Economic Growth
Economic growth enables consumers to consume more goods and services and enjoy better living standards. Economic growth during the Twentieth Century was a significant factor in reducing absolute poverty levels and enabling a rise in life expectancy. Economic growth means more profits and, in return, better financial conditions and higher equity prices for the financial markets.
Growth Rate
GDP measures a national economy’s total output in a given period. Monitoring the change year-to-year removes seasonality and eliminates quarterly variations based on climate or holidays. The most closely watched accurate GDP measure is also adjusted for inflation to measure changes in output rather than changes in the prices of goods and services.
Omega’s Coincident Index
Statistics show the overall growth rate of the U.S. domestic economy follows four leading economic indicators: industrial production, nonfarm payrolls, personal income, and personal consumption. Alone, these indicators often show false signals in economic growth. But when put into an index, they do a relatively good job tracking the direction of the development of the U.S. economy every month as opposed to the quarterly basis of real GDP.
Following the coincident index’s trend provides a decent thesis on the current state of the U.S. growth rate.
ISM PMI Composite Index
Manufacturing often leads to economic growth and leads the actual manufacturing numbers in the Institute Supply Management survey for manufacturing, referred to as the ISM manufacturing PMI. One of the most reliable economic indicators available, providing guidance to supply management professionals, economists, analysts, and government and business leaders. The reports are issued by the ISM Manufacturing and Services business survey committees. Tracking this indicator gives an investor a glimpse into what the U.S. manufacturing industry is doing and, in return, the economy’s overall growth rate.
Inflation
Inflation affects all aspects of the economy, from consumer spending and business investment and employment rates to government programs, tax policies, and interest rates.
Understanding inflation is crucial to investing because it can reduce the value of investment returns. With inflation rising recently after several years of relative calm to its highest level in four decades, investors may benefit from knowing the factors driving inflation, the impact on their portfolios, and steps to consider as the investment landscape shifts. The result is usually felt in a shift in P/E expansion or P/E compression.
Personal Consumption Expenditures
The personal consumption expenditure index (PCEPI) measures U.S. inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy. Of all the measures of consumer price inflation, the PCEPI includes the broadest set of goods and services. The PCEPI is also the Federal Reserves’ choice for measuring general inflation between goods and services.
Keeping a close eye on PCEPI is critical to understanding the overall inflation trend in the economy now.
Trimmed Mean PCE Inflation Rate
PCEPI has some disadvantages, one of which tends to fluctuate with non-sticky price changes. A more practical method for calculating the actual inflation rate is by trimming out the outliers in the PCEPI to create a more sticky inflation number. The Federal Reserve bank of Dallas does just that with the Trimmed Mean PCE Inflation Rate. Statistically, the Trimmed Mean PCE Inflation Rate better fits econometric models developed by the Federal Reserve and, for that reason, provides us with a better understanding of stick inflation.
Inflation Expectations
Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are crucial determinants of actual inflation. The relevant theoretical and empirical literature review suggests that this belief rests on highly shaky foundations. A case is made that adhering to it uncritically could easily lead to serious policy errors.
Inflation expectations can be derived using the treasury market by taking the factor premium between nominal Treasuries minus treasury inflation-protected bonds. The result is the amount of inflation that the bond market has priced in the future.
This is important because if investors believe that Monetary Policy is not in control of inflation, the result would be inflation expectations rising or falling away from the Federal Reserves’ target inflation rate of two percent.
Labor Market
The labor market, also known as the job market, refers to the supply of and demand for labor, in which employees provide the collection and employers provide the direction. It is a significant component of any economy and is intricately linked to capital, goods, and services markets.
Economic growth is related to the employment market. When a slowdown occurs, a spike in unemployment also appears, making the labor market a catch-all indicator of the economy’s health. I also don’t want you to be fooled by the premise of a strong labor market. A strong labor market is also associated with higher wages and thus higher inflation. Before a recession, the labor market was tight and looked extremely strong; this is a warning sign of an overheating economy.
