to charge sim-ply to recoup your purchasing power within the next 12 months. You mightwant to add in one or two percentage points to cover default risk and theopportunity cost, but inﬂation remains the key variable in what interest rateyou would charge.
Inﬂation (along with default risk and opportunity cost) basically ex-plains how interest rates are set on everything from your mortgage and autoloans to Treasury bills, notes, and bonds. As the rate of inﬂation changesand as expectations on inﬂation change, the markets adjust interest ratesaccordingly. The effect ripples across stocks, bonds, commodities, and yourportfolio, often in a dramatic fashion.
Housing Numbers
The explosion in real estate prices across the country and their connectionto the investing public are key to understanding the impact of numbersrelated to housing. Housing starts measure initial construction of residen-tial units (single-family and multifamily) each month. A rising (falling) trendpoints to gains (declines) in demand for furniture, home furnishings, and ap-pliances. This narrow piece of data has a powerful multiplier effect throughthe economy, and therefore across the markets and your investments. Bytracking economic data such as housing starts, investors can gain speciﬁcinvestment ideas as well as broad guidance for managing a portfolio.
Home builders usually don’t start a house unless they are fairly conﬁdent
it will sell on or before its completion.
Changes in the rate of housing starts tell us a lot about demand forhomes and the outlook for the construction industry. Furthermore, eachtime a new home is started, construction employment rises, and incomewill be pumped back into the economy. Once the home is sold, it generatesrevenues for the home builder and a myriad of consumption opportunitiesfor the buyer. Refrigerators, washers and dryers, furniture, and landscap-ing are just a few things new home buyers might spend money on, so theeconomic ripple effect can be substantial, especially when you think of it interms of more than 100,000 new households around the country doing thisevery month.
Since the economic backdrop is the most pervasive inﬂuence on ﬁnan-cial markets, housing starts have a direct bearing on stocks, bonds, andcommodities. In a more speciﬁc sense, trends in the housing starts datacarry valuable clues for the stocks of home builders, mortgage lenders, andhome furnishings companies. Commodity prices such as lumber are alsovery sensitive to housing industry trends.
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Productivity
Productivity measures the growth of labor efﬁciency in producing the econ-omy’s goods and services. Unit labor costs reﬂect the labor costs of produc-ing each unit of output. Both are followed as indicators of future inﬂationarytrends.
Productivity growth is critical because it allows for higher wages andfaster economic growth without inﬂationary consequences. This is a hottopic these days with the economy so strong, the labor market so tight,yet inﬂation so well-behaved. Some Wall Street experts state that dramaticproductivity advances are allowing the economy to continue a much fasterpace of growth than previously thought possible. Former Fed chairmanAlan Greenspan and the present chairman Ben Bernanke have expressedskepticism about those statements, however. In either case, the productiv-ity data gives investors important clues on how stocks and bonds can beexpected to perform, and the market reactions to these releases show thetrue importance of productivity growth.
Durable Goods
Durable goods orders reﬂect the new orders placed with domestic manu-facturers for immediate and future delivery of factory hard goods. The ﬁrstrelease, the advance, provides an early estimate of durable goods orders.About two weeks later, more complete and revised data is available in thefactory orders report. The data for the previous month is usually revised asecond time upon the release of the new month’s data. Investors want tokeep their ﬁngers on the pulse of the economy because it usually dictateshow various types of investments will perform. Rising equity prices thriveon growing corporate proﬁts—which in turn stem from healthy economicgrowth. Healthy economic growth is not necessarily a negative for the bondmarket, but bond investors are highly sensitive to inﬂationary pressures.When the economy is growing too quickly and can’t meet demand, it canpave the road for inﬂation. By tracking economic data such as durablegoods orders, investors will know what the economic backdrop is for thesemarkets and their portfolios.
