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: http://www.llardaro.com/references_for_exploring_stocks.htm .

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.

Rhode Island's Surprising Cyclical Strength

Although it still comes as a surprise to many Rhode Islanders, Rhode Island has been in a recovery since February of 2010. As of the time this is being written, we are approaching the one and a half year mark for this recovery.

In a number of blog posts I have spelled out precisely what a recovery means -- not a return to "normal" times, but a period where the overall level of economic activity is rising. The pace of the recovery ultimately determines how long it will take to return to "normal" times or to peak levels from the prior recovery for key indicators.


Over the past four months, employment in Rhode Island has turned in a surprisingly strong performance. On a year-over-year basis, while job loss has remained roughly constant, job gains have clearly accelerated (see blog post on this).  The result is important enough to show the following graph again here (click to enlarge).

As I was preparing monthly data for my next Current Conditions Index release, I came upon something that is also very welcome but unexpected: layoffs in Rhode Island have now fallen below their median level going all the way back to January of 2000. The next chart shows layoffs over this period (click to enlarge):

I used the median for this since the extreme values of layoffs during the last recession would push the mean significantly higher. The median, which is the middle value when all values are arranged in ascending order, will not get "pulled" higher as the mean would, so it is the preferred measure of "central tendency" here.

Three important points need to be made about the indicators reflected in these graphs. First, layoffs (actually New Claims for Unemployment Insurance), which is one of the indicators in my Current Conditions Index, is a leading economic indicator. This means that its changes today signal future movements in the overall level of economic activity. So, declining layoffs signal that Rhode Island's economy has been gaining momentum of late. Second, payroll employment overall, or its components, job gain and job loss, are coincident indicators, meaning that their changes reflect the current performance of the overall economy. From the first chart, the acceleration of job gain relative to job loss confirms what the recent downtrend in layoffs implies, that Rhode Island's overall economic performance is improving. Finally, since Rhode Island has income and sales taxes, improving levels of overall economic activity, which produce higher levels of income, result in added income and sales tax revenue. This is the basis for the recent "surprises" in tax revenue our state has witnessed.

What about the fact that Rhode Island's unemployment rate has remained stuck around 11 percent as these changes in layoffs and job gains have been occurring? While everyone pays a great deal of attention to the unemployment rate, it doesn't always move in lockstep with changes in payroll employment, for several reasons. Among other things, it is derived from a separate labor market survey, the household survey. And, the unemployment rate is a lagging indicator, so its changes now reflect what has occurred in past months. There is also a strange footnote to the way the unemployment rate is calculated: unemployed persons who stop actively seeking work are not counted as being part of the labor force, therefore they are excluded from the monthly unemployment number. The flip side of this is that when an economy improves, and some of the unemployed who had stopped looking for work begin once again to search for employment, they are now counted as part of the labor force, which tends to cause a short-term rise in the unemployment rate. However, recent declines in Rhode Island's jobless rate have largely been the result of our unemployed ceasing job search. So, it is quite possible that Rhode Island's unemployment rate might actually rise before it resumes declines based on the behavior of layoffs and job gains discussed above.

Let me point out a strange element of Rhode Island's current economic climate. Our state's jobless rate was third highest in the nation in May. Yet in spite of having so many unemployed persons here, and such a high unemployment rate, manufacturing wage growth has been very strong. While this signals recent manufacturing strength here, it also reflects the existence of skill shortages. Go figure!

Finally, at the same time Rhode Island's economy has experienced this enhanced cyclical momentum, a substantial number of structural negatives, most notably the lack of skills of our labor force, have offset some or much of this cyclical momentum. That explains why this recovery doesn't necessarily feel all that different from being in a recession.

EPILOGUE: After posting this last evening (7/7), the June payroll employment report for the US came out this morning. The results took everyone (including me) by surprise, as national employment rose by only 18,000, well below prior expectations. It will be very interesting to see the June numbers for Rhode Island when they are released in a few weeks. If they show no employment pause here, I will have to question the last few months of data here. I'll have a lot more to say on this if it actually occurs.