The Economy And The Market: A Tale Of 2 Indicators

It's tough out there, and all of us know that. All we have to do is go out into our community, read the paper and look at our paychecks (or lack of) and we see that the economy isn't what it once was. But you wouldn't know that by looking at Wall Street. Investment markets have been on a tear in 2010, which has been a source of frustration for Americans who are struggling. So, why is the economy sputtering if the markets are soaring high? (For related reading, also take a look at How Education And Training Affect The Economy.) IN PICTURES: Obtaining Credit In A Bad Economy

Okun's Law
Think of your economic life for a moment: every action you take in your economic life is based on your employment. You, like most people, rely on your job to maintain your standard of living, and the overall economy relies on you having a job in order to expand. Your work is important, and without it the economy suffers, and this is one of the main main reasons why our economy is where it is today.

Before we look at why unemployment is one of the most reliable measures of the economy, let's look at Gross Domestic Product (GDP). GDP is simply the value of all finished goods and services produced in a country during a certain time period. GDP measures the health of an economy, and is directly and most dramatically affected by the unemployment rate.

Arthur Okun, an economist, studied historical data and figured out that real GDP grows at about 3-4% per year when unemployment is at a stable normal rate. (Normal unemployment is hard to define, but 4-5% is a number commonly seen.) For every point above normal that unemployment moves, GDP growth falls by 2-3%. On the other hand, for every point below normal that unemployment moves, GDP growth rises by 2-3%. It should also be noted that Okun himself states that this formula is meant to be an estimate.

The current unemployment rate, just shy of 10%, is nearly twice the normal rate, yet our nation's GDP is not down by 10%. Still, the GDP is down considerably, showing us real evidence that the economy is suffering. Until jobs return, all aspects of the economy will be affected. Housing won't recover, discretionary purchasing will remain slow and the federal government will continue to inject money in to the economy.

The Stock Market
If the economy is really that slow, the investment markets should be slow as well, right? When Americans, 10% of which are not working and/or are evicted from their homes, hear that the stock market has risen nearly 15% since July 2010, some are justifiably frustrated. Nut before we vilify Wall Street, let's look at why this may be the case.

Leading Indicator
Remember in 2008 when the stock market crashed? It wasn't until later that we saw the unemployment rate reach higher levels and the many other effects of the recession really take hold. The reason for this is because investors in the stock market are always making decisions based on what they think will happen in the future. Knowing that the stock market is always looking in to the future is great news for all of us because economists would argue that seeing the stock market continually rising right now means that investors believe that there is bright future for our economy and it may not be as far away as we once thought. (For additional information, see Leading Economic Indicators Predict Market Trends.)

IN PICTURES: Eight Ways To Survive A Market Downturn

The New Investor
On the other hand, it's important to remember that the stock market has various types of participants with different goals. An investor makes long-term bets based on real economic indicators. Watching the actions of the long-term investors can give us a reliable indication of where the economy is going.

Traders see the market differently. Technical traders read charts looking for short-term trends and some make trades based on mathematic formulas instead of real economic conditions. In fact, some traders have computers making trades for them, sometimes in the thousands of trades per day. While you may think that these traders are the minority, in fact an estimated 70% of all trades made in the U.S. markets are done by computers. This instance is referred to as high frequency trading.

QE2
Last, sometimes the stock market reacts to artificial events. The dramatic rise in the stock market in the third and fourth quarter of 2010 is largely attributed to the rumors and the eventual announcement of the government purchasing a large amount of treasuries in order to give the economy a boost (this was called QE2). This influx can be misleading because it makes the economy look artificially healthy. We didn't truly know how to ride the bike until the training wheels are removed. When the government removes the training wheels from our economy, the stock market will be at risk for a big move down.

The Bottom Line
While it may be frustrating to see Wall Street prospering while others are without jobs and evicted from their homes, there may be logical explanations for this. Also remember that if you have a 401(k), IRA, or other investment vehicle, the real economy may still be tough for you but your retirement account has most likely seen a dramatic recovery.

Find out what happened in financial news this week. Read Water Cooler Finance: G20 Leader Spats And China Fakes It.

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