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Tying It All Together
Introduction
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This chapter ties all the concepts
together
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Markets and instruments
Banks
Central banking
Monetary theory
Discussion of the key economic
indicators and how these influence
securities prices
The Economic Indicators
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Economic indicators measure economic
performance
Some indicators are very important
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GDP growth, unemployment and inflation
These embody the ultimate objectives or goals set
by the Federal Reserve
However, other economic indicators are more
focused on specific measures and provide
insight into how the economy is performing
The Economic Indicators
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These indicators can also influence the
price movement of stocks and bonds
Because of the importance of
indicators, traders know exactly when
these indicators will be released
The Economic Indicators
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Understanding how the market reacts
to a particular indicator requires a twostep procedure
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Understand what the indicator is and its
connector to security prices
Understand the way the indicator behaves
relative to changes in the economy
Gross Domestic Product
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Broadest available measure of economic
activity.
Constant-dollar (real) GDP measures
the final output of goods and services
produced in the U.S. in one year,
without including the impact of changed
prices on the value of those goods.
www.bea.gov
Personal Income and Outlays
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Personal income is all the income we earn
(wages, salaries, fringe benefits, profit, rent,
interest, etc.) plus the transfer payments we
receive (such as veterans/ benefits, social
security, unemployment compensation, and
welfare), minus the social security taxes we
pay to the government.
www.bea.gov
Retail Sales
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Released by the U.S. Department of
Commerce monthly.
Has not been a volatile series even
when measured in constant dollars
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Using retail sales to trace the course of the
business cycle is not so easy nor
satisfactory as using auto sales, housing
starts or consumer credit.
www.census.gov
Producer’s Price Index
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The Producer Price Index (PPI) is a
measure of the average price level for a
fixed basket of capital and consumer
goods paid by producers.
Why do investors care?
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The PPI measures price changes in the
manufacturing sector. Inflation at this producer level
often gets passed through to the consumer price
index (CPI). By tracking price pressures in the
pipeline, investors can anticipate inflationary
consequences in coming months. Investors need to
monitor inflation closely. Just knowing what inflation
is and how it influences the markets can put an
individual investor head and shoulders above the
crowd. Inflation is a general increase in the prices of
goods and services. The relationship between
INFLATION and INTEREST RATES is the key to
understanding how data like the PPI influence the
markets (and your investments.)
Consumer Price Index
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The Consumer Price Index is a measure
of the average price level of a fixed
basket of goods and services purchased
by consumers. Monthly changes in the
CPI represent the rate of inflation.
Why do investors care?
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Inflation is a general increase in the price of
goods and services. The relationship between
INFLATION and INTEREST RATES is the key
to understanding how data like the CPI
influence the markets ( and your
investments.)
By tracking the trends in inflation, whether
high or low, rising or falling, investors can
anticipate how different types of investments
will perform.
Industrial Production
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The Index of Industrial Production is a
chain-weight measure of the physical
output of the nation's factories, mines
and utilities. The capacity utilization
rate reflects the usage of available
resources.
Why do investors care?
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The stock market likes to see healthy economic growth because that
translates to higher corporate profits.
The bond market prefers more subdued growth that won't lead to
inflationary pressures.
By tracking economic data like industrial production, investors will know
what the economic backdrop is for these markets and their portfolios.
Industrial production shows how much factories, mines and utilities are
producing. Since the manufacturing sector accounts for one-quarter of
the economy, this report has a big influence on market behavior. The
capacity utilization rate provides an estimate of how much factory
capacity is in use. If the utilization rate gets too high (above 85%) it
can lead to inflationary bottlenecks in production.
The Federal Reserve watches this report closely and sets interest rate
policy on the basis of whether production constraints are threatening to
cause inflationary pressures.
As such, the bond market can be highly sensitive to this report.
