8. The Second Factor: The Economy—Headwind or Tailwind for Stocks?

On a hot day in early September 2007, traders and investors showed up for work early in the morning. They waited, with some trepidation, for the Labor Department’s early morning announcement that would tell the world how many new jobs were created or how many jobs had been lost in August. It’s a ritual that occurs on the first Friday of every month in the year, but on this day, economists were looking for signs that emerging woes in the real estate industry had spilled over into the labor market. They still expected that overall businesses had managed to add 100,000 or so employees to their collective payroll the previous month. Not so. Instead, when the report was released at 8 a.m., it showed that employers nationwide had actually cut a total of 4,000 jobs in the previous month. Even worse, the data for July was revised downward; fewer new jobs had been created that month than the Labor Department had calculated previously. Stock markets from Wall Street to Warsaw plunged; investors from Seattle to Shanghai dashed for shelter.

But why? Why does it matter to your investment plans if the economy starts shedding jobs, as long as your job and those of your friends and family haven’t been affected? That’s true enough—as far as it goes. But no sensible investor can afford to ignore what is happening in the broader economy. Investors during that long hot summer of 2007 learned the same lessons that generations of their predecessors had learned: that the real or perceived impact of economic events or trends on financial markets and portfolios can be sudden and brutal. The drama of 2008 just reinforced that lesson. Within a week, or even a single trading day, economic news can cause the market to gyrate wildly and leave investors with outsize profits or losses. In the months that have elapsed since then, the lesson has become still more apparent, as the economy moved into a recession.

That is why the second factor you must use in building your investment decision-making process is what is happening in the economy. Understanding momentum will give you insight into what is happening within a given asset class and help you weigh each asset class’s relative merits. But you must go further and develop a new set of metrics that will alert you to economic changes that will affect those asset classes. Imagine that you’re heading out to sea for a sail down the Atlantic seaboard. You set out from your summer harbor in Rhode Island, bound for Florida. You have been rigorously attentive to the fundamentals. Your boat is seaworthy, all your navigational equipment works accurately, and you’ve stocked up on all that you’ll need for the journey, from food and water to comfortable cushions in the cabin. But setting out to sea without checking the weather would be foolish.

The economy can be just as unpredictable and uncontrollable as the weather. And just as the weather affects our hypothetical sailor’s safety, so the economy matters to an investor’s financial well-being. The weather may delay a sailor, force a change of route, or perhaps even require the sailor to make repairs to the boat. Economic headwinds can be just as hazardous. An investor caught unprepared might have to postpone retirement, put up with a lower standard of living, or take more risk to compensate for losses. The better prepared you are, the more you can profit from the tailwinds and the better you will be at battling through the storms. Because none of us can control the economy, it’s up to us to identify and understand what economic swings are taking place as well as how and when to react to those changes. If you aren’t attentive enough to the shifting winds of the economy, your portfolio runs a greater risk of being wrecked on the shoals of a recession or depression.

At any given point in time, the economy functions as a kind of backdrop that favors the growth of one kind of asset class or securities over another. Over long periods of time, what happens in the stock market reflects economic activity. Take a look at Figure 8.1. It shows how quarterly changes in gross domestic product are reflected in the quarterly returns of the S&P 500 Index.

Figure 8.1 Quarterly changes in gross domestic product reflected in quarterly returns of the S&P 500.

Although there can be a lot of “noise” (periods when markets respond to other signals or when investors are distracted or find economic data difficult to read), strong economic growth generally speaking goes hand in hand with above-average stock market returns. Similarly, an economic slump corresponds to a period of sluggish stock market returns or outright losses.

