This is MoneyClub

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 14 Chapter Guide

Prelude

Economic Data and the Market

Principles of Market Reaction

Information Content of Data Releases

• Economic Growth and Stock Prices
  • The Employment Report
  • The Cycle of Announcements
• Inflation Reports
  • Core Inflation
  • Employment Costs
  • Impact on Financial Markets
• Central Bank Policy

CONCLUSION

—————————————–

Chapter 14 Chapter Takeaways

Prelude
-Anecdote on the impact of US employment statistics. Low employment in 1996 -> Bonds collapsed as traders expected higher rates. S&P futures fell. European markets sold off almost 2% – world equity markets lost $200 bilion, and world bond markets just as much. Main Street’s good news can be bad news on Wall Street, because interest rates, inflaiton, and the future direction of the Fed policy have a major impact as well as mere profits.

Economic Data and the Market
-Economic data not only frame the way traders view the economy but also impact traders’ expectations of how the central bank wil implement its monetary policy. Stronger economic growth or higher inflation increases theprobability that the central bank wil either tighten or stop easing monetary policy. ALl these data influence traders’ expectations about the future course of interest rates, the economy, and ultimately stock prices.

Principles of Market Reaction
-Markets do not respond to what is announced; they respond to the difference between what traders expect to happen and what actually happens. TO understand movements, one must identify the market expectation for the data released, often the consensus estimate.

Information Content of Data Releases
-Data are analyzed for implications on future growth, inflation, and central bank policy.
-Faster growth raises interest rates because: 1. stronger economic activity makes consumers confident, increasing loan demnd. Firms motivated to expand production, increasing demand for credit. 2. this growth might be inflationary especially at the end of an economic expansion, without corresponding growth in productivity.
-Central banks: the threat of inflation make it likely that the bank will tighten credit.
-Another important principle: the market reacts more strongly after several similar reports in the same direction, as there is a lot of noise in individual reports.

• Economic Growth and Stock Prices
  -Stronger-than-expected growth has 2 opposite implications for the market. A strong economy increases future earnings. But it also raises interest rates. Which effect is stronger depends on where the economy is in the business cycle. From research, a strong report increases stock prices in a recession as profits are considered more important. DUring expansions, the interest rate effect is usually stronger.
  • The Employment Report
    -Bureau of Labor Statistics – single most important data report. It does 2 different surveys, measuring employment and unemplyent. The payroll (also “establishment”) survey counts total jobs on payrolls. The household survey counts total number of people looking for jobs, determining the unemployment rate. Traders typically look at nonfarm payroll as farm employment is very volatie and not associated with cyclical economic trends. Because these are 2 different surveys, the rates can both rise for a few reasons. Economists downplay the importance of this figure because of that. Since 2005, Automatic Data Processing corp has released its ADP National Emplyment Report which provide hints at BLS data 2 days ahead.
  • The Cycle of Announcements
    -See pg 243 for monthly chart of announcements.
    -Purchasing managers index – a reading of 50 means half the managers report rising activity. A reading of 52 is a normally expanding economy. A 60 means a strong economy. Below 50 is a contracting manufacturing sector, and below 40 is almost always a sign of recession. A service sector index is also published two days after this.
    -There are many reports released before those with good correlations, like the Chicgo Purchasing Managers report, UMIch sentiment indicators, and COnference Board survey.
• Inflation Reports
  -The first inflation release is the Producer price Index. The next day – th Consumer Price index, the benchmark measure of inflation, also a link to many government and private contracts. However economists regard the PPI as more sensitive to early price trends as wholesale prices rise before retail.
  • Core Inflation
    - Excluding volatile food and energy sectors (which change due to weather and disruptions). Greenspan and Bernanke have supported the personal consumption expenditure deflator in calculating the consumption component of the GDP accounts.
  • Employment Costs
    -Labor costs – hourly wage rate. Since labor costs average nearly 2/3 of a firm production costs, increases in wage over increases in productivity increase costs and lead to inflation. the Employment index released quarterly also includes benefit costs so is more comprehensive. The Fed weighs this more and so do the markets.
  • Impact on Financial Markets
    -Lower than expected inflation lowers interest rates, boosts bond and stock prices. vice versa.
• Central Bank Policy
  -Chapter 13 showed that 4 of the top 5 largest one-day rallies were involved with monetary policy. Lowering short term rates and providing credit is almost always welcome.
  -Chapter 11 showed that over the past 50 years, tightening by the Fed was associated with poor returns over the next year while easing boosted the market.
  -The only case in which stocks react poorly is if the CB eases excessively so the market fears increase in inflaiton. If so, the investor would prefer to be in stocks than bonds as bonds are hurt more by unexpected inflation.

CONCLUSION
-The reactions of financial markets are not random and can be predicted. Strong growth raises rates but has an ambiguous effect on stock prices. Inflation is bad. Cenral Bank easing is good.
-The focus of traders constantly shift – in the 1970’s, inflation was prime. Volcker then shifted it to monetary supply. 1980’s when the dollar soared, trade stats were it.
-This chapter focused on the short run reaction of financial markets to economic data. Investing on the basis of these releases is a tricky game.