Orders for durable goods show how busy factories will be in the monthsto come, as manufacturers work to ﬁll those orders. The data provides in-sight into demand for items such as refrigerators and cars, as well as busi-ness investments such as industrial machinery, electrical machinery, andcomputers. If companies commit to spending more on equipment and othercapital, they are obviously experiencing sustainable growth in their busi-ness. Increased expenditures on investment goods set the stage for greater
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productive capacity in the country and reduce the prospects for inﬂation.Durable goods orders tell investors what to expect from the manufacturingsector, a major component of the economy, and therefore a major inﬂuenceon their investments.
Consumer Conﬁdence
The Conference Board compiles a survey of consumer attitudes on presenteconomic conditions and expectations of future conditions, surveying 5,000consumers across the country each month. While the level of consumerconﬁdence is associated with consumer spending, the two do not movein tandem each and every month. The pattern in consumer attitudes andspending is often the foremost inﬂuence on stock and bond markets. Forstocks, strong economic growth translates to healthy corporate proﬁts andhigher stock prices. For bonds, the focal point is whether economic growthgoes overboard and leads to inﬂation. Preferably, the economy walks thatﬁne line between strong growth and excessive (inﬂationary) growth.
This balance was achieved through much of the 1990s. For this reasonalone, investors in the stock and bond markets enjoyed huge gains during thebull market of the 1990s. Consumer conﬁdence did shift down along with theequity market between 2000 and 2002 and then recovered in 2003 and 2004.Consumers became more pessimistic in 2005 and 2006 when gasolineprices surged. Consumer spending accounts for more than two-thirds ofthe economy, so the markets are always dying to know what consumers areup to and how they might behave in the near future. The more conﬁdentconsumers are about the economy and their own personal ﬁnances, themore likely they are to spend. With this in mind, it’s easy to see how this indexof consumer attitudes provides insight into the direction of the economy.Just note that changes in consumer conﬁdence and retail sales don’t movein tandem month by month.
Gross Domestic Product
Gross domestic product (GDP) is the broadest measure of collective eco-nomic activity and encompasses every sector of the economy. GDP is theall-inclusive measure of economic activity. Investors need to closely trackthe economy because it usually dictates how investments will perform.Investors in the stock market like to see healthy economic growth be-cause robust business activity translates to higher corporate proﬁts. Bondinvestors are more highly sensitive to inﬂation, and robust economic activ-ity could potentially pave the road to inﬂation. By tracking economic datasuch as GDP, investors will know what the economic backdrop is for thesemarkets and their portfolios.
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The GDP report contains a treasure trove of information that not onlypaints an image of the overall economy, but tells investors about importanttrends within the big picture. GDP components such as consumer spending,business and residential investment, and price (inﬂation) indexes illuminatethe economy’s undercurrents, which can translate to investment opportu-nities and guidance in managing a portfolio.
Although there are many other economic releases that drive the marketin one direction or another, it’s not imperative to get caught up in everynumber. Some numbers, such as the retailers or the car sales ﬁgures, cangive investors and traders a feel for what the health of the consumer mightbe, but the overall impact is minimal. The only times the market acts in avolatile manner following the release of a minor number is if the releaseis unexpectedly good or bad. A car sales ﬁgure that is a surprise to theupside, for example, could lead to a rally in both carmakers and suppliersalike rather than ﬁnding strength in just one concentrated group of stocks.The only other very important part of the economic release cycle is theinstitution that has the ﬁnal word: the Federal Reserve.
The Federal Reserve
The Federal Reserve is a mystery unto itself. Many have tried to studythe Fed and the actions of the Federal Open Market Committee (FOMC),which meets regularly to forge monetary policy, but few really understandits true nature and responsibility. There have been dozens of books writtenabout what it does, and better yet, what it’s supposed to do. Charteredon December 23, 1913, it is the nation’s central bank. Many investors don’trealize that the responsibility of the Fed has changed slightly over the courseof its existence. It was created by an act of Congress with the mission toformulate monetary policy for the country’s economy. It seems that thosewho created the institution never thought they would have the power thatthey clearly have in today’s market.
