Careful investors pay close attention to economic data for hints about future stock market performance. Specifically, investors look to leading indicators, such as initial unemployment claims. The four-week moving average of initial jobless claims can provide insight about the direction of the economy. Many other economic indicators are either concurrent or lagging indicators.
The American Association of Individual Investors provides a list of 10 important economic indicators. Included on this list is the S&P 500 stock index. While many may believe that stock prices follow the economy, economists and stock market analysts see the S&P 500 as a measurement of future confidence levels for businesses and consumers. An advance by the S&P 500 can bring expanded business investment and increased spending by consumers, whereas a falling S&P 500 can warn investors of reduced spending by businesses and consumers.
Leading Indicators Can Fail to Lead
Although many investors monitor the Conference Board’s Leading Economic Index (LEI), the 10 data components underlying the report are nearly two months old by the time the report is published. Reports for these components are usually released before the LEI report. These areas include manufacturers’ new orders for materials and consumer goods, building permits, consumers’ expectations about business conditions, and manufacturers’ new orders for non-defense capital goods.
One drawback from relying on the initial unemployment claims report for signals about future economic trends stems from independent contractors, part-time workers and self-employed people not being counted among the unemployed by the Department of Labor, since they do not qualify for unemployment compensation benefits. As work opportunities decline for these people, the jobless claims report does not convey this slowdown to investors.
The Census Bureau’s data on housing starts, published in its monthly reports on construction for new privately owned housing units, provides no breakdown on the prices of the homes being built. For example, there may be an increase in construction for high-end homes, while construction for less-luxurious housing could stagnate. In such a scenario, Toll Brothers Inc. (NYSE: TOL) could be outperforming analysts’ expectations, while a lackluster report on housing starts might stifle any share price advance for that company.
Additionally, the Census Bureau’s monthly reports on factory orders, officially identified as the reports on manufacturers’ shipments, inventories and orders, are based on data approximately two months old by the publication date of each report. For example, the April 2016 advance report on factory orders was released on May 26, 2016, and the full report was not released until June 3, 2016.
The Stock Market Is Forward-Looking
Economic reports discuss developments that have already occurred. These developments often result from psychological changes. The stock market can trigger these changes by providing alerts to businesses about the need to expand or downsize. A falling stock market can impair consumer spending and cause economic growth to decelerate.
More importantly, stock market activity can influence the Federal Reserve’s monetary policy, and the expansion of U.S. gross domestic product (GDP) since 2009 demonstrates how the Fed’s monetary policy can impact the economy. The Federal Reserve publishes the minutes from meetings of the Federal Open Market Committee (FOMC). The minutes usually feature a section entitled "Staff Review of the Financial Situation," which provides the committee’s reaction to developments in financial markets, including the stock market. This section also reveals how those developments shape the Fed’s monetary policy. For example, the minutes of the April 2016 FOMC meeting disclosed that:
"Over the intermeeting period, broad U.S. equity price indexes moved up, on net, likely because of investors' views that monetary policy would be more accommodative than previously expected along with an improvement in risk sentiment. Stock prices increased broadly across industries, including the energy sector."
This demonstrates that a bullish stock market response to accommodative monetary policy by the Fed could actually cause the FOMC to feel more comfortable about raising interest rates. However, most investors understand that stocks do not perform well during periods of restrictive monetary policy. As a result, advancing equity indexes can provoke monetary tightening by the Fed, ultimately resulting in a stock market pullback. Ironically, under such circumstances, the stock market would lead itself lower by advancing.