Trading the Economic Indicators

The release of macroeconomic data is a source of both risk and opportunity for traders.  While investors can wait for the truth to emerge, often after multiple revisions, the market has an instant reaction to each new bit of information.

At "A Dash" we often discuss the long-term time frame, since it is what we call a "good game" with a lot of opportunity.  To make a trade based upon a data release you need to be able to make two predictions with some confidence:

1. How much will the new data deviate from market expectations?
2. Will that deviation be interpreted as bullish or bearish?

Getting both right can be more difficult than it seems, but sometimes the odds can be right.  The Institute for Supply Management report on manufacturing ("the ISM number"), scheduled for release tomorrow at 10:00 EDT, provides an illustration.

Expectations

The ISM number is regarded as a good source of current economic information, since it goes to people who know (formerly called "purchasing managers") and get data on both activity and prices.  Briefing.com has a nice public calendar of economic events.  They rate the ISM number as one of the most important, giving it an "A-".  Their forecast is for a reading of 51.5 versus the consensus of 51.

The interpretation of this number is often rather sloppy, with a lot of attention paid to readings below 50 since that reflects a decline in manufacturing activity.  Commentators often think of this as an overall economic decline in spite of the ISM's press release, which says that a reading of 50 corresponds to a rate of real economic growth of about 2.5%.  How can this be?  The U.S. economy is more sensitive to services, while manufacturing is in a long-term decline.

The Trading Edge

First quarter GDP growth was recently reported as 1.3%, and many believe that this estimate will be revised lower and may be even weaker in the second quarter.  For the purpose of this example, let us assume that the current GDP growth rate is actually a little stronger at 1.8%.

GDP growth and ISM manufacturing do not have a causal relationship.  In a sense, they represent two measures of the same thing -- the trend in the economy.  It makes sense that ISM researchers would find a long-term correlation between the two.

GDP growth of 1.8% corresponds to an ISM number of 47.2, much weaker than the market expects.  For some reason, most analysts do not study this relationship, so there might be a trading advantage.

Market Reaction?

The second part of the problem is to predict the market reaction.  Sometimes the market cheers weak economic numbers since it makes Fed rate cuts more likely.  Traders are free to make their own judgment here, but our feeling is that a number this weak would have a  bearish interpretation.

Action?

Even though we are currently bullish in all time frames, we reduce our market exposure in our partnership accounts for a short time when situations like this arise.  (Regular readers know that we suggested this trade once before.  It worked for us then.)  Obviously, many things can go wrong.  Correlations are not perfect.  The economy may be stronger than we think.  The market might react differently from what we expect.  We write to illuminate concepts and present interesting ideas.  It is not specific trading advice for others.

We are taking action because it makes sense to us, and fits our current position.

Looking for overall consistency in a variety of economic indicators can be both interesting and profitable.

UPDATE -- AFTER THE ISM REPORT

The ISM Manufacturing Index was 54.7, the strongest report in a year. This was a surprise to the market and, obviously, to us.  David Taylor's helpful economics blog also predicted a weak number based upon relationships with other economic data.  He has an interesting chart showing a tight relationship between ISM manufacturing and industrial production.

The ISM says that this year's readings, taken together, suggest economic growth of 3.1% and the April number, if annualized, would represent a 4% rate of growth.

Tony Crescenzi, the Chief Bond Strategist at Miller, Tabak, and Co., does a great job covering economic releases in his column for RealMoney.  He calls the ISM report the "real deal" with "no quirks."

If this activity is so strong, what is the implication for Friday's jobs report?  More on that later.

And the trade?  The market did not rate to spike higher on a strong report, and we were helped by a weak Pending Home Sales report released at the same time as the ISM.  We eliminated some risk and made a small profit on the trade.

 

Comments

[Nova Law]

Yowie! More bad news. Factory orders at their highest level in a year. Poor Barry. Stock market at record highs, IWM survey very strong, factory orders going up. It's a very bad day for a bear.

Come to think of it, most days have to be bad days for bears. Their curse is to go through life sad, afraid, and generally wrong. Schleprock on Wall Street.

[Nova Law]

Uh oh. Six o'clock and there's nothing from our favorite bear (and jazz aficionado). Maybe if we ignore it, all this good news will go away. :-)

[Nova Law]

ISM number comes in remarkably bullish. Still waiting for Barry Ritholtz to "drill down" the numbers to explain that things look really, really bad. Hopefully by 6:00 pm he'll have that up on Big Picture.

[REW]

Wow, 54.7 which is correlated to 4% GDP growth.
Will this economy please make up its mind!

[Jeff]

Hi Russ,

Thanks for your comment. You are quite correct, of course. Manufacturing output has increased, even while jobs in those companies have declined. Productivity therefore increased.

The decline I cite should have been stated in terms of GDP share.

It is great to have informed and careful readers!

Jeff

[REW]

Prof,
I love the point about ISM and GDP being correlated but not causally linked.

I must nit-pick at your claim that "manufacturing is in a long-term decline". Isn't it more accurate to state that manufacturing output is at an all time high in terms of production value but is declining in its share of GDP?
Thanks,
Russ