The concept, at the time, was to help relieve the cycle of boom and buststhat shook the nation’s banking system to its core. The situation had reacheda point, primarily because of the Industrial Revolution, that boom and bustmarkets seemed to be almost expected. Prior to the creation of the Fed, agreat run in the stock market was always followed by a panic that closedbanks and created depression-like conditions for years. Unfortunately,16 years later the country suffered the worst depression in history, withvery little guidance from the nation’s central bank.
Things seemed to change after World War II, when bankers began tosee the need for a strong central bank in the wave of the massive rebuildingefforts put out by the Marshall Plan. Billions of U.S. dollars began to pourinto the ravaged European countries, with the Federal Reserve cautiously
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adding liquidity to the system. As the U.S. economy began to be the world’sleader, the importance of the nation’s central bank began to grow to unimag-inable levels. In fact, the actions of the Federal Reserve are so important tothe global economy that every equity and ﬁxed-income market in the worldis affected by them.
The Fed really started to morph into the institution it is today afterJimmy Carter’s administration. When Paul Volcker became the chairman ofthe Fed, he inherited double-digit inﬂation and growing unemployment. Theinterest rates were at an all-time high and the constant fear of stagﬂationmade owning U.S. equities very risky. As Ronald Reagan took ofﬁce andstarted to push the supply-side theory, Volcker and the Fed, unilaterally,began to tighten the money supply and contain inﬂation at a manageablelevel. Prior to Volcker, the Fed was a political organization answering tothe whims of the executive ofﬁce instead of maintaining a desired course.The Carter administration had created a mess. Not only were they taxing themost proﬁtable American citizens at ungodly high levels, but the constantprinting of dollars was helping fuel the inﬂation scenario.
Everything changed with the Volcker Fed. The institution stopped act-ing as if it was political and began to function as a central bank. It containedinﬂation through very aggressive tightening and helped pave the way for thesupply siders to help stimulate the economy. Of course, much of the successof the Volcker Fed lay in the hands of the Reagan administration, with itspromise to lower taxes and expand the economy. The rest is history. UnderCarter, smart money was looking to shelter income from the government.Investors were looking for capital preservation instead of capital appreci-ation! Traders were searching for three-to-one write-offs on investments.The word on the Street was not how much an investment could make youbut rather how much one could write off and shield income!
When Reagan lowered taxes and eliminated tax loopholes, investorsbegan to make constructive investments that made the economy grow. It’sno coincidence that the capital that was freed from the vise of the Cartertax policies launched some of the great companies that we trade today.Many of the technology companies started in the late 1980s and early 1990swere seeded with capital that would have otherwise gone to unproductiveinvestments. I have always had a warm spot in my heart for Volcker andReagan because I started at Loyola in the fall of 1979. The year Reagan ranwas my ﬁrst presidential election and I will forever be convinced that hisleadership helped save our economy at a crucial point in history.
Today the Fed has slowly matured under Alan Greenspan’s leadership.As he turned over the gavel to Ben Bernanke recently, we were all remindedof the marvelous job he did in the years he spent in ofﬁce. Sometimes weforget that the economy experienced a stock market crash only months
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after Greenspan’s appointment. At that time he was able to orchestratethe leadership needed to guide the economy to safety. Although the jury isstill out on Bernanke, it’s clear that he intends to follow the legacy set byVolcker and Greenspan to be a vigilant inﬂation hawk with sensitivity to themarketplace. Never has it been more important for investors and traders tolisten to every speech made by Bernanke and other Fed governors. The ﬁrstfew years of a new Fed, when nine members have less than three years onthe board, are critical. This is the time when leadership is earned! This isalso the time when the astute Fed observer can ﬁnd an information edge—something every trader wants!
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C H A P T E R 10
InformationIs Gold
I n the summer of 2004 my wife Donna and I decided to take the children
on a family vacation to London. It was always our hope to be able toshow our children how others lived in the world and give them somethingneither one of us ever had—childhood memories of a vacation abroad. Asstudents of history, both Donna and I were always looking to ﬁnd vacationspots ﬁlled with archeological ruins or historical signiﬁcance. The trip toLondon accomplished our objective. Not only did we live in a London ﬂatfor a week, but we spent our days riding the Tube and working our waythrough the many layers of history. On our way back, we encountered thenecessary preboarding ritual, which included a trip through customs, wherewe were asked to declare anything of value.
