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Economic Indicators

Because the economy is the key driver of investment activity, it is imperative that, as an investor or trader, you keep a close eye on economic indicators, which are simply vehicles by which the condition or vibrancy of an economy is measured. For a trader, a single economic report can turn a good trade instantly bad or save a potentially failing trade. For an investor, waning economic indicators may presage a significant downturn in the markets; conversely, improving economic indicators in a bottoming market can signal an important buying opportunity.

Economic indicators are absolutely essential in order to monitor the state of a modern economy, to plan and formulate economic policy, and to make financial and investment decisions ranging in scope from international right down to the personal level. Without knowing the existing condition of an economy, that economy would function only in a state of uncertainty, subject to widespread instability and frequent financial panics. Interest rates would remain stubbornly high, if lending took place at all, because lenders could not know whether economic conditions might change suddenly for the worse, leaving borrowers unable to repay loans. Currency could not be properly valued, leaving the barter system as the only viable alternative for exchanging goods and services. While basic agrarian economies can function in this manner because they are non-specialized and self-sustaining (A farmer is, by nature and by necessity, self-reliant.), advanced manufacturing societies cannot because the cost of resources (raw materials) and the cost of the finished product must correspond to one another in a consistent relationship over time in order for business transactions to be routinely and equitably consummated.

Economic indicators are compiled by a wide variety of agencies, both governmental and civilian, to illuminate virtually every aspect of an economy. While many economic indicators are publicly available, some are compiled by financial institutions either for in-house use or for proprietary use by clients. Still others may be derived and maintained by educational institutions such as universities or think-tanks as research projects; these may be made public (in part, to enhance the reputation of the institution as caretaker of the indicator) or may be reserved for use by other researchers. Economic reports may comprise hard data (statistics), soft data (consensus and estimate), opinion polls, or a combination of these data types.

A major problem with economic indicators is their inherent tendency toward inaccuracy on a short-term basis. Economic reports of all types are frequently revised at a later date by the agencies responsible for their compilation. An economic report should always be viewed with a grain of salt; when analyzing the data, the trend is usually what is most important. Another critical factor is the measurement process itself; a classic example is U.S. Government unemployment statistics, which fail to take into account discouraged workers (i.e., persons of legal employment age who are not actively seeking employment), thereby undercounting the true number of unemployed within the workforce. It is often enlightening to dig down into an economic report, examining data subsets to see exactly what combination of factors have led to the overall result.

Traders need to anticipate how a particular indicator may play out in the market and read between the lines once the data is actually disseminated. It can be extremely dangerous to enter a trade ahead of the release of important economic news; the best course to pursue is often to wait until market action is confirmed. Some pitfalls associated with trading on economic data include the following:
  • Initial market reaction to important data can be rapid and violent, making it necessary to either chase a trade or abandon it;
  • The initial market response to economic data is often a knee-jerk reaction subject to reversal once the substance of the economic report is digested by more patient and savvy traders and investors;
  • Markets may place differing emphasis on a particular set of data depending upon other factors such as coincident or supporting data and the state of the markets as a whole;
  • Large investors or institutions may pre-position large buy or sell orders to take advantage of market movements resulting from a data release, thereby creating a market reaction opposite to that which would normally be expected;
  • Multiple economic reports issued in a near-coincident timeframe may present a conflicting view of economic activity, thereby muddying the waters for trader and investor alike;
  • Economic indicators which ordinarily affect only a narrow range of markets may at times have a spillover effect which can affect other markets.
Suffice it to say that trading is never easy. Trading on economic data can present tremendous opportunities, but may also lead to staggering losses if the data do not support your premise and, consequently, the trade does not go your way.

For investors, the wait and see approach becomes even more important than for traders. An investor should never rely upon a single data point within a given economic indicator to determine an investment decision. Most indicators have the capacity to fluctuate wildly from one data point to the next, requiring examination of a smoothed average to gain a clear picture of the true trend. Comparisons can also be misleading. Some indicators require quarterly or seasonal adjustment to reveal significant changes or deviations. At times, exogenous influences can distort the numbers, such as the effect the Congressional “cash for clunkers” stimulus program had on U.S. auto sales.

Economic indicators, then, are used to measure the health of an economy and should be a key component of your financial arsenal in order to achieve consistent and successful investment or trading results. Economies are not static; they ebb and flow in distinct cycles of expansion and contraction (recession). The beauty of economic indicators is that they can be used to discover trends that reflect these cycles. Employed properly, economic indicators can assist you in periodically reallocating your investment portfolio or realigning your trading strategies to achieve maximum return on principal.

Authored by Kenneth L. Anderson.  Original article published 13 November 2009.

Follow links to the right to learn more about a number of important U.S. economic indicators, economic statistics and labor statistics, including Consumer and Producer Price Index and information from the Bureau of Labor Statistics. At the left margin, Related Links address topics of interest pertaining to information, resources and services for investing and trading in the stock, bond, commodity and real estate markets. View the Stock & Bond Investing SiteMap for a complete list of stock, equity and bond investing topics.

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