The link is an easy one to understand because it’s all about corporate profits. What drives stock prices? The growth (or lack thereof) of profits earned by the companies that issue those stocks. As a general rule, the more profits grow, the higher the company’s stock price climbs. When Apple’s iPod became a “must-own” for design-conscious hipsters and their imitators, the company’s sales and profits soared. The trendy new product had a lot to do with it, but if the economy hadn’t been in the midst of a rebound, how many of their customers would have been willing to fork over a few hundred dollars for the wallet-sized device? In a slowing economy, one in which people are losing jobs and trying to scale back their spending, consumer wallets snap shut. The first companies to struggle will be those that sell products or services consumers may view as luxuries (a new iPhone, the safari vacation, the new car, or the pool for the backyard). There is a reason that the county with the highest unemployment rate in early 2009 was dominated by makers of recreational vehicles cutting back on their workforce and production as sales of these luxury goods fell off. Whenever the economy slumps, companies respond by scaling back their own spending, hiring fewer people or purchasing less as they brace for slower sales and lower profits. Other businesses will be more resilient; people will still need to shop at drugstores and buy groceries, although those companies may find sales volumes and margins slide, too. The economy drives profits, which in turn make up a larger part of that economy—12% in 2007, compared to less than 2% in 1947, a reflection of the changes within the private sector as smaller family businesses have given way to larger corporate chains.

Despite its importance, the economy remains just as difficult to forecast as the weather (one reason, perhaps, why the field of economics is sometimes referred to as “the dismal science”). Even in periods of prolonged economic growth, our economy doesn’t expand consistently. Spikes and slumps are common, such as those that we all witnessed in the final heady days of the technology boom in 1998 and 1999. Companies nationwide grappled with labor shortages as their employees rushed off to join or form new technology companies. Companies in “old-economy” industries paid hefty bonuses to anyone who could find a successful candidate for vacant positions. Even high-flying start-ups couldn’t find enough bodies to keep up the pace. Veteran economic and business analysts started talking about a new paradigm, a world in which the rules of economic growth involving boom and bust cycles had been revoked.

Sure enough, that boom came to an abrupt and unpleasant end, one that culminated in an economic recession. Happily, investors and economists are sometimes better at anticipating economic transitions. By the time the September 2007 jobs data sparked a stock market selloff, investors and analysts had been fretting about the health of the economy for more than 2 years. Sky-high energy prices worried them, as did the impact of rising interest rates on the real estate market. They were well aware that corporate inventories were rising, while job creation had been slowing as the construction sector laid off employees. Retailers began to report disappointing sales figures.

Few of these twists and turns in the economic cycle surprise me any more. Like most Americans, I’ve battled through several economic and market downturns during my adult life, as well as enjoying the bursts of prosperity. Back in 1980, when I was doing an internship in Washington, D.C., gasoline shortages meant long lines at gas stations. Worse than that, an emergency law ruled that I could only join those lines on odd-numbered days to fill up the tank of my aging Volkswagen Rabbit. I’ve grown accustomed to this kind of ebb and flow in the economy, which pundits often refer to as the business cycle. Today, my goal as an investor is to use economic metrics to figure out what stage we are at in that cycle and thus what investments offer the best opportunities. Is the economy in expansion mode, with companies creating new jobs and seeing their sales and profit growth accelerating? Or is that expansion close to peaking, as productive capacity becomes constrained? Perhaps the economy is contracting; business activity is slowing and job losses are starting to rise. The trough is most painful of all, the stage in which the economy hits bottom and the whole world seems bleak. But it’s in this stage that the seeds for a new economic expansion are planted.

Each of these four stages suggests investors take a different approach to the financial markets and to the array of available asset classes. When the economy slows, for instance, sectors such as health care are likely to outperform: Those who need to take blood pressure medication will keep buying it as long as they can, even if its price rises. (That’s why Colgate Palmolive got away with boosting prices on some of its products in 2008 even as the economy slipped into a recession.) On the other hand, technology stocks tend to be more cyclical. They tend to follow the economic cycle, flourishing when growth is robust and flagging when the economy sours. I can’t control where we are in the economic cycle, but I do have the analytical skills to provide us that information and give us clues as to what is on the horizon. You may have a portfolio that is designed to outperform in a strong economy, but if you can’t tweak it to reflect the changes after the economy peaks, the outcome will be disastrous. It would be as if someone sneaked into your house while you were out and turned up the temperature of the water in your aquarium. All those tropical fish flourishing because you have been carefully cultivating just the right environment will be transformed into bouillabaisse in an instant.

