A Consumer's Guide to Economic Indicators

If you wish to eat nutritious food and buy it inexpensively, or obtain homeowners coverage from an insurance company that has a good record on paying claims, you have to devote some time to research. It’s much the same if you want to understand what a newly released economic indicator means for your investments. Let’s explore the requirements for becoming an informed consumer of economic statistics.

A key principle is that the challenges of interpretation sometimes lie not with the numbers themselves, but with the self-serving spin that politicians put on them. When the economy is performing poorly, the party in power does everything possible to make a silk purse out of a sow’s ear. When things are going well, the opposition cries that the statistics are flawed or even that they’re rigged.

This sort of rhetoric sometimes veers into conspiracy theories. With only 18% of Americans now saying they trust the federal government, down from 40% in 2000,[1]there’s a receptive audience for such claims as, “Washington is artificially depressing the inflation numbers to hold down the cost of living adjustment to Social Security.” In short, smart consumers of economic data have to break through a lot of interference to arrive at a clear perception of the underlying reality.

Deconstructing inflation statistics alone would consume many more words than we have available for this survey (for greater detail, see Footnote 2.)[2] But in a nutshell, much of the controversy arises from conflicting notions about what the Consumer Price Index ought to measure. The original concept was to calculate the changing price of a fixed basket of goods and services. Over time, Congress moved to the view that what’s really needed is a cost of living index. This approach takes into account that consumers shift their consumption patterns in response to price changes, e.g., more chicken and less steak if beef prices rise sharply. The cost of living approach also recognizes that technology advances, consumers get more for their money, somewhat offsetting inflation. For example, today’s cars are much safer and get considerably better gas mileage than those of 50 years ago.

Changes of this nature also affect the long-run trend of another series of intense interest, home prices. Standard measures give people an exaggerated notion of how well homeownership has worked out as an investment, as opposed to simply providing shelter. The average home price has increased greatly over the past half-century partly because the average size of newly constructed houses in the U.S. has doubled since 1960.[3]The real estate industry probably isn’t troubled by this illusion, but Nobel Economics laureate Robert Shiller and Wellesley College Professor of Economics Emeritus Karl Case have addressed the problem by creating an index that measures home price appreciation on the basis of repeat sales of the same houses.

Another variety of measurement problem involves unequal progress among the components of a complex series. A somewhat bizarre example affected this year’s second-quarter Gross Domestic Product report. The far-above-trendline 4.1% annualized rate for real (inflation-adjusted) GDP was partly attributable to farmers rushing soybean shipments to China in anticipation of retaliation against U.S. tariffs imposed on Chinese goods. Investors must guard against getting faked out by such quirks.

Sophisticated users of economic data also need to dig beneath so-called headline numbers. Politically motivated pundits, regardless of party, attack reports of low unemployment on the grounds that they allegedly fail to count “discouraged workers.” If many individuals want to be employed but have given up looking for jobs and have therefore removed themselves from the workforce, say the critics, then of coursethe percentage who are trying to find work but not succeeding will be small. When you hear such comments, bear in mind that the Bureau of Labor Statistics is not hiding the discouraged worker effect.[4] It is reflected in the real unemployment rate, labeled U-6 in the BLS’s press releases. (As detailed in the graph below, the figure currently stands at 7.4%.) Finding the more comprehensive number requires reading beyond the first few paragraphs of the media coverage, which invariably focus on the headline number, known as U-3.

Source: Bloomberg Professional Services

Avoiding Bad Decisions

The above-described complications create numerous ways for economic indicators to trip you up on investment decisions. Getting to the bottom of every single quirk is probably not a realistic goal, given the vast time and energy that economics departments at major banks devote to that task. But you can avoid costly mistakes, particularly in the form of overreaction, by following a few simple rules.

1. Focus on the trend. Even if a statistical series isn’t perfect, its reported changes over extended periods are likely to depict the underlying reality fairly, as long as the series is calculated consistently over time. And the trend is what matters to financial markets. For example, if in a given quarter GDP comes in at a low level such as -1.0%, you can safely assume that a soft economy is already reflected in securities prices. It makes little difference that improved methodology might produce a truer number of -1.2% or -0.8%. But whatever the previously reported number is, the market will interpret an improvement of 0.5 percentage points as a materially bullish development. Just be sure to read the media coverage thoroughly in case some aberration— such as a sudden surge in soybean shipments—distorted the results.

2. Avoid short-sightedness. While a change in direction or an acceleration of a trend may have genuine significance, the short-run changes are sometimes reversed by subsequent revisions. That adds one more element of statistical noiseto economic indicators. Accordingly, radically altering one’s investment stance in response to a short-term move in a data series is inadvisable. Gene Epstein, former Economics Editor of Barron’s, concluded that although institutional investors and hedge funds focus intensively on the monthly unemployment report and move billions of dollars around on the news, the series is actually informative about the economy only when considered on the basis of a three-month moving average.

3. Stay focused on investment objectives. This discussion has addressed legitimate tacticaldecisions in response to cyclical changes in the economy. An individual’s bedrock investment strategy, however, should incorporate an expectation that GDP will vary widely over a span of ten or so years. Revisions to the basic strategy should not be driven by the alternation of recessions and expansions. Rather, investment policy should evolve along with one’s financial circumstances, as a function of such things as accumulation of a larger asset base, achievement of a goal such as fully funding children’s education, and retirement.

Armed with these rules and mindful of the sources of misinterpretation of government reports, the reader is well on the way to becoming a wise consumer of economic indicators.

[1] Source: Pew Research Center, as of December 4, 2017 and February 14, 2000

[2] See https://www.investopedia.com/articles/07/consumerpriceindex.asp. For an even more detailed discussion, see https://www.bls.gov/opub/mlr/2008/08/mlr200808.pdf.

[3] https://www.darrinqualman.com/house-size/

[4] See https://www.thebalance.com/discouraged-workers-definition-causes-and-effects-3305514