You investors are a fickle kind; rather you speculators in investors clothing. Markets go up and markets go down. I was once asked, "Why would you invest in a Bear Market?" My response, "Tell me a day ahead of time then the Bull Market begins and I'll wait." Well, things are not always as easy as they seem. I was working hard the past few days to establish positions to put to work money. The available investable cash was from called stocks or expired options. Yesterday (August 31, 2010), my colleague thought I was crazy as everybody thought the market was collapsing. Today (September 1, 2010), I could not move fast enough as everybody thought the market was rallying. What to do?
The quote above is from a cartoon I cut out decades ago. It was as funny then as it is now. If you do not understand irony, well…… there is a man who is always shouting about stocks on the TV and you should be watching rather than reading this commentary.
We investors are a rare and funny (curious rather than humorous) group. We have patience and usually operate in a vacuum. We use quantitative things like math and analysis, ignoring qualitative things like sentiment and investor momentum. We like information and data but have the courage of our convictions because win, lose or draw we understand why we do what we do and believe in our process. Let us look at some economic and market indicators that I believe are useful to our cause. These are what I like to call bedrock data. They are not subject to revision, have long histories and are generally accurate. Do not get me wrong I do look at the weekly, monthly and quarterly data series. However, the more subject to revision a number is the less I value it. The weekly unemployment numbers certainly fall into this category. How hard is it to count unemployment claims? Apparently, our government has its issues with this task. Although they pay the claims, they never seem to know how many people they pay. The revisions always seem to be more telling than the headline numbers. The explanations sometimes read like a Joel McHale routine. Anyway, let us look at the indicators we hold in high esteem, 1) Capacity Utilization, 2) Commodity Prices and 3) Credit Spreads.
1) Fear and panic create opportunity. We cannot always understand why things happen. A popular quote on my old trading desk when asked why the markets were up or down was, “an imbalance of buyers to sellers” (or vice versa). Economic indicators tell you what happened. There are some “forward” indicators but most of these are ignored. As a newly minted analyst, I was introduced to Capacity Utilization. This is a wondrous statistic. Mostly because it is useful. Certainly, the underlying data can be suspect, albeit no more suspect than any other bit of data. The Capacity Utilization data is provided by the Federal Reserve as part of the monthly from the monthly G17 report that is headlined by Industrial Production. What is so genuine about Capacity Utilization is that this number and its components is its innocent nature. It is simply the percentage use of productive capacity by facilities involved in manufacturing, mining, and electric and gas utilities. This pretty much covers everything involved in making stuff. Headline readings above 82% are great and below 75% are bad. The recent past and current readings are worse than bad. For fun, I suggest looking at the series and analyzing some afternoon. But only with a loved one to show them how much you truly care. It is an amazing data series and I hope you find it as telling, rewarding and fulfilling as I do. (web link: http://www.federalreserve.gov/releases/g17/current/default.htm ).
2) Commodity prices from the cost of food at the grocery to gold futures. The less influenced by the traded markets a commodity price is the better the indicator. Everybody eats food. The type of food is the variable. Mac-n-cheese has become popular, as has bottled water. Mac-n-cheese represents a financial decision while bottle water represents a fashion decision. Keep to the financial decisions. Gold prices are high and trending higher. The price movement has many factors. Including fear of inflation and safety. Gold is an inflation hedge because it is a store of wealth and can easily be converted to cash and less easily be stored and transported. SPDR’s represent an easy way to own gold with lower transaction costs and greater portability. GLD is our poster child and it has a full array of options (the kind we like to trade) behind it. Energy prices for the most part are silly to look at because speculators and hoarders skew their supply demand characteristics (ie: oil). Looking at industrial metals like copper and silver provide a more down to earth view. By the way, the view is not a good one. Industry needs metals to operate. Ore’s are cooked, melted and pounded into stuff people buy. This stuff is a big component in our GDP or the key measure of economic growth. Price charting is helpful although there are price influences that do not always appear and a little history helps. Keep in mind that beef and corn food prices were forced up by the ethanol fiasco, platinum and palladium are hedges against each other and natural gas is seasonal (cheap, abundant and odorless - methane from living organisms excluded).