I began to grasp the way in which the economy and the government’s economic policies could play havoc with my best-laid plans in the mid-1980s while living in Boston, in the midst of a frenzied real estate environment. A friend of mine and I decided we would buy some residential housing units, fix them up, and sell them at a hefty profit. We figured that we couldn’t lose. We toured a building in what in most markets would have been considered a slum. Still, it was priced at a hefty premium of around $100,000 per unit. We wavered, even as the real estate agent pressed us to sign on the dotted line. Then the Reagan administration suddenly eliminated something called the “accelerated depreciation allowance,” a tax break for investing in depreciating assets like real estate. That yanked the rug out from under the real estate market. My friend and I watched the entire Boston-area real estate market pretty much crumble to pieces around us. I put my dreams of becoming a real estate mogul on the shelf and returned to my “day job” managing money with new appreciation for the role in which exogenous events could impact the economy and, in turn, an entire asset class.

Economists love to boil their profession down to lots of numbers. To understand how the economy impacts investments, however, you really need to consider human nature. Trading mortgage-backed securities in the 1980s, I was bemused when homeowners failed to do what seemed very logical to me and renegotiate their mortgages. Their monthly mortgage payments were based on interest rates of 11% or 12%. They could easily refinance at 8% or 9% and save hundreds of dollars a month. What I had failed to factor into my model was the fact that whole segments of the real estate market had been so badly hit by the downturn that owners had no equity left in their houses. No banker in his right mind would lend 120% of the value of a home to a borrower! To refinance, owners would have had to put up more equity, wiping out the benefits of a lower interest rate. (We’re seeing a similar phenomenon take shape in 2009, with the added problem—for borrowers—of very stringent credit standards.) It was much better for them to just stay put and keep paying the extra dollars each month and wait for the real estate market to recover some ground, however much havoc that wreaked on my carefully designed models.

The good news? Developing a reliable set of metrics to help you monitor what is happening to the economy is easier than forecasting the weather. And with the right metrics, you have a reasonable chance of steering clear of economic storms or at least minimizing the damage they can do to the portfolio you have carefully assembled based on your analysis of the other four factors. Certainly, most times that I’ve seen a recession emerge in recent decades, metrics have provided savvy investors with ample warning—and thus with enough time to build protective walls around their portfolio and adjust their holdings accordingly. They also can help you identify those economies (national or regional) that offer the best economic conditions at any given time. Think of the economy as the background or scenery against which all the action of the other four factors is played out.

As is the case with all five factors, however, the key to success is identifying which economic metrics have some kind of predictive power or offer you a tool that will help you weigh your alternatives. There’s no such thing as a “good” economy or a “bad” economy, except in the dreams of economists. Rather, the economies of the 200-plus nations in the world are all either more or less attractive than each other at any given point in time. Each of these national economies must grapple with certain harsh realities: The United States, for instance, saw parts of its manufacturing sector vanish first to Mexico, and then more of it head off to China. Most recently of all, ultra-low-wage nations like Cambodia have seized manufacturing market share from both Mexico and China. The 1990s bull market can be seen as a tribute of sorts to our success in coping with that change in our economy, which suddenly was no longer dominated by these manufacturing giants. An influx of new knowledge-based, technology-based, and service-based companies, notably the flurry of new high-technology companies spawned in Silicon Valley, took their place and led the next wave of economic growth. Productivity soared; corporate profitability and personal incomes expanded at an impressive rate. Meanwhile, inflation was kept at bay by the outsourcing of production to low-wage countries: The DVD players and personal computers that American consumers snapped up at lower and lower prices with their higher earning power were made overseas.

