Most people have at least a general understanding that the stock market is intended to represent our underlying economy.
After all, the companies that make up the TSX Composite (Canada’s benchmark index for publicly traded securities) constitute the majority of the value held in our country’s private sector. When the economy is performing well, it usually bodes well for the stock market too.
But, of course, the economy has also gone through its share of cyclical booms and busts over the years. Consequently, the stock market has tended to follow suit.
This begs the question: what clues should investors look for, to yield better returns from the market?
In this article, we’ll discuss some of the more closely watched economic indicators, and what they reveal about the underlying activity taking place within the economy? What is the relationship between those economic indicators and the public markets?
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What is the relationship between the economy and the stock market?
As mentioned above, these two are closely aligned. If the stock market does well, typically it’s a sign the economy is growing healthily — as measured most notably by gross domestic produce (GDP). Businesses produce more, which leads to higher valuations, and finally, stock market gains.
Related Reading: Is the Longest Bull Market Over?
Economic indicators and the stock market
Governments, businesses, and investors all share a common interest in actively/accurately monitoring the level of activity in the economy.
Having a solid understanding of not only where the economy is today, but also where it might be in six months from now can help a great deal in allowing these ‘economic actors’ to facilitate their planning and capital budgeting decisions.
Usually, the responsibility for monitoring economic activity falls on various government agencies to collect, assemble, and report on key economic indicators. These are of the utmost importance to those making investing decisions.
Broadly speaking, there are three types of indicators.
- Leading indicators help predict the direction the economy may go next.
- Coincident indicators are a barometer to tell us how the economy is doing today.
- Lagging indicators confirm a previously identified trend.
Let’s look at each of these indicators.
Leading economic indicators
The number of initial claims for unemployment benefits is one of the most widely reported indicators in the mainstream press.
The idea behind economists tracking this key data point? Individuals claiming unemployment benefits for the first time are more than likely newly laid off from their employer.
If initial jobless claims show a significant increase over a short period of time? The odds are that employers in the marketplace have been actively letting people go. This would likely be in response to an anticipated slow down in business.
First-time unemployment claims garner the most mainstream media attention.
Laying off employees (mostly captured by initial jobless claims) is often a costly measure for organizations. Employers typically pay severance to former staff. Not to mention the expenses associated with rehiring and training new employees when business eventually recovers.
Because of this, the first step an organization is likely to take when trying to scale back operating costs is reducing overtime hours. This goes in tandem with reducing the number of hours budgeted for its part-time and temporary workers.
A prolonged trend in the reduction of manufacturing hours worked can be another valuable indicator to suggest that business activity may be starting to slow.
Related Reading: The Important Role of Central Banks
Coincident economic indicators
Let’s stick with the theme of studying labour market data for a moment. One of the most widely followed coincident indicators is the number of employees that presently sit on non-agricultural payrolls.
The idea with this measure is essentially the same as the first two (initial jobless claims and manufacturing hours worked). Simply put, economists are trying to get a read on how many people are actively working in the economy.
The difference with non-agricultural payrolls is that it tends to be a more conservative measure for two reasons.
First, it acts to smooth out short-term fluctuations that can arise from the variability of manufacturing hours worked. This can sometimes threaten to provide analysts with false signals. Second, it allows for an increase in demand for hiring in one labour market to offset another market that might be experiencing a decline.
Take, for example, the case of widespread layoffs within the print publishing industry. This would spike initial jobless claims. However, if those job losses were to be more than offset by increased hiring within the technology sector? The result would be a good, rather than a bad one, for the broader economy.
The give and take here with using the monthly non-farm payroll figure, is that in exchange for what is arguably a smoother, more reliable indicator, the signal it provides will coincide with, rather than lead the trend of the economy. This means it may not prove quite as valuable for those trying to forecast into the future as some of the aforementioned leading indicators.
Lagging economic indicators
At this point, you might be wondering what is the point of a lagging indicator — especially if it’s reporting on something that has already happened.
Lagging indicators can be part of economic forecasts. This is similar to how coincident indicators can help confirm a trend first suspected using leading indicators. Basically, they can help to confirm what economists have already been anticipating.
Take, for example, the number of new loans being issued to businesses and individuals by lending institutions. The lending business has traditionally been conservative. An increase in new loans will often indicate that financial institutions have good reason to believe that business conditions have already begun to improve.
Related Reading: How do world events affect the stock market?
How do economic indicators relate to the stock market?
Analysts and wealth managers alike follow economic indicators. These indicators can help to explain what is taking place beneath the surface of the underlying economy.
One of the key indicators not already discussed is the general trend of the stock market itself.
As a forward-discounting mechanism, prices for publicly traded securities should be representative of what investors are anticipating that companies will earn in the future, rather than what they have earned in the past.
No one is suggesting that there is a “fail-safe approach” allowing forecasters to consistently predict the next bull or bear market. Investors will be served well by familiarizing themselves with some of the more widely followed economic indicators, and the role they play in the underlying economy and stock market.
Investors and analysts can’t reliably predict where the market is headed next. At the very least, they have a greater sense of awareness as to where the economy – and the market – is at any given point in time.
Keeping in mind that, like the weather, markets – and indicators – can be notoriously fickle. More often than not, the best plan of action will be to stay the course while maintaining a clear view of the horizon.
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