Thoughts on Following the Stock Market

As this is a blog about economics and the Rhode Island economy, it's time for me to discuss some basic economics. As you are no doubt aware, the stock market has been correcting of late and it has become extremely volatile on a day-to-day basis. This has inevitably lead to both panic and confusion for the everyday investor. What should you do? How can you better understand all the things that are going on?

These are very important questions, ones that clearly need to be addressed. In this post, I will make a few recommendations on reading material, and introduce a several concepts that will help you navigate your way through all of this.

First, let me recommend an excellent book that will provide you with a basic framework for following the stock market in general: Fire Your Stock Analyst (2nd edition) by Harry Domash. I suspect this will be the best $20 you spend in a long, long time. It is not one of the all-too-plentiful "how to make $1 million" books. I find those to be totally worthless (except to the authors)! Domash's text will provide you with a foundation you can build on, by providing a meaningful basis for you to begin understanding how stock prices are determined and how they change.

I also recommend that you use some website or brokerage site that will allow you to graph any stock (or ETF or mutual fund) that you own, or are considering purchasing. For stocks that you already own, look at its chart on both a daily and weekly basis (different time frames are important for perspective). If you are also able to generate monthly charts, all the better.

This leads me to a second book recommendation: STIKKI Stock Charts. Yes, the spelling is correct. This book, which costs $12,will open your eyes to another dimension of following the stock market: don't just focus on closing prices. Over a single time period, whether it be a day, a week, or a month, price will vary over a range. Therefore, information is available on not only the closing price, but on the opening price, the high over that period, and the low. STIKKI Stock Charts illustrates this effortlessly, providing you with numerous examples, so that in about an hour, you will see that there is a lot more going on than you had been aware of before.

Beyond these reference books, there is a pair of very simple concepts, frequently discussed in the media, that you need to know and understand. I am referring to support and resistance. What is interesting about all of this, is the fact that market prices are determined by supply and demand. There is nothing mythical in any of this.

SUPPORT: when stock prices fall, they almost never fall to zero. They generally move to a level where people collectively believe they are unlikely to fall much farther. At this lower level, the stock will often become viewed as being reasonably priced, or even a bargain. Once this lower price is reached, buying pressure, or demand, begins to overpower selling pressure, or supply. The result, is that price stops declining and may well begin to increase. This lower-level for price is referred to as support. You should use lows as the basis for determining support.

RESISTANCE: when stock prices rise, they eventually move to a level where the stock is viewed as being pricey, or not likely to rise much in the future. At this higher level, the stock's price is considered overvalued, or too expensive. So, once this higher prices reached, sellers, or supply, begin to overpower buyers, or demand. As a result, price will and it's increase and may well start to decline. This higher price level is called resistance. You should use highs as the basis for resistance.

Both of these concepts are discussed all the time in the media. You need to be aware of what they are, so you know understand what is being discussed.While you might not realize it, these two concepts are the basis for several things that you often see "prognosticated."

The first of these is the notion of "buy low and sell high." Support and resistance provide us with an operational basis for defining "low" and "high" prices. "Buy low "should mean purchasing a stock when its price is at or near the support. This assumes, of course, that support will hold. And that will ultimately depend on factors such as how well the economy is doing, factors specific to an industry or sector, etc. "Sell high" should mean selling a stock when its price gets close to or at resistance, assuming that resistance holds. Whether or not it holds depends on factors similar to those that determine the support.

The one thing I never hear discussed in the media is that you should avoid putting all your money into or pulling all of your money out of the market at one time. Instead, you should scale into or out of investments. And, you can use support and resistance to help you with this. For example, if stock price has been rising and is starting to move closer to resistance, that might be a good time to sell some of your shares and take profit on them, thus scaling out. You can do this in steps, as well. Similarly, if price has been falling, and it is moving closer to support, you might begin to scale into that stock, purchasing a fraction of the total you might want ultimately invested. So, if support doesn't hold, and price drops farther than you originally anticipated, you won't have all your money on the line, only some of it, which should help you cushion losses.

The second notion related to support and resistance details how far stock price is likely to fall or rise. Did you ever wonder where the analysts come up with these numbers? Do they go into the desert for 40 days and 40 nights, or is there some other process at work? While there are different ways this can be done, technical analysis, which I have been discussing here, has a fairly straightforward way of answering this question, one that is almost always the basis for what you hear in the media.

Q: How far is price likely to fall?
Translation: Where is the next level of support?

Q: How far is price likely to rise?
Translation: Where is the next level of resistance?

Let me clarify this a bit by providing a chart of Gold prices over the past three months (click to enlarge), using the open-high-low-close framework (refer to Stikki Stock Charts).

