In this part, we score the economic environment. In order to score the economic environment, we analyse to parameters: economic surprises and manufacturing activity/ISM.
Economic surprises :
This indicator is interesting because it was built in order to give, on a weekly basis, the net number of statistics coming above or below expectations. Indeed, for each statistic released, it gets a score of +1 if it comes above consensus, 0 if it comes in line and -1 if it comes below consensus. All data have the same weight, there is no difference between payrolls numbers and home sales. Then, at the end of the week, when we do the summation of all scores, we get the net number of economic surprises.
So, if this number is elevated, it means the economy is much stronger than expected by economists and strategists. At the opposite, when this number is deeply in negative territory, this means economy is much weaker than what has been anticipated by economists and strategists.
At Sigma we consider that when economic surprises are very positive, economists will upgrade their forecast because economy is strong.
Then, week after week, upgrade after upgrade, it will become more and more difficult to beat the consensus. At one point, data will miss forecast and economists will start to cut their forecasts and the opposite process will start.
So, we consider that when economic surprises are very high, the probability to get a negative surprise is high and when economic surprises are at depressed level, the probability to get a positive surprise is rather elevated.
Based on this analysis, we consider that when economic surprises are at elevate levels and that a couple of statistics miss the consensus, then the probability that economists and strategists were over optimistic and that we get further miss is high. So, we give a weak score of ‘1’ for the economic surprises.
At the opposite, when economic surprises are deeply in the red and when we start to get some positive surprises, we consider that strategists and economists have been to aggressive in cutting their forecasts and coming numbers have a good probability to beat consensus. Then, we give a strong score of ‘5’ to economic surprises.
Manufacturing activity and ISM :
In the case of manufacturing activity and ISM, we have roughly the same approach. When manufacturing activity (or ISM) is at high level and gives some slow-down signals, we consider the probability to get a slowdown in the economy is rather high. So, we give a weak score of ‘1’ for the manufacturing activity. At the opposite, when the manufacturing activity (or ISM) is at depressed level and that we get the first signs of an improvement in the economy, then we consider the probability to get an upturn in the manufacturing activity is rather high and we give a strong score of ‘5’ at the manufacturing activity/ISM.