by Peter McKenna
In a general sense, tracking the economy means finding, as accurately as possible, the current state of the business cycle. You must know if it is in a period of expansion or contraction. The best way to get this information is to record month-by-month progress of the economy in a journal or a workbook. Do not try to keep this information in your head. You want to see the economy unfold before your eyes. Look for the type of workbook that also has a large calendar in the back. Remember, you are making very serious preparations in an effort to make money. You could also lose money; this is a time to be disciplined.
Here’s the way an event trader should begin tracking the economy. Go to the MarketWatch web site, or any of the other resourceful web sites that are available. Find the information below and record it in your journal:
- The last three GDP (Gross Domestic Product) reports. Use the revised figures. The date of the next GDP report.
- The last three unemployment reports. The date of the next unemployment report.
- The current interest rate as set by the FOMC (Federal Open Market Committee). The date of the next FOMC meeting.
- The last three CPI (Consumer Price Index) reports. The date of the next CPI release.
- The last three consumer spending figures. The date the next consumer spending figure will be released.
These broad indicators will give you a good idea of the state of the business cycle. If GDP has declined over the past three reports, the economy is contracting. If it has improved, the economy is expanding. If it stayed the same or increased or decreased just slightly, the economy is stuck in neutral.
The latest interest rate decisions by the FOMC will give you a clue to the state of the business cycle, but not a firm reading. Generally, if rates have been coming down, the cycle is contracting. If they have been going up, the cycle has been expanding and the FOMC is trying to slow it down. Interest rates however, are just part of the overall information you need to judge the state of the business cycle.
The CPI reports give you an idea of the level of inflation in the economy. Generally, if inflation is high, we are in a contraction.
The consumer spending reports will be strong during an economic expansion and week during a contraction.
The following is important. In addition to the information above, you also have to record the expected results for each indicator above. You want to know what Wall Street fund managers and other institutional investors expect the indicators to show. For example, if the next indicator due for release is the rate of unemployment, determine exactly what the professionals expect the rate to be. Their expectations will determine the extent of the market’s reaction to the release of an indicator. As we have seen, a better or worse than expected reading can result in the “alert days” event traders wait for. In your journal, next to the date of the next report, record what the market expects from each report.
With the above in mind, you also need to get a fix on the current state of the market. As part of the event-trading discipline, you must know if the market is oversold or overbought, and to what extent. Record the following information in your journal:
- The daily closing price of the S&P 500 Index. Add these prices together every ten days and divide by ten. Record this average price in your journal every ten days.
- The daily closing value of the TRIN. Add these prices together every ten days and divide by ten. Record this average in your journal every ten days.
- Record the exponential moving average of the S&P 500 as shown in Investor’s Business Daily.
- Get a Stochastics reading of the S&P 500 at the website above. Record this value in your journal.
If the 10-day closing average of the S&P 500 is declining, the market is in an oversold position. If it is rising, it is in an overbought condition. If the daily and 10-day closing value of the TRIN is increasing, the market is oversold, and it is overbought if the number is falling. The direction of the EMA gap found in the 200-day S&P 500 in Investors Business Daily will also give you an indication of the oversold, overbought nature of the market. When these numbers are extreme in either direction, the market is either greatly oversold or greatly overbought.
Use Common Sense
Another way to judge the oversold/overbought nature of the market is to use the insight that comes with following the market every day. For example, in late September and early October of 2002, my journal showed that the market lost ground for six straight weeks. I went back over a year’s worth of journal entries and could not find another period in which the market had gone down for such an extended period. Given the protracted length of the downturn, the strong rebound off this oversold level that came on September 11, when the DOW gained more than 200 points despite bad economic news, was predictable.
I decided to use this six-week period as a measuring stick of the market’s oversold/overbought level in the future. Accordingly, if the market has gone down for three weeks, I consider it to be moderately oversold. If it goes down more than three weeks, I consider it to be greatly oversold. The same applies in reverse for overbought markets. This is a simple, common-sense approach to judging the market’s oversold/overbought level.