The trip back from London to Chicago always seems a bit shorter be-cause of the time difference that makes it earlier when you arrive in theUnited States, as opposed to the jet lag that follows when you land there.Not one to be social on airplanes, I have been known to put on my ear-phones and keep to myself—out of the fear of sitting next to someonewho won’t shut up! This trip was a little different; Donna and the kidswere sitting across the aisle and I ended up sitting next to a gentleman inhis late 30s whose name escapes me (hopefully, he’ll read this book andcontact me).
About an hour into the ﬂight, the man turned to me and started to talk,and I broke my unwritten rule and responded. I ﬁgured, what the heck, itwas a long ﬂight; it would be nice to have an intelligent soul to talk with forthe duration. My hope was to ﬁnd someone to engage in, in the words ofChicago columnist Irv Kupcinet, “the lively art of conversation.”
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The gentleman began by asking about my occupation and whether I wasin Great Britain on business or pleasure. I told him I was traveling with myfamily, but that I had been to London on business trips in the past. I explainedmy role in the ﬁnancial services industry as best I could to someone whoseemed clueless about it. After I gave him the “Readers Digest” version ofmy career, the conversation turned to his occupation. He told me that he wasan engineer by training but had crossed over into research and developmentfor the auto industry. In short, he was an inventor!
He related to me the many different inventions that he had helped de-velop or had patented, among which were the capless gas cap and a specialscrew containing an alloy mix, which made it invaluable in modern autoproduction. I sat in awe as he went on for roughly an hour talking about themany wonderful things that the future holds because of creative individualssuch as him. I remember thinking how great it must feel to dream on paperlike that and then turn it into the real thing. This man was actually makingsomething out of nothing!
After the eight-hour ﬂight, we exited the aircraft and waited in line to gothrough customs. I stood with my family and he stood directly in front of us,waiting for the next available agent. As he went through, the customs agentasked him if there was anything he wanted to declare, to which he answeredno. A British national coming into the United States is required by law todeclare anything over a certain value. It occurred to me that he was walkingthrough customs declaring nothing, which was probably correct, but inreality he was entering the United States with perhaps hundreds of millionsof dollars in ideas! The information stored in his brain was like gold. Thisman could enter this country with very little in the way of material resources,yet he would produce ideas that could potentially generate unbelievableproﬁts. Intellectual capital, or information, is often priceless!
WHERE DO PROFESSIONALSGET THEIR INFORMATION?
One of the questions most asked of me when I speak at conferences or toa group of clients is “Where do you get your information?” It’s a questionI asked as a new trader and one that should be on the lips of every partic-ipant in the marketplace. There are many ways to acquire the informationneeded to remain competitive, but the effectiveness of the information isdetermined by the type of trader the person is. There are three distincttypes of traders when it comes to the need for information. The ﬁrst typecould not care less about anything other than the bid and offer and the ﬂowof orders in the market. The second type keeps up on current events just
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enough to get a feel for the macroeconomic landscape. But the third typeis my favorite—the information junkie.
What kind of trader could not care less about the surrounding worldwhen trading? It would surprise many average investors and retail-basedtraders that some market participants would risk capital without lookingfor the guidance offered through information and research. In fact, someof the most successful traders and investors on the ﬂoor of the ChicagoMercantile Exchange (CME) have made fortunes by understanding thenature of the edge rather than basing trading decisions on information.I’ve met traders who don’t read a thing before they enter the trading pit,relying instead on pure gut feeling rather than any information from thenewspaper or the Internet. Average investors tend to perceive professionaltraders as being in the know about what is going on.
In other words, professional traders are on the inside, whereas all othermarket participants are on the outside. Nothing could be further from thetruth, however. The reality is that the average informed individual has abetter understanding of both geopolitical events and macroeconomic trendsby staying informed. The average scalper standing in any pit at any exchangecould not care less which direction the market moves as long as the edgeis in his or her possession.
