4.1.1 Economy

The stock market does not operate in a vacuum. It is an integral part of the whole economy of a country. To gain an insight into the complexities of the stock market one needs to develop a sound economic understanding and be able to interpret the impact of important economic indicators, which may be studied to assess the national economy as a whole. The leading indicators predict what is likely to happen to an economy. Perfect examples of leading indicators are the unemployment position, rainfall and agricultural production, fixed capital investment, corporate profits, money supply, credit position and the index of equity share prices. An overall growing or a contracting economy affects every industry in the country positively or negatively. One can seldom find flourishing industries in an otherwise stagnant economy. Thus, understanding economy and capital flows, interest rate cycles and currency fluctuations, etc. is very important as it impacts the stock prices.

Economic Indicators

An economic indicator (or business indicator) is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance. Economic indicators include various indices, earnings reports and economic summaries, such as unemployment, housing starts, consumer price index (a measure for inflation), industrial production, bankruptcies, Gross Domestic Product, broadband internet penetration, retail sales, stock market prices, money supply changes etc. Economic indicators are primarily studied in a branch of macroeconomics called “business cycles”. Economic Indicators can have one of three different relationships to the economy:

• Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the same direction as the economy. Therefore, if the economy is doing well, this number is usually increasing, whereas if we are in a recession this indicator is decreasing. The Gross Domestic Product (GDP) is an example of a procyclic economic indicator.

• Counter cyclic: A counter-cyclic (or countercyclical) economic indicator is one that moves in the opposite direction as the economy. The unemployment rate gets larger as the economy gets worse so it is a counter-cyclic economic indicator.

• Acyclic: An acyclic economic indicator is one that is not related to the health of the economy and is generally of little use. They have little or no correlation to the business cycle: they may rise or fall when the general economy is doing well, and may rise or fall when it is not doing well.

Economic indicators fall into three categories: leading, lagging and coincident.

Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession. Baltic Dry Index, an index that tracks bulk dry freight rates across the world is another leading indicator and indicates a slowdown in the bookings for bulk dry carriers with its fall and thus indicating a subsequent slowdown in the international trade. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Personal income, GDP, industrial production and retail sales are coincident indicators. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle.

Many different groups collect and publish economic indicators in different countries. In the U.S. the collection of economic indicators is published by the United States Congress. Their Economic Indicators are published monthly and are available for download in PDF and text formats. The indicators fall into seven broad categories. Each of the statistics in these categories helps create a picture of the performance of the economy and how the economy is likely to do in the future.

• Total Output, Income, and Spending

These tend to be the broadest measures of economic performance and include such statistics as the Gross Domestic Product which is used to measure economic activity and thus is both procyclical and a coincident economic indicator. The Implicit Price Deflator is a measure of inflation. Inflation is procyclical as it tends to rise during booms and falls during periods of economic weakness. Measures of inflation are also coincident indicators. Consumption and consumer spending are also procyclical and coincident.

• Employment, Unemployment, and Wages

The unemployment rate is a lagged, countercyclical statistic. The level of civilian employment measures how many people are working so it is procyclic. Unlike the unemployment rate it is a coincident economic indicator.

• Production and Business Activity

These statistics cover how much businesses are producing and the level of new construction in the economy. Changes in business inventories is an important leading economic indicator as they indicate changes in consumer demand. New construction including new home construction is another procyclical leading indicator which is watched closely by investors. A slowdown in the housing market during a boom often indicates that a recession is coming, whereas a rise in the new housing market during a recession usually means that there are better times ahead.

• Prices

This category includes both the prices consumers pay as well as the prices businesses pay for raw materials and include:

• Producer Prices [monthly]

• Consumer Prices [monthly]

• Prices Received And Paid By Farmers [monthly]

These measures are all measures of changes in the price level and thus measure inflation.

• Money, Credit, and Security Markets

These statistics measure the amount of money in the economy as well as interest rates and include:

• Money stock (M1, M2, and M3) [monthly]

• Bank Credit at all commercial banks [monthly]

• Consumer credit [monthly]

• Interest rates and bond yields [weekly and monthly]

• Stock prices and yields [weekly and monthly]

Nominal interest rates are influenced by inflation, so like inflation they tend to be procyclical and a coincident economic indicator. Stock market returns are also procyclical but they are a leading indicator of economic performance.

• Government Finance

These are measures of government spending and government deficits and debts:

• Budget Receipts (Revenue)[yearly]

• Budget Outlays (Expenses) [yearly]

• Union Government Debt [yearly]

Governments generally try to stimulate the economy during recessions and to do so they increase spending without raising taxes. This causes both government spending and government debt to rise during a recession, so they are countercyclical economic indicators. They tend to be coincident to the business cycle.

• International Trade

These are measure of how much the country is exporting and how much they are importing:

• Industrial Production and Consumer Prices of Major Industrial Countries

• International Trade In Goods and Services

• International Transactions

When times are good people tend to spend more money on both domestic and imported goods. The level of exports tends not to change much during the business cycle. So the balance of trade (or net exports) is countercyclical as imports outweigh exports during boom periods. Measures of international trade tend to be coincident economic indicators.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going which is of great help when assessing the overall health of the economy