But no economy can ever remain frozen at a single point in time. The goal of economic metrics is to figure out at any point in time just where in the cycle the economy is (and at what point others are). Are we emerging? Growing? Peaking? Declining? And what about the other economies in whose securities we could invest as an alternative to those of our home market?

The starting point for an analysis of the economic factors is within our home market. The metrics most helpful to determining what’s going on aren’t those that grab headlines and drive markets into a frenzy; that kind of data is just too “noisy.” The monthly release of figures such as new job creation or retail sales, for instance, tries to measure trends too frequently to be useful, while at the same time sparking too much market volatility to be helpful in an analytical framework. Sure, back in the days when I was trading bonds, I was just as fixated as everyone else still is today on the monthly jobs number on the first Friday of every month. But as I grew to realize that the fewer trades I made and the more those were based on longer-term indicators that measured the bigger picture, the better I performed. I understood I needed to steer clear of all the fuss surrounding those monthly data points. (After all, even if I correctly predicted the number right, I could still take a big hit if investors responded in a way that I hadn’t predicted or thought would be irrational—a not infrequent occurrence.)

Other pieces of economic data can be useful only selectively. Some traders jump on retail sales data as a signal of how the economy is faring, arguing that because consumer spending makes up such a big chunk of the U.S. economy, the willingness of consumers to fork over spare cash at their local Wal-Mart is a useful indicator of the economy’s health. Well, not really. Leaving aside all the problems inherent in measuring retail spending, it is really only helpful when it comes to telling me what is happening to a handful of big retailers. I’ve already demonstrated to you early on in this book that investors capture the biggest bang for their bucks making asset-allocation decisions. So, you and I need data that tells us about the health of the economy as a whole. Because retailing is only one of several sectors in the S&P 500 Index, and far from the largest, even a reliable retail sales figure won’t significantly hint as to what is likely to affect the overall stock market. (The one exception, in this case, is if I have, or want to include, commercial real estate as an asset class in my portfolio. In that case, I want to know what’s happening to sales of the companies leasing that property, retailers among them.)

Traders and other market pundits track inflation data, such as the producer price index or the consumer price index, but that might be less useful than it seems. It may indicate whether inflation is on the rise or ebbing. So far, so good. But it doesn’t help me understand whether the stock market will thrive. The stock market is made up of sectors that respond in very different ways to inflation: Even expectations of higher inflation are toxic to utility stocks and damage the financial sector, as rising interest rates eat into profits and make their returns less competitive. Technology stocks, meanwhile, historically thrive when prices are climbing.

Above all, these well-known and widely tracked economic indicators share a single large flaw: They are backward looking. They tell us what has happened in the recent past. (Indeed, the more useful they are, the more firmly rooted in the past they are: I find jobs data and retail sales data that summarize the trend of the past 12 months to be more useful than a single data point about the events of the past few weeks.) As investors who want to make rational asset-allocation decisions, we don’t need to know what has happened but rather what is likely to happen. What is more useful, being warned by your television meteorologist that a blizzard is on its way, or watching footage of snow-removal crews struggling to clear the streets? The latter might be more entertaining, but odds are it will be less helpful. Similarly, the metrics I seek out are those that can tell me whether the economic environment is positive, negative, or neutral; whether it’s likely to encourage a growth in profits and thus a bull market for stocks or is more likely to favor bonds.

