In Chapter One we discussed the concept of risk and the importance of protecting your portfolio from losses. Managing your investment risk should be the primary objective of your strategy. Looking at games of strategy like poker, investors can learn how to develop an investment strategy centered on flexibility and sensible risk-taking. As poker players plan their bets, depending on the odds of winning, the investor has to change the amount invested in each asset depending on the odds the investor has to make money in that particular investment.
One of the main objectives of this book is to show that prices of most assets are driven by changes in economic conditions. As the economy moves from a period of fast growth to slower growth, assets prices change to reflect the evolving economic conditions. Understanding how and why prices change is the main step in developing an investment strategy leading to risk management.
In Chapter Two, we began the process of understanding the forces acting in the economy and how these forces are related to each other. Economic indicators were introduced and sub-divided into categories. This subdivision did not have any specific purpose except to make it simpler to explain and introduce these indicators. They were categorized into consumer-related indicators, manufacturing indicators, construction indicators, inflation indicators, and finally, measures related to productivity and profitability. We purposefully did not discuss indicators related to interest rates and the stock market because they will be discussed in much detail in the following chapters.
In Chapter Three we showed how these indicators are related to each other in a cause and effect type of chain reaction. This was achieved by discussing some examples of business cycles. One of the objectives was to show how the process of feedback develops in the phase of acceleration of the business cycle and how forces leading to a slowdown eventually develop to bring growth back to its long-term average.
But the mosaic is still not complete. In this chapter we will attempt to put the pieces together and show how all indicators impact the growth of the business cycle and how the financial markets react to changes in economic growth. In the following chapters we will discuss how to develop investment strategies that take advantage of economic changes.
But first, we have to introduce the concept of leading, coincident, and lagging indicators. Their introduction greatly simplifies the understanding of cyclical forces and makes it easier to understand what is happening in the economy. In the late summer of 1937, then Secretary of the Treasury, Henry Morgenthau, Jr., asked the National Bureau of Economic Research (NBER), an organization devoted to studies in business cycles and other economic problems, to compile a list of strategic indicators that would best indicate when the recession would end.
Wesley C. Mitchell, then NBER's Director of Research, enlisted the help of Arthur F. Burns who later headed the NBER and then became Chairman of the Federal Reserve. The report presented to the Secretary discussed a list of the most reliable indicators of business expansions, explained how they were selected, and included a record of their past performance. This report was published in May 1938. The first set of leading, coincident, and lagging indicators was born.
In the summer of 1938, the indicators were put to their first test. The recovery began in June, and the first signs of their appearance were registered by the leading indicators identified by Mitchell and Burns.
Many new theories relating to various aspects of business activity became available and new findings about cyclical upturns and downturns were published. The original list of indicators was revised several times.
At present, The Conference Board maintains and updates monthly the latest data concerning the leading, coincident, and lagging indicators and is made available free through the Internet by The Conference Board. Most industrialized countries have copied the system developed by the United States because it is one of the most sophisticated and timely ways of collecting information to develop economic and monetary policies.
Additionally, the advantage of looking at composite indices is that instead of examining the behavior of hundreds of indicators, a composite index summarizes their action. The analyses of just three indicators provides the analyst with a fairly good idea of what is happening in the economy. However, a better understanding of what is happening is derived by examining the detailed action of the components.
(From Chapter 4 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager
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