3) Finally, the credit markets are another great economic/risk indicator. Keys to the understanding risk pricing are: yield spreads, the value of a basis point and forward pricing. Yah, right, I am not going to explain these but provide just enough information to tease you and make you dangerous. The levels/amount of spreads is the easiest to look at but as with all else, there are deeper indicators that are frankly damned hard to understand. The levels/amount of spreads is the differences between yields on credit/corporate bonds to government bonds from over night to 30 years. Changes in the levels are a simplified indicator of investor risk appetite. When the spread difference from corporate bonds to government bonds is wide, things are bad. Speculators especially, and when things are really bad investors, sell risky assets (Corporate bonds) to buy safe assets (Government bonds). When there is a crisis, everybody runs to the cover of the dollar and US Government bonds. All the foolish talk about US Government’s poor credit is mostly nonsense (when investors start buying Chinese Government bonds the risky US Government bond argument may begin to make sense). Things are going to get a little complicated in the explanation at this point. Read the next part slowly and thoughtfully, it is really truly geeky technical interest rate risk stuff but invaluable in understanding how risk is priced. As always, I will be happy to provide more information if you ask (just e-mail me at addingalpha@consultant.com ). While the quick and dirty current risk assessment above is the absolute spread in yield, the yield on one bond minus the other, is important it is not as important as the value of each basis point in the spread. This is based on a technical measure called the value of a basis point (0.01% of yield). It is related to a derivative of price sensitivity measure called duration. Duration is a measure of price sensitivity based on the maturity, yield and interest rate of a bond. Since this is the concern of geeky bond people, I will not go into any detail except to tell you it is a very important measure of price sensitivity and becomes more valuable as yields decline. Think of it in simple common ration terms: if prices increase $1 it is more meaningful when the original price is $1 than if it was $100. A move from $1 to $2 is a 100% increase while a move from $100 to $101 is a 1% increase. The same absolute $1 increase in price is significantly more meaningful when prices are low than when they are high. The same is true for a 0.01% price change in bonds. All this being said the yield difference between corporate bonds and government bonds is wide on a yield difference basis and the value of each basis point of yield – this is a real danger sign. Finally, the forward yield curve is conceptually easy, if you have a PHD in math. Basically, it is shifting the term structure of interest rates, aka yield curve, forward. If we look at a graph of interest rates made up of yields on the y-axis (vertical) and maturity on the x-axis (horizontal) we have a yield curve. Using some math we can simulate what the price of any given interest rate will change to if we move forward in time. Let us use 1 year forward in time. Therefore, today’s 2-year bond becomes a 1-year bond; the 5 year becomes 4 years, on and on. We know how what the 1 year forward price is? We use formulas designed by some really smart, and possibly lonely people, figured out how to use today’s prices to predict the forward price of a bond. The formulas use yield change calculations, duration adjustments, income payments, convexity (another key indicator and is related to the behavior of price movements), etc. to figure out what the forward yield curve would look like. This is similar to our stand Still Rate (SSR) but takes a whole lot more work to calculate. The results are not always what you would expect and the exercise can be very telling as to where investors think interest rates are headed (do not think that bond invertors actually do this – it is the realm of the back room guys who do not always get the respect they deserve). This information can be found on the web but for now, we will know this exists and focus on it at a later date.
Quick note: Point to praise a brilliant analyst. Stanley Dillar, a true genius, has written extensively on the subjects of duration and convexity. I was fortunate enough to have met him in the late 1980’s at a conference. Dillar operates at a level most investors try to avoid. Google his name and if possible read his work. It is well worth the effort. The following blog is an excellent review of his methods: http://webcache.googleusercontent.com/search?q=cache:BDQj2TASeKIJ:alephblog.com/2009/12/23/my-tips-treasuries-and-inflation-model/+stanley+diller+bear+stearns&cd=5&hl=en&ct=clnk&gl=us
I mention the three chosen indicators above, Capacity Utilization, Commodity Prices and Yield Spreads for a reason. These three indicators are priced nearest to action. Capacity Utilization reflects what people who are operating businesses are doing at this moment, Commodity Prices reflect the costs of doing business
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