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The Metrics That Matter

Reading the Markets by the Numbers
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From unemployment figures to the ratio of put/call options, Charles Schwab chief investment strategist Liz Ann Sonders discusses numbers that investors should monitor, and what those numbers mean.

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Rick Karr:

Most of us would probably drown if we had to deal with the flow of information that Liz Ann Sonders gulps down starting the moment she wakes up.

Liz Ann Sonders:

I drink from a firehose every single day.

Rick Karr:

That firehose spews out data that can affect investments, job figures, economic growth numbers, earnings reports, industry surveys, obscure market statistics. She combs through them for the clues that tell her where the economy and markets might be headed next.

On this installment of the Insights & Ideas podcast, brought to you by Charles Schwab, she’ll tell us how she looks at the numbers, what she sees in them, and how she keeps up with them without drowning.

I’m Rick Karr. Numbers are especially important to Liz Ann Sonders because she’s Schwab’s chief investment strategist. We talked about two kinds of numbers she relies on. Measures of investor sentiment or psychology, which you’ll hear more about later, and measures of the economy, starting with employment numbers. When they take a sudden turn for the worse, investors can get nervous and share prices can fall.

But sometimes the problem isn’t the economy, it’s the underlying data. And a couple of months after the damage is done, the numbers are revised to reflect a rosier outlook.

Liz Ann says that’s why investors should never react to one lone statistic in isolation, no matter how bad it looks.

Liz Ann Sonders:

Particularly, not only the numbers that are lagging in nature, but the ones that are highly subject to revision. And certainly many of the jobs numbers would fall in that category. So I don’t want to dismiss the value of the headline and the attention it gets and the type of conversation one has around those numbers.

But if you’re overly dogmatic in terms of applying them to, say, an investment strategy, that’s where you’re going to run into some peril because they are so highly subject to revision. If you think about the jobs numbers, there are first of all a number of different sources. But that headline payroll number that you get on a monthly basis comes from looking at government sources for data, the Bureau of Labor Statistics. And there’s only so much accuracy they can get on a monthly basis.

So as more information comes in, they will revise those numbers. Same thing with gross domestic product, GDP, which obviously is a measure of the overall growth in the economy, which is an $18 trillion behemoth, and there’s only so much accuracy you can get a month later, even two months later, three months later. So as the data comes in, some of which lags, some of which leads, it takes a while to really get a firm grasp on those numbers.

So, yes, I would say that it’s not that these numbers aren’t important, but the trend is what matters. But you want to make sure that any deviation from trend isn’t just part of normal volatility.

Rick Karr:

If I am thinking in terms of my investments, what to do with my own portfolio, it sounds like the lagging economic indicators aren’t really very useful to me. Or would that be wrong? I mean, can I still glean something as an investor that’s useful from the lagging economic indicators?

Liz Ann Sonders:

Well, interestingly, if you want an interesting example about how lagging indicators in the stock market tend to work, compare the unemployment rate—a very popular economic indicator, obviously—to the stock market. So here you’re comparing one of the most lagging of economic indicators, the unemployment rate, with one of the more leading of indicators, which is the stock market.

And what is interesting about that, is that historically, when you are at or near a low in the unemployment rate, like a full-cycle low in the unemployment rate, you are typically at or near the next recession. Conversely, peaks in the unemployment rate have tended to come around the beginning of recoveries, coming out of a recession. In fact, actually, in most cases, the unemployment rate continues to rise even after we find out in hindsight that the recession is over.

Rick Karr:

Are there any leading indicators that have a track record of telling us where the markets are headed?

Liz Ann Sonders:

There’s one leading indicator that has kicked in prior to every single one of the last, I think, seven or eight recessions. And that’s an inversion in the yield curve, where short-term rates go above long-term rates, which is not a common environment. Normally, short-term rates are lower than long-term interest rates. But when that reverses and long-term interest rates are below short-term interest rates, that’s an inverted yield curve.

And that has occurred every time in advance of the last seven recessions. The lead time varies from a few months to more than a year, but it’s been consistent.

Rick Karr:

Are there any sort of industry-specific numbers that come out regularly that send a message to investors?

Liz Ann Sonders:

That list is thousands long. Two of the more popular economic indicators that get down to a broader separation among sectors would be the ISM indices. So ISM puts out a Manufacturing Index and a Non-Manufacturing Index. The Non-Manufacturing would basically be the services side of the economy.

