Most people understand the basics about the stock market and the economy – but few people have a deep enough knowledge of the two to serve them well in making financial decisions. With that in mind, I thought it would be helpful to outline how the economic cycle works and how stocks, the underlying economy, and the leading indicators can help us forecast what’s coming next so that you can make solid financial decisions.
Outline of This Episode
- [0:30] Why it’s important to know how the economic cycle works
- [1:10] The historic stock market drop in December 2015 – as an illustration
- [3:07] Why you need to understand the basics of the economic cycle
- [6:44] How does the movement of the stock market affect the underlying economy?
- [8:55] What SHOULD we look at to understand economic health?
What is an economic cycle?
Simply put, the economic cycle is the booms and the busts of the overall economy. During a boom time, the overall economy is healthy, jobs are available, corporations are profitable, etc. A bust is just the opposite – jobs are scarce, corporations are having a hard time making money, and the overall spending of the population is down as a result.
Economic cycles are important to watch and understand because we can learn to see patterns and correlations from one cycle that can possibly inform us about the next. In this episode I describe the way the economic cycle works and what we start to see as a recession or downturn happens. Be sure to listen.
MYTH: The stock market is a leading indicator of the overall economy
In December 2018, The S&P 500 (stock market) fell by 15%. The concern was that we were entering a recession and many believed they might be losing their job, or that they should sell their stock holdings. Many people hold the misconception that the stock market is a leading indicator of the underlying economy or that it represents the overall economy. But it’s not true.
The stock market is more of a forward-looking indicator that is actively trying to price in the overall economy itself. Even though it’s forward-looking, it’s not a reliable leading indicator. It’s constantly trying to guess whether the economy is going to get stronger or weaker – it’s an aggregate of many variables. The overall economy will typically drive stock prices, but the stock market does not necessarily have that much of an impact on the economy overall. A great example of this was what happened in 1987’s “Black Monday” when the stock market fell 23% in a single day but the underlying economy didn’t even bat an eye.
4 things that drive the health of the underlying economy
Naturally, there are many things that impact the direction the economy goes, but on a very basic level there are 4 things that drive the underlying economy. These can legitimately be called leading economic indicators. What are they?
- Employment – people lose their jobs
- Income – resulting from loss of jobs
- Sales – people are buying less because they are earning less
- Output – companies reduce output to be comparable to the decreased demand
During an upturn in the economy, these indicators feed into each other, driving prices higher. The sales cycle is extremely difficult to predict, no matter how much economists and those forecasting the stock market try to do so.
What should we be looking at as recession indicators?
There are many things that point to the possibility of a recession. Traditionally, there are eight things that we can watch to discern if a recession is on the horizon. They are…
- Sensitive commodity prices
- Average manufacturing work weeks
- Commercial and industrial building contracts
- Inverted yield curve
- New incorporations
- New orders
- Housing starts
- Money supply
I think the one we need to understand is the INVERTED YIELD CURVE : it’s a highly reliable tool to track, if there is an unexpected slow-down in economic activity. It’s not perfect, but it’s extremely reliable. Here’s how it works…
A yield curve shows interest rate points across several maturity dates. Most of the time it’s just a chart of the US Treasury Bond yield curve – from 3 months all the way up to 30 years. It’s important because the Treasury Bond is quite possibly the largest and most widely held security in the world. A normal yield curve (which shows a normal risk appetite among investors) is an upward sloping chart… the rates of a 3 month treasury bond will be lower than a bond of greater maturity length. However, that curve can flatten or invert – inversion means shorter term rates are higher and longer term rates are lower.
The problem with this indicator is that there is a long lead time – it usually inverts years before an economic slowdown. Used in tandem with other economic indicators it can be very helpful.
Listen to learn more about why the stock market is not a leading economic indicator and how you can become a better observer of the economy.
Resources & People Mentioned
Connect With Ryan A. Hughes and Bull Oak Capital
- Podcast (at) BullOakCapital.com