Economic Data and Alpha Generation

A whole bunch of noise - and critical signal

Practically every trading day some economic data is released in a major country. In the US data is released 3-4 out of every 5 days of the trading week. An entire industry exists to predict the data before it’s released and then after release either boast about the accuracy of the prediction or attempt to explain why the wrong prediction was actually right if you parse the data in a certain way. Don’t get me started on the fact that all this noise occurs and then a month or quarter later revisions change the data completely. While we all get sucked into this vortex of the “most important “xyz” data release of our lifetime” perhaps you may consider that you are being manipulated to care about something by an entire industry that benefits from your research budget and the trades you may do based on these data releases. As a cynic I recommend you pay zero dollars to research providers that predict economic data releases and do zero trades based on economic data releases. Your pnl will thank me.

As you probably know by now I think beating the market is really hard and most people can’t do it. However, I also really believe in risk tolerance, probability and random distributions and know that people can beat the market in two ways

• Luck

• Taking more risk than their benchmark

If you are lucky and you take on more risk than benchmark you can beat the market. Good luck.

This article is about beating the market via skill, not luck or risk tolerance, and particularly by using economic data to beat the market.

What is economic data good for?

I will break this question into two parts. Economic data is critical in one sense and almost certainly useless in another sense. Critical in understanding the overall economy and how it is likely to evolve and useless in “trading” the specific data releases. Using economic data for its critical function is what macro investing is about. Trading the specific data releases is mostly a fool’s errand. Before I move to how I use economic data i’ll deal with the fool’s errand.

Trading data releases

I repeat this is a fools errand and you should pay zero dollars to those who encourage this activity and do zero trades based on economic data releases. However if there was reliable alpha here is what it would take to generate that alpha.

1. Predict the economic release relative to expectations

2. Predict the market positioning before the release

3. Respond to market movements after the release that missed the implication of the release

4. Incorporate a true and accurate surprise data release into your medium term understanding of the future path of the economy in a high quality way - I’ll come back to this one in my critical uses of economic data but will note that the industry always extrapolates this sort of surprise as life changing and excitement provoking when most a overwhelming majority of such cases are false signals

Predict the economic release relative to expectations

Hundreds if not thousands of published and internal institutional economists predict every single economic release. Some are long term biased pessimistic and some are long term biased optimistic. Others use “established” consensus as their analytical tool and tweak their own estimate to be out of consensus to be “edgy” and sell their research. Others are legitimate unbiased and data driven economists truly predicting the numbers with all manner of high quality work and while rare some of these guys isolate themselves from group think and don't even know what consensus is before they print their estimate. The result of all this “work” is a distribution of guesses of the economic release. That distribution has a mean/median which generates a “consensus” and a distribution curve. What is needed from those who guess the number is NOT accuracy its accuracy when the number releases is NOT consensus. An economist who always matches consensus will be most accurate and completely worthless. An economist who is always pessimistic will be accurate when the release is pessimistic which may appear to be valuable but is extremely costly when the release is optimistic relative to consensus. The ideal economist for this alpha source would be at consensus when consensus is the release, pessimistic when pessimistic release occur and optimistic when optimistic releases occur. That economist has a chance of beating markets with skill. But the distribution of all guesses including the mean and median do not have to have any connection to market pricing prior to the release.

Predict the market positioning before the release

As mentioned above economist guesses form a distribution of guesses with a “consensus”. Economists who guess economic releases are ill suited to determine the market positioning before the release. I am a believer in efficient markets over a reasonable time frame but simply can’t imagine a scenario where “economic consensus” and “market positioning consumes” are the same moments before a data release. The odds are extremely low at any moment and extremely high over 100’s of data releases in aggregate. So that's an interesting source of alpha. If you are able to assess positioning ahead of a number you may have alpha even if the number is dead on economic consensus. But besides the short term catalyst of the data point which may make you right quicker the alpha is not in the guessing it’s in the assessment of positioning. Do you have that source of alpha locked in?

Respond to market movements after the release that missed the implication of the release

After the release a combination of the two potential sources of alpha above can overwhelm available liquidity and the data when analyzed can also be interpreted better at the detail level by economists As an economist quickly and in an unbiased fashion (you may have just blown your estimate or you may be patting yourself on the back) interpreting the new data may provide some edge. As a positioning expert you may be able to see the end of a badly positioned unwind. These are potential sources of alpha.

Notice all of this stuff is very hard to do and everyone is hyper (over) focused on the release Plus market makers widen their spreads during the whole 30 minutes it might matter. Also notice it’s 30 minutes of window before markets lose interest in the data and look to the next data release

Incorporate a true and accurate surprise data release into your medium term understanding of the future path of the economy in a high quality way

One of the most common and utterly useless outcomes of a well of consensus economic release is the false signal. Economists and some market participants will take a noisy piece of data that may be revised away in the next release and suggest a major pivot has occured. They then extrapolate that pivot to a major market or policymaker move. This is almost always wrong. BUT it does happen. The first soft inflation print in the fall of 2022 resulted in the bottom of the post Covid stock and bond selloff. It was critical to place the data release in the context of a larger pricing and macroeconomic framework and differentiate noisy data from signal. Hundreds or perhaps thousands of data points are produced each year. Dozens or perhaps scores of these data points are well off consensus A handful are pivotal. Aloha exists medium term in ignoring the noise and finding the signal

Data release alpha generation

I think guessing numbers is hard and even the best economists suck at it not because they are inaccurate but because they are accurate when it doesn’t matter and unreliable or perma biased when it does. Positioning is extremely hard to assess. Post release reaction is extremely short lived and requires a rare combination of speed, trading and economist expertise. Most off consensus outcomes are false signals of a pivot By and large it’s just gambling on a well covered event with the house charging research fees and spreads I don’t bother and I am pretty well versed in every aspect of collecting alpha mentioned above

Economic Data is Critical for alpha generation

Wait, Wut? After all that I’m now saying that economic data is critical? What the heck. Let me explain.

imagine that all the recent economic data and all other positioning, flow, value, momentum, policymaker actions, and a full range of issuer and investor data is placed in front of you as a snapshot of current conditions. Imagine that snapshot is digital and pixelated and while rich in detail is incomplete. Then imagine stacking 1000’s of frames of that picture into a movie that spans back through all recorded history of every data feed today (becoming more pixelated the farther back you go). That’s the critical data that I am speaking about and each release piles an individual pixel on the current snapshot. Great investors have seen the movie over and over again. Great computer systems have digitized every frame of the movie and its progression through time. The truly great have filled in pixels and the perhaps even more importantly have built alternative cuts in their mind or computer of movies that never happened but who could have happened based on the data linkages they observed in this particular “metaverse”. Having watched the movie and individual scenes the macro trader can consider the whole current snapshot and project the next snapshot with greater confidence. Thats the whole deal!

The whole movie allows us to test linkages and consider the whole picture with greater confidence. The linkages built allow us to consider alternative snapshots that may not have existed before providing increase confidence dealing with a new and unusual picture

Lastly by seeing what a picture looks like across a full range of data when an out of consensus data point is released we get a fighting chance to determine if it’s a false signal or a rare and truly actionable pivotal release

btw this critical usage of data is really really hard to do as well. But it’s valuable unlike the nonsense and uselessness of a majority of noise your read in the hours before and after some silly standalone data release that the entire industry of ink spillers and bid offer spread collectors want you to act on. Better to just own beta and go about your life