Clearly, gold price has been in a sharp uptrend since early July. The pace of that uptrend went "parabolic" in early August. Looking at the end of the recent upturn, resistance was established over the August 8 - 20 period at around $1,825. Gold price went above resistance (a breakout), but that breakout was not sustainable, so gold price corrected (parabolic price moves mean too far, too fast). How much might gold price decline? First, nobody knows that with perfect certainty. Using this framework, in the near term, look at early August support, $1,725. Should that level not hold, the next support, shown above, is from very early August, $1,675. I'll leave it to you to find the next lower level of support from the chart.

Let me conclude with one other element of technical analysis. Should the price of gold begin to move higher again, and I believe it ultimately will, how high is it likely to go? To answer this, determine resistance levels. Note, interestingly (to me, at least) that PRIOR SUPPORT LEVELS WILL NOW DEFINE RESISTANCE!

Recent Media Appearances

Over the past few weeks I have made a several media appearances and my monthly indicator was covered locally.

On August 8, I was on WPRO radio with Buddy Cianci where I spoke about the stock market's recent volatile behavior. I was also on WHJJ with Helen Glover, where we discussed the US debt downgrade,  and WPRO with Tara and Andrew, where we talked about the progress of Rhode Island's economy.

This week, I released the June Current Conditions Index report (see previous post and my web site). It was given excellent coverage, as has been the case for a while now, in both the Providence Business News and GOLOCALProv.com. On Monday, August 15th, I was interviewed by Bill Rapley of Channel 10 about Rhode Island's economic status and made my monthly appearance the next day on Channel 10 with Mario Hilario this month to present the June Current Conditions Index and its implications for Rhode Island.

Current Conditions Index: June 2011

This post contains most of the June Current Conditions Index report, but it excludes the data table and The Bottom Line. If you would like to see the entire report as well as previous reports (in PDF format), go to my web site.

It looks like déjà vu all over again! Until only a few months ago, using labor market data from the prior rebenchmarking, the Current Conditions Index was apparently stuck between values of 50 and 58, leading me to wonder whether this recovery would continue or if Rhode Island’s economy was about to stall. Then, in February, the new labor market data were released. I was pleasantly surprised to learn that not only had Rhode Island’s economy been in a recovery longer than I had been led to believe, but that the actual levels of economic activity were substantially stronger as well. Now, only a few months after receiving this revised data, Rhode Island finds itself in essentially the same situation we thought it was in prior to the release of the new data.

Clearly, Rhode Island’s economy has slowed since the end of the first quarter of this year. And, based on a revision to Retail Sales data from last month, the CCI fell to its neutral value of 50 during May. Thankfully, it returned back to 58 in June, but during the second quarter, Rhode Island’s rate of growth plateaued, moving us uncomfortably close to reaching stall speed. As of June, the CCI has now failed to exceed its year-earlier value for four consecutive months. At times like this, when our state’s economy is slowing, it is important to keep in mind that Rhode Island is still in a recovery, and that the current recovery is moving closer to the eighteen month mark. So, Rhode Island does have  positive momentum and some margin for error with which to counter whatever weakness lies ahead. The ultimate question, of course, is what happens nationally throughout the remainder of this year.

As I noted in last month’s report, the trends in several indicators have changed in ways that will make it more difficult for our rate of growth to increase. Our Labor Force has now declined or failed to improve for the last five months, making recent declines in our Unemployment Rate somewhat suspect. The number of Employment Service Jobs, a leading labor market indicator that includes “temps,” has fallen for the past four months. Along with all of this has been one particular surprise: strength in our state’s manufacturing sector. Total Manufacturing Hours has now improved for the last twelve months, something I thought I would never see again. And, growth in the Manufacturing Wage growth has accelerated to well over five percent for the past two months. Will the substantial momentum provided by this sector continue? Let’s hope the dollar doesn’t strengthen very much from here. 

Retail Sales rose by 1.4 percent in June after falling in May. Along with this, US Consumer Sentiment fell by 6.4 percent versus last June. It is another indicator whose past momentum appears to be slipping away. New Claims, a leading labor market indicator that reflects layoffs, fell by 7.7 percent this month, its sixth consecutive improvement. Private Service-Producing Employment rose by 1.9 percent in June, sustaining its highest growth rate in over a year. Sadly, the benefits of its change were somewhat offset by public sector employment weakness. Government Employment fell sharply once again, declining by 3.2 percent in June, as budget cuts continued. Our state’s Unemployment Rate declined dramatically once again, from 11.6 percent one year ago to 10.8 percent in June. That fall, however, was not necessarily good news, as our Labor Force fell in part because of unemployed Rhode Islanders dropping out of our Labor Force. Single-Unit Permits, which reflects new home construction, declined by 47.5 percent in June, while Benefit Exhaustions, which reflects long-term unemployment, dropped by almost 35 percent, sustaining its overall downtrend.

