Courtney Abbott's Key Ideas from Ahead of the Curve
by Joseph H. Ellis

Analyzing economic data is as simple as gathering historic and current data from the internet and using Excel or similar software to assemble it all into an easy-to-read chart. Anyone can do this. It doesn’t require special skills or tools.

Econometric analyses, on the other hand, are complicated statistical analyses that economists use. But these forecasts are less useful than you’d expect. They tend to be rigid in their modelling and don’t provide a complete, dynamic picture of things.

 To get a reasonably good forecast, one has to just construct charts out of historical data and look for possible cause-and-effect relationships.

The trick is to be smart about how you chart the relationships. Changing the organization and tracking of data can be useful preparation for analyzing relationships, and the book sets forth a simple method for doing so.

The economic cycle is driven by cause and effect. Personal income drives consumer spending. Businesses respond to consumer spending by increasing production which, in turn, requires greater investments in infrastructure/capital spending. Consumer spending, production and capital spending all drive corporate profits.

Stock market performance is dependent on corporate profits; corporate profits also drive employment. And so, you see that job growth is at the very end of the food chain. Employment is a trailing economic indicator, and for this reason, it isn’t useful for making forecasts.

Consumer spending dominates the economy. Because it is such a large share of GDP, it drives corporate profits — and corporate profits, as we saw, drive employment. The stock market is a predictive indicator, moving up and down with consumer spending.

Consumer spending forecasts, then, can be used to predict the stock market, although there are lots of other factors that affect the stock market. Net-net: monitoring consumer spending is the best way to determine where the economy is going.

• At the peak, consumer spending and GDP are growing, profits are rising, and employment is hunky-dory. The stock market continues to peak and investors are enthusiastic.  
• Then, things slow a little. The economy is still growing, but the rate of growth has been reduced. Interest rates rise just a little. The stock market cools down. Soon enough, worry sets in.
• Interest rates and inflation rise. The rate of growth in GDP slows to 2 or 3%. People start predicting a recession. The stock market slumps.
• Finally, the recession hits. GDP declines, profits fall, capital spending declines.

Market Cycles have long periods, sometimes lasting years, during economic slowdowns when stocks just aren’t a good investment. In cycle after cycle, businesses always seem to get caught in periodic downturns, and by the time the leaders realize they’re in a downturn, it’s too late to do much about it.

There’s a traditional fear of recession (defined as two quarters or more of decline of real GDP), but ultimately, the downturn is already in the cards before a recession even hits.

There are two big errors in traditional economic analysis. The first mistake is regarding recession as the main indication of economic slowdown. Recession is identified by GDP, but by the time the decline has hit GDP and it reflects the slowdown, significant portions of the economy are already damaged.

The second mistake is the practice of tracking economic data quarter to quarter and month to month. This causes a lot of noise; there are lots of adjustments that have to be made to the data. Year-to-year tracking is better.

A recession, as a reminder, is defined as more than two-quarters decline in real GDP. This measurement tends to put observers into a simplistic, dualistic head-space. If GDP is positive, then it’s good; if GDP is negative, then it’s bad. A slowdown that doesn’t land GDP in the negatives doesn’t provoke much horror — it’s seen as a soft slowdown, more of a minor worry if anything. But Such slowdowns can cause almost as much damage as proper recessions. 

Recessions are infrequent. Slowdowns are more important, and when you look at the numbers during these periods, GDP growth is actually inhibited more than you’d imagine if you were just looking at recessions. Recessions are bogeymen. Declining rates of growth are the real culprit.

Recessions might have some value in predicting the beginning of a new cycle, but that’s about it. 

Too much reliance on recession as an indicator is one problem; the second problem is the standard practice of measuring the change in short-term increments– periods so short they can disguise larger trends.

The noisy, quarterly charts with wild swings of data and little context are confusing. The better solution is year-over-year charting, which makes trends much easier to spot.

Since recessions have been dethroned a new milepost is needed:

The rate of change economic tracking (ROCET), tracking turning points in growth, rather than absolute levels, to help make economic forecasts.

Leading indicators cycle through several phases. Starting with the last phase of the previous cycle.

It’s important to use the right leading indicators. The cause-and-effect relationship should make sense. When they’re charted out together, a causal relationship should be easy to see. But remember: there’s sometimes difficulty knowing if two things have a causal relationship or if the correlation is just casual. You need to evaluate the evidence as best you can.

It’s dangerous to imagine that you’re looking at unique circumstances and that on this occasion the usual pattern won’t hold. Chances are good that you’re wrong. Look at charts of historical data — you will see these same patterns. Of course, there are unique variations with iterations of each cycle, but the cause and effect relationships stay the same.