The Employment Report
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Compiled monthly by the Bureau of Labor Statistics
and the U.S. Department of labor
Contains information on employment, average
workweek and hourly earnings
Primary focus from the press is on the
unemployment rate and the level of payroll
employment
Because this report is released monthly, the
employment statistics offer a frequent update on the
state of economic activity
The Employment Report
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Household Survey
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Based on a monthly sample of about 6,000 households
Estimates the unemployment rate based on two questions—
1) are you employed, and 2) if not, are you actively looking
The unemployment rate is the ratio of the number of people
unemployed to the number of people in the labor force
(those working plus those not working, but looking)
Possible bias is a person’s reluctance to admit they are no
longer actively looking for a job, but has dropped out of the
labor force
The Employment Report
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Establishment Survey
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This is the basis for payroll employment
The source of data comes from canvassing
business establishments rather than
households
Excludes self-employed and domestic
workers
Persons who hold multiple jobs can be
counted several times
The Employment Report
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Market brokers/dealers place more
weight on the payroll numbers
compared with the unemployment rate
because the measurement problems are
less
Both reports are lagging indicators—
follow behind changes in overall
economic activity
Housing Starts and Building
Permits
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This report reflects activity in a very
important sector of the economy
Housing accounts for more than 25% of
the investment component of GDP and
40% of the household budget
This report is a leading indicator—
housing increases have a ripple effect in
the economy
Housing Starts and Building
Permits
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Housing Starts—recorded when excavation
begins for a new house or apartment
Building Permits—precedes housing starts
since most localities require building permits
before excavation begins
Housing starts are about 10% greater than
building permits because some localities do
not require permits
Why do investors care?
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Two words...Ripple Effect. This narrow piece of data has a powerful
multiplier effect through the economy, and therefore across the
markets and your investments.
Home builders don't start a house unless they are fairly confident it will
sell upon or before its completion. Changes in the rate of housing starts
tell us a lot about demand for homes and the outlook for the
construction industry.
Furthermore, each time a new home is started, construction
employment rises, and income will be pumped back into the economy.
Once the home is sold, it generates revenues for the home builder and
a myriad of consumption opportunities for the buyer. Refrigerators,
washers and dryers, furniture, and landscaping are just a few things
new home buyers might spend money on, so the economic "ripple
effect" can be substantial especially when you think of it in terms of a
hundred thousand new households around the country doing this every
month.
Purchasing Management
Index (PMI)
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Based on a survey conducted by the
Institute for Supply Management (ISM)
Consists of six questions about
production, orders, prices, inventories,
vendor performance and employment
Respondents are asked to characterize
each activity as either up, down, or
unchanged
Purchasing Management
Index
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A composite index is formed—A number
over 50 represents an expanding
manufacturing sector and below 50
implies contraction
This is a coincident indicator
meaning that its movements occur
simultaneously with economic activity
Consumer Credit
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Changes in consumer credit have been
an important barometer of consumer
activity because they have borrowed
heavily to finance purchases of autos
and other expensive and postponable
items.
Consumer credit growth threatens
inflation.
Consumer Confidence
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The Survey Research Center at the University
of Michigan compiles the Index of Consumer
Expectations.
Consumers are asked a variety of questions
regarding their personal financial
circumstances and their outlook for the
future.
Responses are tabulated according to
whether conditions are perceived as better or
worse than a year earlier.
www.conference-board.org
Index of Leading Economic
Indicators (LEI)
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A group of 10 components that form
the basis for predicting recessions and
economic upturns
This index is released each month by
the Conference Board
As a general rule of thumb, the LEI
turns down before a decline in GDP and
turns up before GDP resumes its
uptrend
Index of Leading Economic
Indicators (LEI)
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Market participants view three
consecutive monthly changes in one
direction as anticipating a change in
economic activity
On average, the LEI seems better in
terms of accuracy and lead time in
predicting downturns compared with
upturns, although neither set of
forecasts are all that accurate
Why do investors care?
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Investors need to keep their fingers on the pulse of the
economy because it dictates how various types of investments
will perform. By tracking economic data such as the index of
leading indicators, investors will know what the economic
backdrop is for the various markets.
In the past ten years, this index has been less useful in
predicting economic turning points, because the index tends to
focus on manufacturing indicators. The economy is more
service-oriented than it was 25 years ago.
