Every week, dozens of economic surveys and indicators are released and reported on in the business news. In fact, there are so many - and the data often makes such small moves - that it can be easy to overlook the importance of this data on the markets. However, as an educated investor, it's important to keep your finger on the pulse of the economy, and indicators are an important way to do that. This article will examine some of the most important economic and market indicators for investors to monitor. Get to know them, and you'll be better prepared to anticipate and react to future market developments.
Tutorial: Economic Indicators
Perhaps the most important indicator of the health of the economy is employment. On the first Friday of each month, the U.S. Bureau of Labor and Statistics releases its monthly unemployment report and nonfarm payroll; these indicate the current unemployment rate and how many jobs have been gained or lost by the U.S. economy, respectively. Market participants eagerly await these reports, and they often result in some of the biggest one-day movements in both bond and stock markets. The employee situation report also influences other important indicators, such as consumer confidence and consumer sentiment.
Because consumers make up nearly 70% of U.S. economic activity, the state of the labor market is of paramount importance to the overall well-being of the economy. This means that a weakening or strengthening labor market can influence the economy. For example, a weakening labor market often translates into lower corporate profits. The basic premise is that when people are out of work, they cannot buy homes or make the necessary purchases that drive corporate profits. (To learn more about the unemployment rate, see The Unemployment Rate: Get Real.)
The mandate of the Federal Reserve is to promote economic growth and price stability in the economy. Price stability is measured as the rate of change in inflation, so market participants eagerly monitor monthly inflation reports in order to determine the future course of Federal Reserve monetary policy.
There are many indicators of inflation, but perhaps most widely known is the Consumer Price Index, or CPI. The CPI measures the change in consumer prices and theoretically determines to what extent life is getting more expensive for the average consumer. Another important measure is the Producer Price Index, or PPI. PPI fluctuations measure the rate of change in inflation for producer goods; if these prices increase substantially, it is more likely that companies will eventually pass the price increases along to consumers. Many economists and market participants prefer to analyze both CPI and PPI without the impact of food and energy, as these industries are known to be very volatile.
Market participants also keep track of the price of key commodities such as oil. Since oil is such a key component of economic activity around the globe, its price is worth paying special attention to. Increases in the price of oil can sometimes have offsetting effects. However, higher oil prices can lead to higher prices for a wide variety of goods because oil is part of many materials as well as a determinate in the cost of transporting goods waiting to be sold. (For more on inflation and the economy, see The Importance Of Inflation And GDP.)
Inflation is a useful metric of corporate valuation because the discount rate to perform discounted cash flow analysis factors is the rate of inflation. Higher inflation corresponds with a high discount rate and subsequently lower project value. On the other hand, deflation is also dangerous because decreased revenue means future layoffs for firms that cannot maintain their full workforce.
Changes in the activity level of consumers have a direct impact on corporate profits and the level of stock prices. There are several ways of measuring consumer activity. (What people buy and where they shop can provide valuable information about the economy. To learn more, see Using Consumer Spending As A Market Indicator.)
One of the most popular ways is to measure consumer confidence. There are several measures of consumer confidence; all are designed to determine how consumers feel about their economic prospects in the coming months. The theory is that when consumers feel more confident, they are more likely to spend; conversely, they are less likely to spend when they feel less confident. Also, because markets are forward looking, there is a tendency for stock prices to reflect the future opinions of consumers today. Another measure of the consumer is retail sales. While consumer confidence is forward looking, retail sales indicators reveal historic shopping patterns. (For more insight, read Understanding The Consumer Confidence Index.)
The housing market serves as another vital economic indicator. Although housing is highly localized and difficult to measure on a national basis, there are several indicators that do a reasonable job. Market participants pay attention to monthly releases such as housing starts, building permits and new home sales in order to get a reading on the level of activity in the housing market. Market watchers also monitor price changes through a variety of indicators such as the S&P/Case-Shiller Home Price Index which monitors home price changes in 20 large American cities. By synthesizing a variety of housing reports, market participants can deduce whether or not people are willing to make large purchases.
In addition to economic indicators, market participants focus closely on measures of investor activity for market clues. Despite popular belief, the best time to invest is not when everyone is bullish but instead when most investors are bearish. If everyone else is bullish, there is no one left to buy and drive prices higher - but this does, of course, depend on your investment strategy. Therefore, readings of investor sentiment are important. A variety of indicators are available. Some are published by large investment firms or research firms, which periodically poll their clients to determine market consensus.
As overseas investors have become increasingly important participants in the U.S. financial markets, measures of their activities have garnered more attention. One of the most closely watched reports focuses the purchase of U.S. Treasuries by foreign central banks. When central banks are buying more Treasuries, interest rates often head lower – when rates are lower, stock prices tend to move higher. The reverse – less buying, higher interest rates and depressed stock prices – also tends to hold true.
Other important market indicators include advance/decline ratios and the number of new highs and new lows in the market. These readings indicate how healthy the overall stock market is and can provide confirmation as to the "quality" of a stock market advance or decline.
The Bottom Line
Knowing what economic and market indicators move markets is only half the battle; the real trick is interpreting the indicators and determining their likely market impact. In addition to the absolute level of an indicator, two other important factors to consider are the trend in the indicator and the market's expectation for that indicator. Taken together, these often determine the market's reaction to a given economic or market report. Learning to anticipate the market's reaction to various indicators requires careful monitoring of financial markets as well as experience interpreting these reports. As with most aspects of investing, hard work and persistence will help an investor determine the likely reaction to economic and market data. (To learn more about indicators, check out Leading Economic Indicators Predict Market Trends.)