Unemployment Rate
The unemployment rate represents the number of unemployed as a percentage of the labor force. Low right before a recession, then quickly rises during a recession, making this indicator a must watch on the economic radar.
Labor Force Participation Rate
While Unemployment Rate is considered the default for measuring the labor market, it has some downsides. Namely, it does not consider the individuals who have left the workforce entirely. To counter this, we use the Current Population Survey (Household Survey), which measures the percent of the population in the force. While not as cyclical as the unemployment rate, it does give us some insight into the long-term productivity capacity of the economy.
Initial Claims
A little noisier, but also a canary in the coal mine, the weekly initial claims on unemployment insurance can give us an early warning sign of trouble ahead. A perfect example (all be it a policy-induced recession) was the shutdown during the pandemic, weekly claims spiked and then abated extremely quickly, showing how quick of a recession the pandemic was.
Interest Rates
Treasury yield is the return on investment, expressed as a percentage, on the U.S. government’s debt obligations. Looking another way, the Treasury yield is the effective interest rate that the U.S. government pays to borrow money for different lengths of time.
Treasury yields don’t just influence how much the government pays to borrow and how much investors earn by buying government bonds. They also affect the interest rates that individuals and businesses pay to borrow money to purchase real estate, vehicles, and equipment. Treasury yields also tell us how investors feel about the economy.
Two Year Treasury Yield
Most investors care about future interest rates, none more so than bondholders. If you own a bond or a bond fund, consider whether Treasury yields and interest rates are likely to rise in the future and to what extent. If rates are headed higher, you probably want to avoid bonds with longer-term maturities, shorten the average duration of your bond holdings, or plan to weather the ensuing price decline by holding your bonds to maturity to recoup par value and collect coupon payments in the meantime. The two-year rate is a good proxy for the direction of interest rates in the short-term.
Ten Year Treasury Yield
The importance of the 10-year Treasury bond yield goes beyond just understanding the return on investment for the security. The 10-year is used to proxy many other critical financial matters, such as mortgage rates.
This bond also tends to signal investor confidence. The U.S Treasury sells bonds via auction, and yields are set through a bidding process.5When confidence is high, prices for the 10-year drop and yields rise. Investors feel they can find higher-returning investments elsewhere and do not feel they need to play it safe.
But when confidence is low, bond prices rise, and yields fall as more demand for this safe investment increases. This confidence factor is also felt outside of the U.S. The geopolitical situations of other countries can affect U.S. government bond prices, as the U.S. is seen as a safe haven for capital. This can push up prices of U.S. government bonds as demand increases, thus lowering yields.
Treasury Yield Curve
The 10-year minus 2-year Treasury bond spread is generally considered to be an advance warning of severe weakness in the stock market; credit spreads often widen during times of financial stress wherein the flight-to-safety occurs towards safe-haven assets such as U.S. treasuries and other sovereign instruments.
Profit Cycle
The profits cycle is a critical factor behind the cyclical performance of equity prices and provides the basis for tactical asset allocation. In addition, within the equity market, different sectors perform better or worse relative to other industries and the overall market according to the comparative advantages and disadvantages reflected in relative earnings growth during the various phases of the business cycle.
Profits growth results from revenue growth and margin expansion, where the margin is the share of revenues left over after a company covers its expenses. To measure and track the profit cycle, we use the S&P 500 Index as a proxy for the U.S. domestic equity market. While the S&P 500 is not the entire U.S. equity market, it is a good benchmark for the U.S. domestic market. With about 503 securities, it is also manageable to aggregate fundamental data.
S&P 500 Index EPS (Omega’s Calculation)
When measuring the profit cycle, we start with the aggregate EPS of the S&P 500 Index. This is not the official S&P 500 Index EPS but our internal calculation. We prefer ours because we use the aggregate revenue by the outstanding shares. The S&PP 500 uses a multiple for the shares outstanding, which we do not like.