I find the metrics that help me answer that question are those tied to interest rates (specifically in metrics tied to the yields on bonds, because the bond market is the most direct reflection of the investment “backdrop” that I have found). Every slight change in economic trends, in inflation expectations or in credit risk is reflected (and sometimes magnified) in the market for Treasury bills, notes, and bonds. What happens to the prices and yields (the amount of interest paid to investors as a function of the prevailing price) on these securities embodies a whole array of investor expectations. Worried that corporate profits are declining? Odds are that if the market shares your unease, there will be a flight to “quality” in the shape of Treasury securities, whose prices will rise, and yields will fall as a result. At the same time, the gap between the yield on a Treasury note or bond and that on a corporate bond may widen—investors feel safer owning the government-backed security than they do taking the risk that the corporate issuer will buck the trend and earn enough in profits to maintain its regular interest payments to bondholders. If you want a snapshot of investor expectations of the economy, of corporate profits, of the relative risks of stocks and bonds, all you need to do is look at bond market data. Are the spreads on bond yields issued by low-credit-quality companies and those issued by companies with investment-grade ratings narrower than has been the case historically? That can tell you whether the economy is contracting or expanding and give you insight into lenders’ and investors’ respective attitudes to risk, confidence, and speculation.

For me, the crucial economic metrics, the ones that tell me whether it’s time to shun or embrace U.S. stocks, are the shapes of two different curves. One is the yield curve, calculated by plotting the yields of an array of Treasury securities of different maturities, from 30 days to 30 years. The second is the “federal funds” futures curve, established by plotting the yield associated with futures contracts tied to whether investors expect Federal Reserve monetary policy makers to raise or lower key lending rates. (That might sound complicated, but really it isn’t: Buyers and sellers of the publicly traded futures contracts essentially agree on where they think Fed interest rates will be at various dates in the future; the curve takes shape when these are all plotted out.) It’s not the absolute levels of the yields or expected interest rates that are important, but the shape of the curves themselves.

Let’s start by looking at the yield curve (see Figure 8.2). Traditionally, this slopes upward from left to right. The further away the date on which the bond matures, the higher the yield. That reflects the fact that lenders view the risk and uncertainty of lending as growing as the repayment date stretches further into the future.

Figure 8.2 Treasury yield curve.

If the U.S. Treasury wants to borrow money for 10 years, it will have to pay more in annual interest than it would have if it wanted the cash for 30 days; more can go wrong in 10 years than 30 days. When the yield curve takes this kind of positive slope—and where there is a gap between the yield on the 3-month Treasury bill and the 10-year Treasury note of more than 2 percentage points—that yield spread tells me that the economic backdrop is generally bullish for stocks. A steep yield curve (one where the slope goes up dramatically) signals strong economic growth. That is potentially a great stock market environment so long as the growth doesn’t get to the point where inflationary pressures tempt Federal Reserve monetary policy authorities to get into the act and choke it off by raising interest rates.

One of the best predictors of the economy’s health that I have been able to find is the spread (over the past 50 years) between the 3-month Treasury bills and the 10-year Treasury notes. When that yield curve inverts—that is, when the yields investors can earn on 10-year Treasurys are lower than those on shorter-term securities—the yield curve is telling me that investors expect an economic slowdown, even though this might not yet be showing up in the data being released on a monthly or quarterly basis. But it tells me that it’s time to consider pulling back from the U.S. stock market and look at other asset classes in search of alternatives that offer more upside potential or even a better chance of maintaining their value. Over the past quarter century, the yield curve has been inverted only 8% of the time; in many cases, these inversions were followed by either an economic slowdown or an outright recession.

So how can you, as an investor, look at the yield curve and get a useful signal? One of the best things to do is to track what happens to the yields on both the 2-year and 10-year Treasury notes. If the latter is higher than the 2-year yield, the economy is expanding. If the 10-year yield is lower than the 2-year yield, it’s an economic contraction: Bond investors are betting that interest rates will fall in the coming months and years. Because the stock market thrives in an expansion and suffers in a contraction, you probably won’t be startled to learn that over the past 30 years the average monthly return of the Dow Jones Industrial Average when the 10-year yield exceeds that on the 2-year notes is about 1%, compared to 0.2% when the yield curve is inverted and the 2-year yield exceeds that on the 10-year Treasury note. The yield curve’s shape is an even more dramatic predictor of stock market performance looking a year out (our target time horizon). When the yield curve is positive (that is, when the yield on the 10-year Treasury note exceeds that on the 2-year note), the Dow Jones Industrial Average has returned an average of 11.4% over the following 12 months. An inverted yield curve? The 30 stocks in the Dow benchmark returned less than half of that (an average of only 5.2%) in the following 12-month period.