So the Manufacturing Indices really track what the manufacturing part of the economy, the export-oriented part of the economy, industrial part of the economy—that only represents about 12% of our economy. The ISM Services or ISM Non-Manufacturing is the other 88%. So within that it covers the entire rest of the economy. So I would say of the broad, popular, well-watched economic indicators, that’s one of the ones that gets down to that breakdown.

Rick Karr: I want to talk about that other category of statistics, the measures of investor sentiment or psychology. How can you measure what’s going on inside people’s heads?

Liz Ann Sonders:

There are so many ways to measure it, and the two categories I like to think about and I speak about would be attitudinal measures of sentiment and measures that actually show what investors are doing with their money. So there are dozens and dozens of attitudinal measures of sentiment.

A couple of the popular ones: one is put out by the American Association of Individual Investors, AAII for short. And they have a bullish and bearish survey. They literally just survey their tens of thousands of members on a weekly basis, and ask a fairly simply question: “Are you bullish? Are you bearish? Or are you neutral?” And each member will give a response, and they’ll tabulate the results—and they’ll have a percent that are bullish, a percent that are bearish and then the default is the percent that are neutral.

So that’s a very popular one. But that’s a pure attitudinal measure of sentiment. It doesn’t necessarily tell you what these individual investors are doing with their money. So it can be biased. You might be fully invested but the market may have been in a tough environment and when somebody calls and asks you what you think, you might say, “Oh, I’m bearish.” But it’s not necessarily reflected in how you’ve been investing your money. So it’s a little like all of this stuff is grain-of-salt kind of stuff.

Then there’s another popular one called Investors Intelligence that measures the bullishness or bearishness of the very popular newsletter writers who many investors follow. So it’s a bit of a proxy for individual investor sentiment. Then there are ratios you can look at inside the stock market like the put/call ratio. What percentage of investors are buying put options, which is a negative strategy, versus call options, which is a positive strategy?

And then...there’s a firm called Rydex, which has both bullish and bearish mutual funds. And you can look at what the flows are into the bullish funds. You can look at what the flows are into the bearish funds as a proxy for, and, again, that’s both a behavior as well as an actual movement of money. There’s one I get a kick out of that I look at on a daily basis that’s put out by SentimenTrader.

And it’s called the Smart Money/Dumb Money Confidence Index. And it measures—it’s their terminology, not mine—but the so-called Smart Money would be the big position traders and commercial hedgers, and you tend to want to follow what they’re doing. They’re the non-contrarian indicator. And then, in contrast, they look at the so-called Dumb Money indicator, which they look at for small individual trades, odd-lot sales. And that tends to be what the smaller individual investor is doing, and they’re the so-called—again, not my term—Dumb Money.

And what’s interesting is when you get to extremes, they almost always are at polar opposites. So in a riotous kind of market, Smart Money tends to get more optimistic. They see value. They see prices getting better. Whereas of course the Dumb Money tends to be more trend-following. So they go into panic mode. And some of the best bottoms in the stock market have come when Dumb Money optimism is at an extreme low and Smart Money optimism is at an extreme high, and, of course, vice versa in the opposite direction.

And then you can look at where money is actually going. You can look at mutual fund flows to see whether money is going into the market or coming out of the market or going into bonds or coming out of bonds. So that’s measuring what investors are actually doing with their money.

Rick Karr:

There are a lot of days when I feel information overload. And from the sound of it, it would be even more extreme in your case.

Liz Ann Sonders:

It is except that I have 30 years of doing this, which means I have learned what is the information of value and what is the information that should just be tossed in the garbage can. And that’s something that has been honed over years.

Rick Karr:

You can hear more of my conversation with Schwab’s chief investment strategist Liz Ann Sonders in a companion to this podcast. In that one, she talks about the human factors that can affect the markets and don’t always show up in the numbers. You can follow her on Twitter @LizAnnSonders, L-I-Z-A-N-N-S-O-N-D-E-R-S, all one word.

And that’s it for this installment of the Insights & Ideas podcast, brought to you by Charles Schwab. We’re at insights.schwab.com and you can find us on iTunes. I’m Rick Karr, thanks for listening.

Important disclosures
Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions. Supporting documentation for any claims or statistical information is available upon request.

The ISM Manufacturing index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

ISM Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms' purchasing and supply executives, within 60 sectors across the nation, by the Institute of Supply Management (ISM). The ISM Non-Manufacturing Index tracks economic data, like the ISM Non-Manufacturing Business Activity Index. A composite diffusion index is created based on the data from these surveys, that monitors economic conditions of the nation.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

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