Friday, June 1, 2012

A Crash Course in Making Sense of the Stock Market: Part 1

Today, the May labor market data for the US were released. The stock market tanked, continuing a strong downtrend that has persisted for a few weeks now. How can you make sense of what is happening now or what might occur in the future? First, let me recommend a very well written and readable book about following the stock market: Fire Your Stock Analyst (2nd ed.) by Harry Domash. I also have a link on my web page with numerous references about the the stock market: .

To start with, let me outline an important principle about the stock market's performance:

Principle #1: Over the long term, the primary determinant of stock price movements is the expectation of future profits.

Of course, in the short-term, emotion and a host of other factors may dominate stock price movements. I don't recommend that you attempt to anticipate very short-term movements.

You are no doubt already aware of the fact that in a global economy, the performance of US corporations is not immune to events overseas, since many US corporations receive a substantial portion of their revenues and profits from overseas operations. Thus, the macro performances of Europe and Asia have a major bearing on what will likely happen to future US corporate profits. We know that Europe is now in a recession and Asian growth has slowed. Add to this a very disappointing US employment report for May, and there have been lots of negatives already factored into profit expectations, which have been much of the driving force behind the recent stock market declines.

The real question, though, is what will happen to growth and profit from here? This brings me to a second principle:

Principle #2: Because the expectation of future profits tends to be the driving force underlying stock market prices, stock price changes tend to occur before (lead) changes that will ultimately occur in the overall economy. Based on this, the stock market is called a leading economic indicator.

The recent decline in the stock market therefore indicates the expectation that the rate of growth of the US economy will slow further in the coming months. One should be careful not to make too much of this, however, since, as the old saying goes, "The stock market has predicted eleven of the last six recessions." Indeed, the stock market tends to do a better job of predicting upticks in economic activity than downturns. So, I do NOT recommend that you use the stock market's behavior as the basis for predicting if a recession is coming.

Since we now live in a truly global economy, to truly understand what is happening in the stock market, or what may occur in the future, it is necessary to look beyond stocks.

Principle #3: Different types of markets are linked (interrelated), so that clues for future changes in the stock market can often be gleaned by observing what is happening in those other markets. This is called intermarket analysis. You should follow at least the stock market, the bond market (for interest rates), and commodity prices. Currency markets also matter as well.

The stock, bond, and currency markets are all leading economic indicators. Commodity prices, however, tend to lag. I will focus on the bond market here.

Interest rates are determined in the bond market. Bonds, if you are not up on these, are debt obligations. The entity issuing the bond  (ex: government, corporation, etc.) wishes to borrow money for some purpose. So they issue bonds, which in exchange for the money they receive from the bond investor, pay a fixed amount of nominal income over their term. There is a bond value, let's say $1,000, a stated interest rate, say 3%, and a term until the bond matures, lets assume 10 years. So, for when this bond is newly issued, you pay the $1,000. In return you receive a fixed income stream of $30 per year (the stated interest rate times the bond value = .03x$1,000) every year until the bond matures, then you receive the $1,000 back when the bond matures. Because bonds pay fixed amounts of income, these are called fixed income assets. Furthermore, the income is a nominal value. So, the greatest threat to bond holders is inflation, which lowers the real, or inflation-adjusted value, of the bond's fixed income.

Principle #4: Anything that raises actual or expected inflation makes bonds less attractive, since their fixed income then has a lower real (i.e., inflation adjusted) value.

As bonds are often sold before they mature (in secondary markets), higher expected inflation leads to some combination of lower bond demand (fewer buyers), and greater supply as some bondholders wish to unload their existing bonds. Both cause bond prices to fall in what is called a bond market sell-off.

The interesting thing concerns what causes expected inflation to rise. Generally, this is the expectation of more rapid economic growth.

Principle #5: Good economic news, which signals the likelihood of more rapid future growth, leads to higher expected inflation, which results in a bond market sell-off and lower bond prices.

Principle #51/2: Bad economic news, like the discouraging employment report today, signals the likelihood of slower future growth, which lowers expected future inflation, causing a bond market rally and higher bond prices.

These principles take a while to get used to: bonds tend to do well with bad economic news and the prospects for a weak economy. For this reason, bonds are referred to as a recession hedge.

Principle #6: When bad economic news occurs and expected growth falls (like today), the stock market sells off (due to lower expected future profits) while the bond market rallies (based on the expectation of higher real income from holding bonds). Money thus moves from stocks to bonds. This is called a flight to safety.

The stock market weakness over the past several weeks has therefore been a flight to safety. You are no doubt aware that the stock market has been declining. And, I will guess, you probably think there is no way to make money when the stock market is declining. WRONG!!! The bond market has been rallying.

Below is a chart of stock prices (the Dow-Jones Industrial Average) and bond prices (the 10-year US Government Bond Price) which illustrates what a flight to safety has looked like (click to enlarge).

Let me conclude by noting a principle I use all the time: which market changed direction first? Both stocks and bonds are leading economic indicators, but bonds have a longer lead time. In the next installment, I will discuss how to use changes in interest rates to help predict future stock price changes.

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