Distinguishing Between Signals and Noise

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 11, 2017 2:40:14 PM

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signals and noiseI have written about this concept before, but given some conversations I’ve had recently, I think it’s a great time to revisit it. When trying to understand both what is happening and (ideally) what is going to happen, we need to be able to identify what is important—and what is not. In other words, what signals should we pay attention to—and what noise should we ignore?

Economic and market signals

There are several key indicators that investors need to pay attention to, in my opinion.

For the economy, what really matters are jobs, consumer and business confidence, and whether the Federal Reserve is stimulating. These are the real signals, which is why I track them every month, most recently on Tuesday. While you can learn from some of the other data, much of it is just noise.

For the markets, we need to understand when we’re heading toward a bear market. The important signals here are recession, oil prices, the Fed (again), and valuation levels. In this case, we also have to look at more immediate indicators, such as trend lines and changes in debt levels, but again this is what and why I track them monthly, most recently yesterday.

Putting the noise in perspective

When you focus on the signals—which helps you get the big picture right—you can keep the other data (i.e., the noise) in perspective. In a presentation I’ve been giving for some time, I point out that over the past several years, we have been worried about both a strong dollar and a weak dollar, a rising China and a collapsing China, high oil prices and low oil prices. In each case, if we looked at the longer-term data, there was nothing to worry about—and so it proved. While each of those trends was worth watching, they were not part of the core signal.

Today’s economic concerns are turmoil in Washington, DC, North Korea, and the Middle East. The second two speak for themselves; I am over 50 and can’t remember a time when we have not had problems with both North Korea and the Middle East. As for Washington, DC, the concerns may be real, but from an economic perspective, history suggests that they simply won’t matter that much.

Today’s worry points for the markets are the low level of the CBOE Volatility Index, occasional small dips, and the underperformance of individual companies. Each of these, for various reasons, simply has not been indicative of trouble in the face of the positive signals.

Keep calm and carry on

With strong job growth, high consumer and business confidence, and a Fed that’s still adding vodka to the punch bowl, the economy is likely to keep growing for some time. With improving corporate earnings, high investor confidence, and low interest rates, the market fundamentals remain sound—and so, very likely, will the markets.

That’s not to say this will always be the case. It won’t. Again, though, by identifying what matters—the signals as opposed to the noise—you will be better prepared to make the right decisions when the time comes, and not before.

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