31 Dec 2018
Key Indicators for Investing in U.S. Markets
Given that U.S. market is the world’s largest and most liquid market, it is a good opportunity for investors to diversify their portfolio by investing in the U.S.
To give investors a sense of how the economy is faring, U.S. government agencies and other organizations release data throughout the year. Many investors focus on statistics which measure things such as gross domestic product (GDP) growth, unemployment and inflation, so as to get a sense of the economy’s health and forecast possible investment trends.
The concern is that while there is a lot of data out there, not all of it is useful for gauging stock market behavior. Although sudden changes in economic conditions can have short-term impact on the stock market, the effect of any single economic data on share prices eventually fades over longer periods, ultimately providing little insight into the future direction of the market.
For the investors who are keen on managing their own portfolio, let’s take a closer look at two of the most significant economic indicators that can help investors think strategically about shifting conditions in the market.
1. Yield Curve
As far as indicators go, the yield curve is an important one. On its face, the yield curve is a snapshot of the yields, or expected rates of return, on a collection of bonds of different maturities, from the very short to the very long. The “curve” is the line you could plot connecting those yields, and its shape can tell us quite a bit about market perceptions of the economy. In fact, every recession in the United States—and accompanying global economic recession over the past 50 years—was preceded by an inverted yield curve.
Normally, the yield curve slopes upward from the shorter maturities to the longer ones, because yields on short-term bonds are usually lower than those on longer-term bonds. The shape of the curve can change as yields fluctuate in response to shifting economic conditions. In general, the short end of the curve is dictated more by the Federal Reserve’s interest rate decisions, while the longer end of the curve reflects investors’ expectations about the future course of inflation and economic growth.
The yield curve tends to steepen when the economy is growing strongly and investors grow concerned about inflation and potential interest rate hikes by the Fed. As a result, they might start to avoid longer-term bonds, causing their prices to fall and their yields to rise. Remember: prices and yields move in opposite directions.
When the Fed does raise interest rates, the yield curve tends to flatten as short-term yields rise and inflation expectations ease.
However, if the Fed raises rates too quickly, causing short-term yields to rise above long-term yields, then the yield curve can invert. That’s when investors start worrying about a potential recession, as high rates slam the brakes on growth and inflation expectations.
2. Leading Economic Index (LEI)
Many investors sift through statistics such as gross domestic product (GDP) growth to get a sense of the economy’s health and divine possible investment trends. However, it’s important to remember that it is a lagging economic indicator.
GDP reveals what has happened in the past, and not what’s about to happen. Therefore, market tends to focus more on the leading indicators, such as the Leading Economic Index (LEI). This index includes 10 components ranging from the S&P 500 to the yield spread, all of which tend to lead changes in the economy. While the index’s individual components might not mean much on their own, there are times when they all start moving in tandem and markets sometimes follow.
The LEI was based on major inflection points in the economy and provide an early alert as well as an indication when the economy is coming out or with elevated risk of a recession.
Planning and rebalancing
In short, individual data points can lead to short-term movements in the market, but over the long term they have much less influence. So, while there is little long-term value in basing your investing plans on the pace of growth, in some cases signals about the health of the economy might prepare you for short-term bouts of volatility.
Rather than focusing too much on indicators, investors are suggested to formulate and adhere to a long-term investing plan that accounts for their time horizon and tolerance for risk. Regularly rebalancing to keep your investments in line with your target asset allocation is a disciplined way to buy low and sell high.
Planning and rebalancing minimize the common mistakes driven by crowd psychology, and is much more conducive to achieving your long-term investing objectives.
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
About the author:
Peter Yiu, Associate Director, Portfolio Consultant, Charles Schwab Hong Kong