A trader who has a tendency to stay mildly informed usually relies ontechnical work to guide trading decisions. I know many traders who lookat the world through the eyes of a technician with no desire to understandthe geopolitical nature of the market; instead, they base every position ontechnical analysis of the market. There are very few people who fall into thiscategory, although some have been very successful. Usually scalpers, whoalso hold long-term positions, ﬁnd themselves staying somewhat informed,but not to the extent of the information junkie.
I always thought it must be very difﬁcult to put on a position in themarket without doing as much due diligence as is humanly possible. It’sbeen my experience that traders who fall into third class, for the most part,fail. The problem lies in the fact that it is very hard to be both a scalperand a position trader at the same time. Usually, a scalper who turns into aposition trader got stuck on one leg of the scalp, which renders a scalperuseless. Once a position has been established, the trader can no longerremain objective and ﬂexible—he or she now needs the market to move acertain way, period!
As I said, my favorite kind of trader is the information junkie. When Iﬁrst arrived on the ﬂoor back in the early 1980s, information was very hardto obtain. This was in the days before the Internet and even prior to the pro-liferation of the personal computer. All information was received throughTV, print media, and word of mouth. I immediately realized the importanceof having adequate information when it became clear that knowledge was
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the key to proﬁtability. I’m not talking about insider trading; I’m talkingabout having the network and the resources available to ﬁlter out the noiseand ﬁnd the truth. Many of the things I have discussed so far in this book,such as the 2:40 PM order imbalances and the days of the month when capitalﬂows are committed, were considered a few years ago to be informationthat was available only to professionals. But as information becomes morereadily available to the general public, the effectiveness of the information issomewhat diluted. Today’s information junkies are addicted to the Internetand have found that technology has inﬁltrated every aspect of their lives.Between the BlackBerry phenomenon and the advent of the cell phone,staying in touch with the world around you has never been easier.
I’ve always been fond of reading the newspaper to get my daily doseof information and opinion. I rely on the Chicago Tribune and the WallStreet Journal for guidance. Occasionally I read the New York Times butonly when there are larger political issues that I want to understand. Forthose of us who rely on information for everything, the Internet has beenthe saving grace. It’s hard to imagine a world without being able to Googleany topic you could think of. This phenomenon has turned everyone whohas access to the Internet into a semiexpert on any given topic. Recentlywhen oil prices began to drift higher and higher, the traders with opencrude oil positions started to watch certain things such as the rig countin the Persian Gulf and other obscure data that they had never followedor even looked at before. Even today the media has become very familiarwith terminology that once was the exclusive domain of wildcatters and oilservice employees.
BUSINESS TV
When I talk with traders and reporters who appear on TV, I’m often surprisedat how little they really know. There are certain individuals who have myutmost respect, such as Rick Santelli, but there are others who seem to betrying to justify their opinions rather than give an accurate read on the mar-ket. I ﬁnd that at times I might be a little too bullish for the market condition,but I have my own rationale for being bullish and ﬁnd very little reason tochange my long-term view. I will always give a reasonable argument for anypositions I have about the market condition and do the necessary homeworkbefore I go on the air. But there are others who don’t qualify what they aresaying. People who appear on business television or radio broadcasts andtell the audience that they are bullish or bearish better have sound reason-ing to back up their opinion. They don’t necessarily have to be right; afterall, we’ve learned that calling the market is an art not a science. But it is a
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responsibility to listeners and viewers that public ﬁnancial commentatorsuse sound fundamental logic to support any analysis they offer.
One of the interesting things to watch for is the way the different re-porters feed off the information received by other reporters. Sometimeswhen I’m watching an interview on one business channel, I ﬁnd the otherbusiness channel commenting about what’s being said on the ﬁrst channel.One reason for this might be that there are only a handful of media outlets,outside of the Internet, that give anyone reporting on the market the neededbackground. With only two major business television stations, CNBC andBloomberg, the world is collectively watching the same thing.