The Role of Growth in the Debt Crisis

For the first time since 1917, the US no longer has the highest possible credit rating, AAA. As everyone knows by now, last Friday, shortly after the stock market closed, S&P reduced its rating of US debt to AA+, its second highest ranking, based on a combination of the political wrangling involved with the way the US conducted itself during the debt/deficit deal process, the deal itself (deferred cuts + smoke and mirrors), and the economic prospects for the US moving forward.

Critical to all of this is the likely trajectory of the future debt burden on the US economy, which clearly impacts our ability to afford this debt. But how is debt burden defined? As a basic economic tenet, this is defined in relative terms -- the debt relative to our country's ability to afford it. Our ability to afford it, or ability to pay, is predicted on GDP, the value of final goods and services produced in the US. So, the focus of whether we can afford to pay our debt in the future is defined based on the Debt to GDP Ratio:

Debt to GDP Ratio = National Debt/GDP

This is not unlike what your credit worthiness is evaluated based on if (say) you apply for an auto loan: what percentage of your income (which works like GDP here) will the payments (debt) account for? Generally, if this ratio exceeds 28%, you'll be instructed not to forget to close the door on your way out -- application over! The lower is the relevant ratio, or debt relative to the ability to pay it, the more credit worthy the person or country is deemed to be.

Permit me to digress to an algebraic result at this point: through time, this ratio falls when debt grows more slowly than GDP. In other words, economic growth (the change in GDP) must outpace increases in debt for debt burden to decrease through time. So far, so good. The problem is that things get much more complicated because changes in the rate of growth themselves alter national debt by changing the federal budget.

Consider what happens when the rate of economic growth falls, either during recessions or periods of slowing growth. The way our fiscal system is designed, two critical elements automatically impact the federal budget: progressive income taxation; and entitlement spending for programs such as unemployment insurance or welfare.

1. In a slowing economy or a recession, income tax revenue automatically falls, as there is now less income available to tax (the result of layoffs, reduced hours, etc.).
2. At the same time, more persons qualify for entitlement programs such as unemployment insurance, automatically raising the amount spent by those programs. (FYI: the reason these are called entitlement programs is that the government only sets the criteria for entitlement, not the actual amount spent in any year. That is determined by how well or badly the economy does.)
3. Entitlement spending is countercyclical, meaning that it rises when the level of economic activity falls (such as in recessions), and falls when economic activity improves (in recoveries).

The overall result is that the federal budget either has a smaller surplus (yeah, right!) or a larger deficit when economic activity deteriorates. More importantly, the larger deficit then adds to the national debt. The result is a greater debt to GDP ratio. As this shows, changes in the national debt are necessarily linked to changes in the rate of economic growth.

In light of this, what do governments often attempt to do? Pad the denominator -- overstate likely rates of future economic growth, making the debt appear to be less of a burden than it will actually prove to be. Actually, there is an added bonus to doing this: based on what I outlined above, if the rate of economic growth is overstated, tax revenue will also be overstated ("smoke"), while entitlement spending will be understated ("mirrors"), making the deficit, and thus the change in debt, appear to be smaller than it will eventually turn out to be!


The problem is, you can only get away with this for so long. Eventually, either voters or rating agencies will figure out what's been going on. That's when the party ends!

Of course, there are lots of other fiscal tricks that have been utilized by our government for quite some time now. I won't get into those now, but they often consist of deferring future cuts or revenue changes, assuming that these will definitely occur when assumed. This is essentially what the first round of debt reduction did.

Perhaps had the recent political process dealing with this not been such a fiasco, we might have continued to get away with these practices and gimmicks. While two of the rating agencies did not deem our debt and this process to be problematic, the S&P finally had enough, making the downgrade call. Interestingly, S&P also made mathematical errors in their determination our creditworthiness. Apparently their mind was already made up - they refused to be confused by the facts! They claimed that it was just merely a matter of different assumptions in future years. Obviously, the effects of padding exist in both directions -- symmetrical fudge factors!

Instead of arguing with S&P's decision, I prefer to view it as a very necessary wake-up call to our nation and its leaders. We have to change and to abandon the pervasive use of "smoke and mirrors." Remember, the S&P rating was not only a downgrade, it included a negative outlook as well. So, if the "committee of twelve" does what appears to be likely, more theatrics and gridlock, the US could be downgraded even further by S&P. And, I don't rule out possible downgrades by either or both of the other ratings agencies.

At the top of my holiday wish list is one very prominent wish: that members of the US House of Representatives stop acting like a bunch of spoiled three year olds, and that they finally place the good of our country ahead of their fragile egos. Unfortunately, this is not likely to be the case. As we have now begun the move toward "round two" of the debt ceiling process, the markets yesterday were rather unequivocal -- they tanked today just after hearing the list of persons who will make up the group of twelve that will potentially decide the next round of spending cuts. Unless a miracle occurs, this group will almost certainly end up deadlocked, resulting in mandatory cuts being put into place -- but they only go into effect after the election. Here we go again!