Tying It All Together

Tying It All Together

Introduction • This chapter ties all the concepts together • Markets and instruments • Banks • Central banking • Monetary theory • Discussion of the key economic indicators and how these influence securities prices

The Economic Indicators • Economic indicators measure economic performance • Some indicators are very important • 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 • 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 • Understanding how the market reacts to a particular indicator requires a two-step procedure • 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 • 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 • 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 • Released by the U.S. Department of Commerce monthly. • Has not been a volatile series even when measured in constant dollars • 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 • 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? • 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 • 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? • 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 • 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? • 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 • 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 • Household Survey • 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 • Establishment Survey • 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 • 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 • 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 • 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? • 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) • 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 • 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 • 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 • 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) • 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) • 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? • 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? • 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 • 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 • 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 • 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 • Why do stocks and bonds react in opposite directions with unanticipated news in the economy?

Bond Prices • 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 • 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 • 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 • 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: • Stock Price = D/k

Stock Prices • 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 • 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 • 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 • 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 • 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? • 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

Tying It All Together