Understanding The Effects Of Critical Economic Indicators On The Stock Market (Part1)

If you have been following the news on a daily basis, you surely would have heard the repeated news on the fall of the US and European markets that are currently spreading across the globe. With the risk of global recession on the incline, global stock markets are not left unscathed by the predicament the world’s economic giants are in.

Stock markets worldwide are left to face strong selling pressures that are wiping out their asset values. Underpinned by such scenario, you would be wondering whether your portfolio (albeit confined to the local business environment) is strong enough to weather the adverse external shocks that are causing jitters in markets across the globe?

Why do you need to understand and monitor the economic situation?A company’s earnings and future prospects depend largely on the overall business and economic climate. No matter how strong a company’s fundamental is, if the economy is down, the performance of a company will inevitably be affected to a certain extent.

Cyclical stocks will probably face a larger impact compared to non-cyclical or defensive stocks. Meanwhile, the stronger companies will be able to weather the harsh economic situation compared to the weaker ones. Therefore, as an investor, it is important for one to understand the macro picture of the economy, not just the sector/industries or stock/company that one is interested in investing.

What is an economic indicator?
An economic indicator is in simple terms, the official statistical data of a certain economic factor that are published periodically by the government agencies, that investor can use to gauge the economic situation.

It allows the investors to analyze the past and current situation, and to project the future prospects of the economy. There are three basic indicators that are significant to the investors in the stock market, namely inflation, GDP (gross domestic products) and the labor market.

Inflation
Inflation is important to all investments, simply because it determines the real rate of return that you get from your investment. For instance, if the inflation rate is 5% and the nominal return is 8%, this means that your real rate of return is 3% as the 5% has been eaten by inflation.

Inflation’s impact on the stock market is even more complicated. A company’s profit will be impacted with higher inflation. Its input cost will increase and the rate of increase would depend on how much of the incremental cost the company is able to pass on to its consumers.

The amount that the company will have to absorb will reduce its profits, assuming all else being equal. The stock market will suffer further negative impact if it is accompanied by increased interest rate as bond market is seen as a cheaper investment vehicle compared to stocks. When this happens,investors will sell off their stocks to invest in bonds instead.

The most commonly used indicator for the measurement of inflation is CPI (consumer price index). It consists of a basket of goods and services commonly purchased by consumers, such as food, housing, clothes, transportation, medical care and entertainment.

The total value of this basket of goods and services will be compared to the value of the prior year and the percentage increase will be the inflation rate. On the other hand, where the value drops, it will be a deflation rate. A steady or decreasing trend will be favorable to the overall stock market performance.

GDP (Gross Domestic Product)
Another important indicator is the GDP measurement. It is the total value of goods and services produced in a country during the period being measured. When compared to the previous year’s reading, the difference between these two readings indicates whether a country’s economy is growing or contracting.

GDP is usually published quarterly.
When the GDP is positive, the overall stock market will react positively as there will be a boost in investor confidence, encouraging them to invest more in the stock market. This will in turn boost the performances of companies. When the GDP contracts, consumers would tread cautiously and reduce their spending. This in turn will affect the performance of companies negatively, thus, more downward pressure will be exerted on the stock market.

Labor market
The unemployment rate as a percentage of the total labor force will basically indicate the country’s economic state. During an economic meltdown, most companies will either freeze hiring or, in more severe cases downsize, by alleviating cost and reducing capacity. When this happens, the unemployment rate will increase, which in turn, creates a negative impact on the market sentiment.

Bottom line
By understanding the economic indicators, you should be able to gauge the current state of economy and more importantly, the direction in which its headed. Pooling this knowledge together with the detailed research on the companies that you are interested in, you should be well equipped to make sound investment decisions.

Bear in mind that when the economy slows down and the market is on a downward trend, it is not necessarily bad as this could be your golden opportunity to spot some good stocks at a bargain that are worth buying.