Today, we are going to be bouncing back and forth between several different economic and market data sets I reviewed this morning and using this information to form both specific and general conclusions. Each of these data sets could reasonably be interpreted as either good news or bad, so it's important to see whether we can tell the difference.
Understanding the Numbers
Let’s start with inflation, specifically, the Producer Price Index (PPI) inflation figures and the University of Michigan inflation expectations, both of which came out this morning. The details don’t really matter—what matters is the big picture. The PPI dropped significantly on a year-over-year basis but came in high on a month-to-month basis. Similarly, the Michigan inflation expectations number dropped significantly for the next year but remained unchanged for the next five. So, is this good news or bad news?
It could be either, depending on how you interpret it. For me, the correct answer depends on how you look at the underlying data since the headline numbers don’t tell you that much. I am on record as saying inflation has peaked, so I could look at the year-over-year and one-year numbers and claim that this supports my position. Or, I could look at the monthly and five-year numbers and argue the opposite. How should I decide?
Looking for Trend Changes
In both cases, the best way to decide if this is good news or bad news is to figure out whether the new data represents a change in trend. For example, the current trend has been for inflation to be higher, so any data indicating lower inflation would be good news.
On an annual basis, looking at the PPI data, we see that lower number—so, good news. Turning to the monthly number, even though it is higher than expected, it results in a lower inflation number than the current trend when we annualize it. So, in this case, both the monthly and annual numbers show a positive change in trend and indicate good news.
For the Michigan inflation expectations number, the same analysis applies. In the next year, inflation is expected to be lower than the current trend. Good news. And over the next five years, inflation is projected to be the same, which is also lower than the current trend. Both data points are positive compared to the current trend and lean on the side of good news. What matters in both analyses is how the data points compare with the trend.
Analyzing Earnings Expectations
On the investing side, a chart I saw this morning outlined analysts’ expectations for corporate earnings. Interestingly, it had more upgrades than downgrades for the first time in 26 weeks. If I look at the one-week number, this is certainly good news for the market. But then I remember that analysts have been downgrading earnings for the past six months. Surely, that has to be bad news, right? And how will the market process this?
Since this is about the markets rather than the economy, we have to be careful. The economic news evolves according to the underlying economic facts, so we can look at trends in isolation. Markets, however, incorporate expectations directly, so the analyst earnings estimates, and the changes, affect future performance. Therefore, we have to consider the data recursively, not only in light of the past data, but also in the context of future expectations.
In this case, 26 weeks of more downgrades than upgrades have already been reflected in current market prices. The most recent data point is simply part of that evaluation and might be an anomaly. To evaluate whether this is an anomaly or a genuine change in trend, we have to dig a bit deeper. When we do, we see that the negative balance of downgrades and upgrades has been improving for the past six weeks before breaking into positive territory. Here, we can conclude this is indeed a change in trend and, therefore, good news. But we also have to consider that it should already be reflected in prices, so this may not make much of a difference going forward.
Taking Note of the Details
These types of analyses are especially important right now, as we see both the economy and markets potentially changing their trend lines. With worries about a recession rising, trends in job growth and confidence will be crucial next year. Similarly, with inflation starting to drop, the impact of this on the Fed and interest rates will be determinative for markets.
We should always approach the headlines with a critical eye, but critical in this case doesn’t mean dismissing them, but rather understanding them in context. Looking at what the good news and the bad mean, in the context of trend changes, will help us do just that.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held registered investment advisor-broker/dealer.