Anyone who follows the markets or the economy knows about gross domestic product and the consumer price index, but sometimes those well-known indicators don’t give us the clearest view of where the economy has been or where it is going.
Like a jeweler using a magnifying glass to look into a gem to see its virtues and flaws, the best analysts dig deeper into the economic reports.
“If you peel back the onion, it can help you figure out what the bigger picture is,” said Stu Hoffman, chief economist for PNC Financial. “Sometimes it makes you cry,” he said, but you can get a better view.
Every analyst has favorite hidden indicators. Here are seven favorites you can use to get a better understanding of the economy.
LOOK AT AVERAGES
The first trick, one that can be used with almost any economic indicator, is to use a three-month running average to smooth out monthly fluctuations.
Many of the better-known indicators ? such as housing starts, durable-goods orders and retail sales ? can be extremely volatile on a month-to-month basis. They have a high noise-to-signal ratio.
Unless you are a trader who needs volatility in order to profit, it’s the underlying trend that matters most.
“To look at any one month is meaningless,” Hoffman said. A smoothing average tells you what the trend is. “That’s the information that matters; the rest is noise.”
Economists often speak about year-over-year changes, essentially a 12-month average. Year-over-year changes are useful in portraying long-term trends, but they can mask turning points that can be revealed by three-month averages.
LOOK AT THE CORE
Many indicators are noisy because one special factor can have an outsized influence on a monthly basis. Gasoline prices go up one month and down the next. Aircraft orders swell in one month, and then shrink the next.
That’s why economists talk about “core” measures of indicators such as consumer prices, retail sales or durable-goods orders. Core measurements exclude or ignore special factors in order to focus on underlying trends. It’s like an X-ray that shows only bones, not the soft tissues.
The core CPI is the best-known and most widely misunderstood example. The core CPI excludes food and energy costs, which are among the most volatile components in the consumer price index. Economists study the core not because food and energy don’t matter, but because they matter too much on a month-to-month basis.
Because of the extreme volatility in food and energy prices, the headline CPI has swung from a 4.9 percent inflation rate a year ago to a 1.3 percent deflation rate now. By contrast, the core CPI has slowed more moderately, from a 2.5 percent inflation rate a year ago to 1.5 percent now. That’s probably a better reflection of the disinflationary environment than the headline CPI.
The Cleveland Fed has a better idea for a core CPI: Rather than automatically excluding food and energy prices, its core gauge excludes only the items that rose or fell the most in any given month. Sometimes it would be gasoline, sometimes tobacco, sometimes chicken.
This so-called trimmed mean CPI published by the Cleveland Fed is probably the best way of looking at the trend in consumer prices. The trimmed mean CPI is up 1 percent in the past year.
For retail sales, economists look at sales excluding autos and gasoline. For durable-goods orders, it’s good to pay attention to capital equipment orders excluding aircraft and defense goods, which tracks business investment trends closely.
Some economic reports are chock full of interesting information that one number cannot do justice to.
The monthly employment report is a prime example of a report where the parts are greater than the whole. Most people pay attention to the number of payrolls lost or gained, and maybe to the unemployment rate.
But the report reveals more about the job market than can be summed up in one or numbers. It has information about different demographic groups, industries and occupations. It can tell us something about hours and wages.
The alternative unemployment rate (also known as the U6 rate) has become a favorite because, unlike the regular (or U3) unemployment rate, it measures underemployment; people too discouraged to look for work, or people whose hours have been cut back.
The GDP report is also worth a deeper dig.
GDP ? the total value of all goods and services produced within the United States ? is a useful accounting concept. But it can be misleading during big inventory swings.
A better gauge of the economy’s strength is the number that’s reported as final sales. Final sales, as the name implies, counts the goods and services that were actually sold, rather than the number that were produced and stuck in a warehouse someplace. A related concept is final domestic sales, which counts goods and services sold within the United States.
“The balance between final sales and inventories is an excellent leading indicator,” said John Silvia, chief economist for Wells Fargo Securities.
DON’T BE DISTRACTED
Sometimes, the government, the media and the markets just focus on the wrong number. Instead of paying attention to housing starts, for instance, it’d be better to look at the number of building permits for single-family homes.
Why? Because the monthly housing starts figures are ridiculously inaccurate, compared with the permits figures that are statistically more reliable. Multi-family housing construction is too volatile on a monthly basis to be meaningful.
AVOID THE PITFALLS
It’s fine to find favorite hidden indicators, but you should beware of cherry picking the data to fit pre-conceptions. If you’re being honest about trying understanding the economy, you have to be consistent. If you use the three-month averages to prove your point one month, you shouldn’t switch to crowing about the monthly figure the next time, if that number suits your argument better.
On the other hand, it’s all too easy to cling too tightly to a favorite indicator and become oblivious to trends that are obvious in the headline indicators. Don’t let your agenda blind you.
(c) 2009, MarketWatch.com Inc. Source: McClatchy-Tribune Information Services.