One of the risks associated with an economic expansion is that the expansion will overheat and turn into inflation. In emerging markets such as China and India, growth rates of 6%, 7%, or even 10% can be tolerated and even welcomed. In more-developed economies, however, that tends to create inflationary bubbles that, if not slowly deflated by monetary policy makers, can explode with ugly consequences, as those of us who struggled through the 1970s can remember all-too vividly. All things being equal, the Fed prefers to see what economists refer to as a “soft landing”—a period of expansion followed by a gentle contraction—to a “hard landing” of the kind that produces a recession. That’s why Fed policy makers jump into action whenever they perceive the economic expansion to be too dramatic. And that’s why I also keep a keen eye on the shape of the federal funds futures curve, which signals the market’s collective thinking about what the Fed’s interest rate policy is likely to be into the future. The steeper that curve, the greater the likelihood that interest rates will be higher in the future, creating a headwind that companies must confront. A flat to inverted yield curve suggests that the Fed is more likely to lower key lending rates, and that the business environment is benign; that policy makers are more likely to encourage companies to borrow money to grow their businesses than they are to install artificial roadblocks to higher profits in the shape of higher interest rates.

These two indicators are a starting point for evaluating the economic environment in which I make asset-allocation decisions. Used alone, they can offer the single most valuable clues to the direction in which the economy is headed. They give me a capsule summary. If I have the time, interest, and inclination, I can venture further afield in search of confirmation or additional, more-specialized indicators. For instance, the Conference Board’s Composite Index of Leading Indicators is another forward-looking gauge of economic well-being. It tracks ten components, ranging from the number of new building permits issued to the average number of hours worked weekly in the manufacturing sector (and including the yield differential between the 10-year Treasury note and the Federal funds rate) and wraps them up in one neat package. It’s not as reliable a predictor as the shape of the yield curve has proved to be over the past 30 years, however. Still, I have discovered that when the rate of change in that index hovers above 0.1 for 3 months in a row, the economic outlook seems positive, and the Dow Jones Industrial Average returns an average of 10.9% in the following 12 months. On the other hand, if the rate of change in the index falls below 0.1 for 3 consecutive months, there is a negative trend in place, and the Dow’s average 12-month return following that falls to 9.7%.

These days, the kind of asset-allocation decision I make in response to economic metrics is no longer likely to be just a simple switch from stocks into bonds. Indeed, faced with a negative environment for U.S. stocks, my own first choice isn’t to pull my money out and invest in the bond market instead. These days, Treasury notes are an expensive luxury investment rather than being attractive in their own right, because the Treasury is printing money at a rapid rate as part of its efforts to stabilize the banking and financial system. (Eventually, the value will drop and inflation will pick up; holders of these Treasury securities will be left holding the bag.) So, if the economic backdrop looks as if it will be bearish for, say, U.S. growth stocks, my next step is to ask whether the same holds true for value stocks. Or if the rapid growth rates, which tend to favor small-cap stocks, have abated, do I believe that the economy has enough upside potential to make larger-cap stocks attractive? What’s bad for one part of the stock market can be good news for another kind of equity. For instance, the weakness in the U.S. dollar that sent the greenback to the lowest level in decades against other major world currencies in the first few months of 2008 was good news for investors in overseas stocks. Even if those stocks turned in relatively lackluster returns in absolute terms, when translated from the euro, the pound, or the Canadian dollar back into U.S. dollars, the actual profits from owning the stock were much larger for a U.S. investor. For the same reason, a slump in the greenback also tends to favor large U.S. multinational companies, which earn an outsize portion of their sales from overseas markets. Small-cap stocks, which tend to be net importers rather than exporters, would be at a relative disadvantage. That is just the kind of disparity in potential market returns that can boost the investment returns for those who spot it early on.