Capital spending is driven by consumer spending — not the other way around. Capital outlay includes things like facilities and equipment costs. Usually, it’s after growth has been up for a few quarters that companies will update their capacity.

Eighty percent of GDP is from the demand cycle, wherein consumer spending leads to industrial production which leads to capital spending. How does the demand cycle effect the stock market? Well, lots of things can move the market, but there are only a few consistent, significant market movers out there. The demand cycle shouldn’t be the only factor referenced in forecasting the stock market, but it’s definitely something useful to consider.

The best time to sell is when the economy is peaking, which is counterintuitive for many people. People want to believe the good times are going to keep rolling. Alternatively, the best time to buy is when the market is still tanking but close to reaching bottom. It’s hard to have faith when everything looks so grim; it takes a lot of self-discipline to time the market like this. We’ve all heard the old saw, “Buy low, sell high.” It’s so obvious, and it gets repeated so often that people take it about as seriously as they would a nursery rhyme.

There are lots of different things that influence consumer spending. There are financial factors (for example, wage and consumer borrowing), fiscal and monetary factors (for example, taxes and interest rates) and there are psychological factors (for example, war, terrorism and instability). There are all different factors, and because there are so many diverse factors, it’s important to focus on a few indicators. Try to find factors that are rooted in common sense and that are proven to have causality over several cycles.

There are two kinds of consumer spending power: personal income (including things like paychecks) and personal wealth (investments and similar things). Income has a large influence on consumer spending — the more money flowing in, the more people have to spend — so you’d think employment would be an important factor for income.

And it is, however, labour is hired after the economy goes up and fired as it goes down.

Real wages, that is to say the actual amount that workers make, is more relevant to growth than changes in the number of employed or unemployed workers. Although often overlooked as a leading economic indicator, wages and salaries are more important than wealth, which usually isn’t as liquid (if it is in the form of an investment, it has to be sold before it can affect the economy).

Increases in wages will have a greater impact than employment.

People with jobs are more likely to spend money, and it should follow that employment drives the economy. But when the economy goes sour, companies fire workers. It should follow that the economy drives employment. Both contradictory statements are true.

The market finally bottoms out. But as employment bottoms out, consumption should already be on its way up. So if you’re scared to get in the market when employment figures are bad, look to see whether consumption is on its way up. If it is, it’s time to act.

One of the forces with the most influence on the economy is the Federal Reserve Board’s influence on interest rates. Some types of interest rates can affect consumer borrowing which affects consumer spending. Because the Federal Reserve Board gets so much media attention, its actions have a psychological effect, influencing impressions of the country’s economic health.

As it turns out, consumer spending is influenced by interest rates. We can see that interest rates do in fact lead to spending. Increases in Fed rates presage economic turndowns and vice versa.

The Fed rate is also tied to inflation, which impacts earnings, which affects consumer spending. Inflation also moves hourly wages and direct interest rates. This can create the impression that interest rates and consumer spending are more closely related than they are.

The Federal Reserve responds to economic growth rates and inflation rates. When either get too high, they cool things down by raising the Fed rate. When things get sluggish, they raise the rate. Even if consumer spending isn’t interest-rate sensitive, the Federal rate appears to predict consumer spending.

Interest rates have two important effects on the stock market:

1) they affect overall economic growth

2) they affect price-to-earnings ratios.

Charting out these relationships is useful for understanding market trends. Consumer spending drives corporate profits and, ultimately, affects the stock market. Because interest rates affect consumer spending, they can also affect the market.

To figure out the relationship between the federal deficit and interest rates, you have to remember that federal debt is just one category of all the debt in the economy.

There’s also state and local government debt, not to mention consumer debt and corporate debt. In fact, of all the debt in the economy, only 18% is federal debt. By itself, federal debt doesn’t seem to have much of an influence on interest rates, but all debt combined most definitely does.

Manufacturers should determine the categories of expenditures or sales that are appropriate for and relevant to their products. Producers can use consumer spending to predict what the upcoming cycle will look like.

All sorts of sectors are sensitive to consumer spending. For business managers trying to make decisions, looking at performance in the context of historical economic cycles is most instructive.

Economics professors would also benefit from teaching the ideas in this book. Most economics classes cover a lot of theories and have plenty of graphs, but they don’t use enough real-life data for modeling.

They need to get down to the nitty-gritty of cause and effect. Economics is great for economists, but there is considerable room for improvement teaching how to use data for real-world questions. Economics should always be taught using historical data.