Turn market wisdom on its head

Conventional wisdom uses economic data as the basis for calls on the stock market. But what if this approach was turned upside down?

Most economists, market strategists and analysts work from a model that uses economic forecasts to underpin or justify their financial market calls.

If the US economy is forecast to be heading into a period of moribund growth or even a double-dip recession, the obvious market calls are to be underweight stocks and overweight government bonds. If the call for the economy is for a sustained pick-up in economic growth as the Federal Reserve successfully delivers the final game-changing bout of stimulus, then sell bonds and buy stocks.

You get the drift.

This approach is all well and good, but there are clear flaws with it that can lead to unprofitable investment decisions. If the underlying forecasts for the economy prove to be wrong, the associated investments will lose money.

Another problem is that hard economic data are released with a long time lag, usually well after the economy and financial markets have moved on. For example, Australia has not yet released its June quarter GDP numbers. If, for example, you were relying on the GDP growth rate of the Australian economy to determine an investment strategy, you would inevitably be relying on old and unreliable data. In the meantime, investment opportunities have come and gone.

This brings us to an approach that turns the conventional approach on its head. What about using the information in financial markets to judge how the economy is going? While markets can sometimes send false signals or overshoot, they contain the collective wisdom of thousand of investors and are driven by billions of dollars (and euros, yen and yuan) each day.

Every now and then it pays to step back from the data flow, economic forecasts and judgments about the economy and look carefully at trends in financial markets. If, for example, stock markets are trending higher, bond yields are rising and commodity prices are also on the up, there is a good chance that economic conditions are improving regardless of what the recent economic data might show. Conversely, everyone knows that a stock market crash spells pending disaster for an economy and policymakers now react swiftly with action whenever we see sharp and sustained falls in stock prices.

The beauty of using markets to assess an economy, rather than using economic data to try to assess where markets might go, is the availability and timeliness of financial market data. Stocks prices are available minute by minute, day by day, as are foreign exchange rates, bond yields and commodity prices. I don’t need to see the June quarter GDP result from the Australian Bureau of Statistics (which isn’t released until early September) to see that good economic growth rates in Australia are likely to be sustained for a while yet.

This optimism about ongoing growth in Australia, at least for the next little while, is based on the observation that stock market prices and bond yields have been creeping higher in recent months. This doesn’t happen in an economy that is about to hit a brick wall.

That said, it is unlikely that the economy will be so strong that there is a material risk of overheating. This is because global commodity prices have been generally flat to lower in Australian dollar terms over the past few months. If commodity prices were rising strongly, this would suggest either strong global growth or a supply shortfall, which either way would show up in inflation pressures.

This is not to suggest that all economic forecasts are worthless or that all economists are equal when it comes to assessing economic pressures and translating those into good and generally reliable calls for financial markets. It does suggest that a balance of sound data analysis and an understanding of financial market trends can work together to help economists, strategists and investors understand where the risks are.

The other moral of the story for investors that comes from this, which is as old as the hills, is to always have a diversified portfolio which can smooth the returns whether the economy is strong, weak or somewhere in between. No one knows where markets are going, so it’s best to have a bit of money in every asset class, just in case the economists and strategists are wrong.