The index has been more useful in predicting turning points in
the index of industrial production than in the overall economy.
This indicator tends to get a lot of attention in the media;
nevertheless, bond market players and Wall Street economists
don't place a lot of faith in this indicator because they have not
found it to be very reliable.
How do the stock and bond markets react
to improvements in each of the economic
indicators?
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In general, good news about any of the
indicators related to expenditure drives stock
prices up and bond prices down
Good News Versus Bad News:
The Role of Expectations
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This would suggest that the stock market
should go up if GDP goes up
However, the important issue is not whether
it goes up, but how the movement relates to
the expectations in the market
Upward movements that are larger than
expected will generally increase stock prices,
whereas movements upward less than
expected will tend to lower stock prices
Good News Versus Bad News
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If the expectations are fully realized,
there should be no change in stock
prices since the market has already
fully discounted the movement in
GDP
Thus markets react only to
unanticipated news—only to new
news
Good News Versus Bad News
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The LEI, for example is mostly old news
because most of the component indicators
have been released earlier
Some indicators are less reliable than others
because they are subject to substantial
future revision
An indicator that is less vulnerable to revision
will be more powerful in moving the market
Stock and Bond Valuations
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Why do stocks and bonds react in
opposite directions with unanticipated
news in the economy?
Bond Prices
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Assume a ten-year zero-coupon government bond with a face
value of “F”
Therefore the bond price is as follows:
Bond Price = F/(1 + r)10
Where “r” = the yield on 10 year government bonds
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Since the numerator in the formula (F) is a fixed obligation,
bond prices will decline with increase in interest rates (r)
What causes movements in the yield on 10 year government
bonds?
An expanding GDP and expectations of increasing future
inflation will cause an increase in “r”
Bond Prices
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In addition, The Federal Reserve may elect to tighten
monetary policy to restrain inflation which drives up
interest rates through the term structure of interest
rates
Higher interest rates means that the future cash flow
from the ten-year bond will be discounted at a higher
rate
Therefore, fears of emerging inflationary
pressure plus concern that the Fed will drive
up the federal funds rate will decrease the
value of the ten-year zero-coupon bond
Stock Prices
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Assume a stock paying out all of its
earnings in dividends (D) and that
these cash flows will last forever
These cash flows are discounted at a
rate (k) which consists of the risk-free
rate plus an adjustment for the riskiness
of the stock
Therefore the stock price is as follows:
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Stock Price = D/k
Stock Prices
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Valuation of stocks is more complicated since
good news will likely affect both the
numerator and denominator of the formula
The denominator behaves as it does in the
bond formula, good news will increase
interest rates which lowers value
However, good news about the economy
means that companies will earn more,
implying they will pay higher dividends in the
future
Stock Prices
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This indicates that the numerator will
increase with good news, driving up the value
of the stock
Thus in the stock valuation formula
there are two effects which work in
opposite directions
Which one of these effects dominates-Conventional wisdom on Wall Street is that
the effect on the numerator is usually
stronger than the denominator, so that stock
prices rise on good news
Economic Indicators and
Market Behavior
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One notable departure from the pattern
that stocks and bonds move in different
directions is the reaction to inflation
Unanticipated good news about
inflation (lower than expected) drives
the interest rate down and has a
positive effect on both the stock and
bond market
Economic indicators
and market behavior
Putting It All Together
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Economic indicators are at the center of
a feedback mechanism operating
through economic activity, economic
policy, and investor behavior
These indicators measure how the
economy is currently performing and
suggest how it will perform in the future
Putting It All Together
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Investors, forecasters, and analysts all
observe the indicators and make
assessments about the future—mainly
future dividends and interest rates
Because the Federal Reserve monitors
the economy through these indicators,
favorable or unfavorable news can alter
monetary policy
Can an individual investor make money
on newly released economic indicators?
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Hinges on the ”newness” of news—by the
time we read about an economic indicator, it
is old news
Professional stock and bond brokers/dealers
probably see the “new” news immediately
after the indicators are released and act
accordingly
U.S. economy is intertwined with international
events which impact domestic economic
activity