocks -- are headed is all most investors end up with when it comes to reading the daily economic reports that so influence the market. Take today's employment data, for example.

Many investors find macro-economic data such as this interesting, and they know it's important as it provides a sense of where the economy might be headed. However, beyond a sense of the economy, most investors lack the ability to turn that reported data into a useful predictive tool of future stock prices.

Specifically, what many investors lack is a process by which regularly reported macro-economic data can be incorporated into the investment strategy decision-making process - which is (or should be) the centerpiece of one's asset-allocation decision process.

(Numerous studies have shown and there's little real debate over the fact that the asset allocation constitutes approximately 85% of the investment performance in well-diversified portfolios. Given how highly correlated markets have become, this point is even more relevant.

Only portfolios that aren't well-diversified don't adhere to this fact - such as concentrated (non well-diversified) portfolios. It should also be noted that those portfolios that are both concentrated and assume a greater degree of risk (higher beta stocks like NVIDIA (NVDA), or Amazon (AMZN), or Kodak (EK), for example) move even further away from the asset allocation fact noted above. That said, nearly all portfolios, whether diversified or concentrated, are impacted by the general trend of equities, leaving only the relative (and not absolute) performance as the final results upon which an investor can hang his/her hat.)

In this article, I'll describe what I've developed over the past several months that provides something more than a sense of where the economy, earnings, and stocks are headed.

To understand how to use the daily economic reports for fun and profit, you first need to understand the process by which most individual equity analysts make their earnings forecasts. Since earnings and their growth rates are 2 of the 3 anchors of valuation (the third being the risk or discount factor; standard components of the discounted cash flow model), having a tool that can help in predicting the likely directional change of future earnings forecasts can be a very useful device for investment decision-making.

Individual analysts form their earnings forecast by incorporating 2 independent but interdependent sets of data into their financial and valuation models. One comes from the companies they follow and the industries within which these companies operate. The other, the larger macro-economic picture (which isn't within their primary skill sets), is provided to them from economists, whether in-house or outsourced.

Beyond company and industry-specific aspects of business (such as products, management, competitive environment, etc.), the macro-economic environment is usually the single most significant factor in future earnings, growth, and risk prospects of companies and industries. An apt way to look at it: The rising (or falling) tide lifts (or sinks) all boats. So, it's to the primary providers of macro-economic forecasts that we now turn; the purveyors of the dismal science: the economists.

Like individual analysts, economists make their economic forecasts in a deliberative process, analyzing the data they receive and then making adjustments to their forecasts. These economic forecasts, like the earnings forecasts from individual equity analysts, are compiled into a consensus view. This helps guide investment strategists, portfolio managers, and (many...most?) individual investors in their investment decision-making process.

For forward-thinking investors, there's an opportunity to (a) better understand how this process can be turned into a predictive stock-market tool and (b) a way to exploit the process.

Since individual forecasts are aggregated to form a consensus view, and since markets derive their collective current values from predictions derived from the consensus view, it seems reasonable to conclude that changes in the consensus view will result in changes in economic forecasts, which will then result in changes in earnings forecasted and ultimately realized. Therefore, if it's correct that stocks are based on the consensus view, it behooves investors to monitor current economic data for trends that will likely change future consensus views (economic then earnings). In the current environment, this works out as follows:

Economic reports at or above consensus will result in future upward adjustments to economists' views, which will result in higher forecasted earnings from individual equity analysts. The follow table illustrates this quite well.

Click to enlarge

Each week, I list the major economic reports to be reported as well as those that were reported the prior week. What I'm looking for is the aggregate trend of reports vis-à-vis their consensus forecasts. What the above table shows quite clearly is that most reports are coming in at or above consensus views. Not one report, most reports.

Therefore, it's logical to conclude that in time, economists will begin to incorporate this new data into their individual models. Doing so will increase their economic forecasts, driving individual analysts to increase their individual company forecasts. This will result in higher forecasted earnings, which provide the basis for analysis on where stock prices are today.
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