Portfolio Management - Economic Indicators (Part 2 of 2)
Leading indicators are intended to determine the level of economic activity six to nine months from the time the data is gathered. They include the following:
- Average weekly manufacturing hours
- Average weekly initial claims for unemployment insurance
- Manufacturers' new orders for consumer goods and materials (that is, supplies to make new finished products)
- Vendor performance, slower deliveries diffusion index (when suppliers cannot get goods to industrial customers fast enough, that suggests demand may be growing)
- Manufacturers' new orders for non-defense capital goods (that is, machinery to make new finished products)
- Building permits for new private housing units
- Share prices of 500 widely held common stocks
- M2 (cash and cash equivalents) money supply (if people are selling their stocks, bonds and real estate and putting the money in checking accounts, it suggests big purchases are about to take place)
- Interest rate spread, 10-year Treasury bonds less federal funds (if interest rates are lower for long-term investments than for short-term, the economy is in trouble)
- Index of consumer expectations
Coincident indicators vary directly and simultaneously with the business cycle, and include:
- Employees on nonagricultural payrolls (jobs being a major component of the economy, a current measure of the total work force would, by definition, have to be a coincident indicator)
- Personal income less transfer payments (that is, active and passive income not including Social Security and other human services entitlements)
- Index of industrial production (broad indicator of goods in process throughout the industrial pipeline)
- Manufacturing and trade sales
Lagging indicators confirm long term trends in the economy, but do not predict them. They include the following:
- Average duration of unemployment
- Inventories-to sales-ratio for manufacturers and sellers (high inventories suggest the economy is in recession)
- Change in labor cost per unit of manufacturing output (peaks during recessions, just before layoffs)
- Average prime rate (bank interest rates follow Federal Reserve interest rate policies, which tend to follow rather than lead the economy)
- Total commercial and industrial loans outstanding, in dollars (companies take out fewer loans and pay down the ones they have when they have no incentive to invest in new means of production or sales channels)
- Consumer installment credit to personal income ratio
- Consumer price index for services
The private, non-profit Conference Board, under the auspices of the Commerce Department, defines and disseminates the official indicators. When the Conference Board took over the job in 1995, the composition of the index and its methodology changed drastically. Older Series 7 guides and economics texts are outdated.
Indicators Effects on Securities Markets
These indicators have profound effects on the securities markets:
- In the bond market, for example, as inflation rises, interest rates rise. Interest rates rise as bond prices decline. In a healthy economy, longer-term bonds have higher interest rates than shorter-term bills; however, as the economy experiences a contraction, the yield curve inverts and it costs more to borrow money overnight than to borrow it over 10 years.
- In the equity market, some stocks are sensitive to interest rates; that is, the higher interest rates go, the lower their share prices plummet. REITs and mortgage lenders are hit especially hard. Utilities, which mirror the bond market with high dividends that act as coupon payments, also drop in price when interest rates go up.
The stock market as a whole is allergic to high interest rates for a very good reason: suppose that during a healthy expansion you expect your bond portfolio to yield 4% and your stock portfolio to earn 10% between dividends and share price appreciation. That difference is fine, because your bonds are much less risky than stocks. Now comes the contraction and interest rates - that is, your bonds - are suddenly 6%, while your stocks are only returning 7%. Why take on the risks of equity ownership as opposed to debt holding for that paltry difference? In such situations, Wall Street money flows out of stocks and into bonds.