When I go overseas, I’m amazed at the number of traders who recognizeme from my appearances on CNBC or Bloomberg TV. I’m surprised becausethese are European traders trading European markets, not dislocated Yankstrading from abroad. Many of these traders and portfolio managers see mevia the Internet, keeping a close eye on the markets in the United Statesalong with their positions at home. With the world becoming a much smallerplace through globalization, the incestuous relationships among the globalmarkets cannot be ignored.
Traders in Chicago and New York are strange in that they think theworld revolves around them and the products that they trade. Whether itis commodities, equities, or bonds, traders making the market think theyare the center of the universe. It really wasn’t until the ruble meltdown in1998 that traders in the United States realized that what happened on theother side of the world while they slept was just as important as events thatoccurred while the U.S. market was open. Forex traders had known this foryears, but the rest of the U.S. ﬁnancial services industry was slow to catchon. This period forced traders to begin paying attention to the movement ofboth the Asian markets and the European markets in order to gauge whatwould happen when the U.S. market opened. It used to be that the U.S.market set the trend for the entire world, but that is no longer the case. Thesize of the various markets around the globe and the amount of U.S. capitalinvested in those economies forced the close-knit relationships among allthe major equity markets around the world.
Back before business television became as popular and widely acceptedas it is today, the most important tool for any trader looking for informationwas the newswire. The most famous wire services are Reuters and DowJones, both of which are still used today by the majority of the tradingpopulation. In fact, if you were to go to the ﬂoor of any major exchange,you would see a large TV monitor strategically placed somewhere around atrading pit or post. There are traders who, even today, cannot trade unlessthey are staring at a newswire in search of information that might move themarket. These traders have turned the gathering of information into an artform.
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Some of the greatest traders in history have been information junkieswho were absolutely addicted to the newswires and now have found solacein the use of the Internet. It’s the information junkie who follows the obscurereleases that the average trader ignores. If I were to ask the average S&Ptrader what the car sales ﬁgures are, or what the retailers are showing forany given week, I would be met with a puzzled look and a shrug of theshoulders. But the information addict knows every detail that is moving themarket. In fact, I ﬁnd that these traders are the best sources to have whenpreparing for the day ahead.
ORDER FLOW
The most proﬁtable type of information comes from people who understandthe nature of capital ﬂows and how they affect the market. The importanceof watching capital or order ﬂow is one of the best-kept secrets amongtraders. Many traders have made untold fortunes because they understoodthe market condition and the nature of the order ﬂow. Again, I’m not talkingabout insider trading but, rather, a true understating of what makes themarket tick. When the Hunt brothers were trying to corner the silver marketin the late 1970s and early 1980s, it was knowledge of order ﬂow that madetraders huge sums of money.
Back in 1973 Nelson Hunt and his brother William Hunt, the sons ofa rich Texas oilman, along with a group of Arab investors, decided theywould try to corner the world’s silver supply. When they began to buy thecommodity, it was trading at roughly $1.95. In 1973 President Nixon hadrecently taken the country off the gold standard and politically the countryseemed to be falling apart. As the decade moved on, the price of silver movedsteadily higher until late 1978 and early 1979, when the price started toreach the $5 mark. It didn’t happen overnight but the move was nonethelessamazing for any commodity at that time. As 1979 progressed, the price beganto skyrocket until it peaked in early 1980 at $49.95 an ounce. The trading inthe pits in Chicago and New York was frantic, with life-of-contract moveshappening in a day. What used to take a year to complete in terms of pricemovement was now happening in a day’s time. The volatility was absurd.Information was at a premium—but what kind of information?
The Hunts used a certain broker in the New York market (the primarysilver futures market). Despite having a presence in Chicago and in London,the New York broker seemed to have a large chunk of the business thatwas generated from the attempted cornering of silver futures. Traders paidclerks to do nothing but stand by the elevator waiting for this broker toemerge and walk toward the trading ﬂoor. I have heard the story from ahandful of veterans who got their start by standing next to the elevator and
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