Watching economic metrics means monitoring global data, not just that produced by our domestic economy. After all, investment opportunities exist globally, and thanks to the interrelationship between trading partners, what happens in another country’s economy can affect our own. As a broad rule of thumb, I argue that any stock portfolio should consider having a third of its capital invested outside the United States. Our stock market now makes up only slightly more than half of the world’s total stock market capitalization. So if the business cycle in the United States has peaked and is beginning to contract, that doesn’t automatically signal that you should bolt for the low-yielding bond market. Rather, the logical next step is to look abroad in search of a region where the economy is expanding, as measured by its general business activity (such as growth in corporate profits) and gross domestic product. Despite the fact that economies worldwide can be interrelated, great disparities remain in both the direction and rate of economic (and market) growth. Japan, for instance, has been a longstanding laggard, with hints of economic turnarounds and market recoveries to date having proved so far to be nothing more than false dawns. In contrast, China’s runaway growth and market expansion (in terms of the number and nature of the stocks listed on the various exchanges) has offered immense opportunity, along with outsize volatility and risk. Again, the trick is to find the most attractive economic backdrop on a relative basis, adjusting for the different level of risk you take on whenever you leave your domestic market.

There are headaches that go along with applying the economic factor to our global investment decisions. Just because the economy of one country or region is beginning to wane doesn’t mean another is poised to thrive, for instance. The majority of economic downturns flow from local excesses, just as the dot.com boom in the United States produced the recession that finally ended in 2002. But that kind of downturn in the United States is certainly felt by our trading partners, although its impact can often be more muted than some fear mongers, buzzing anxiously about “contagion,” believe. Today, as American consumers try to repair their personal balance sheets, the ramifications are clearly global, although most of the pain will be felt here at home. Typically, problems with a domestic market produce a situation where stocks overseas are relatively more attractive, even if the correlation isn’t perfect in terms of timing or magnitude.

Another mostly local economic condition is inflation. Just because the prices of consumer or business goods are growing rapidly in one economy doesn’t mean that the same is true throughout the global economy. China, for instance, is exporting its growth to neighbors and trading partners, but it hasn’t exported much inflation despite average GDP growth of 10% a year over the past decade. An inflationary economy will see its bond investments decline in value, but bonds issued in economies that are experiencing relatively lower inflation rates will continue to thrive, history suggests. Keeping tabs on local conditions such as inflation and consumer spending is particularly critical for an investor who is interested in capturing some of the outsize growth that can come from investing in the rapidly expanding economies in emerging markets such as China, India, and Brazil. It isn’t just U.S. demand for Chinese goods that has fueled Chinese growth; the swing factor is the surge in demand from local consumers, particularly an emerging middle class that may already outnumber the entire population of North America. Now that the valuations applied to these emerging markets have reached levels that approximate those of the S&P 500, tracking those bits and pieces of economic data that give us clues to relative strengths and weaknesses is becoming more important, because they might well provide the first signal that a change in other factors, particularly fundamentals, is on its way.

Compared to other metrics, the tools investors use in evaluating the economic climate might seem more like blunt implements than surgically precise instruments. That’s just fine. When it comes to the economy, what you need can be found without having to sort through and fine-tune each set of economic data. The economy, like a giant oil tanker, changes direction only slowly and after giving lots of warning. If you’re watching the right indicators—the yield curves that spell out forward direction rather than metrics that tell you where you have already been—you’ll get enough advance notice of a change in direction to begin planning changes in your investment portfolio. Precision is less important than accuracy in predicting the general direction and approximate time frame. The objective is to be able to dig just deeply enough into the vast amount of economic data that exists to be able to get a valid and reliable signal of the stock market’s health: thumbs up or thumbs down.