52.50157.00160.50163.20166.70172.80
131.60136.60140.90144.80149.00152.90157.30160.80163.40167.10172.80
132.70137.20141.30145.10149.40153.20157.80161.20163.60167.80173.70
133.50137.40141.80145.70149.50153.70158.30161.60164.00168.20174.00
133.80137.80142.00145.80149.70153.60158.60161.50164.00168.30
133.80137.90141.90145.80149.70153.50158.60161.30163.90168.30
19901991199219931994199519961997199819992000
Figure 6.7 CPI Increases by Month 1990–2000—Shows what a basket of goodswould cost during successive time periods. (All Items, All Urban Consumers (CPI-U),1982–1984 = 100, as revised)
three levels of production: raw materials, intermediate goods, and finished products. In addition, the PPI tallies the overall rate and the core rate of production(excludes food and energy sectors). Of the two, the core rate is more important toinvestors who look for an annualized PPI rate to stay below 3%. If it rises abovethis point, inflation is perceived to be on the increase, which has a negative effecton the stock market.The Price Producer Index has it own web site at stats.bls.gov/ppihome.htm.
National Association of Purchasing Management Index(NAPM Index)Another indicator of economic growth, the NAPM Index presents a wide-rangingview of the manufacturing sectors’ ups and downs. This growth or decline reflectsin the general economy; as the NAPM rises it will usually bring the stock market up
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along with it, while forcing bonds down. The NAPM is broken down into specificcomponents of supplier deliveries, order backlog, new orders, production, employment, inventories, import orders, new export orders, and prices paid. Each component reflects the activity of each specific sector. For instance, statistics for orderbacklogs and new orders reflect the vendor performance index and can become afactor in the Fed’s decision to raise interest rates.The NAPM Index web site can be accessed at www.napm.org.
Retail SalesReported monthly by the Commerce Department, the retail sales component is one ofthe most closely watched economic indicators. Since consumer spending makes upapproximately two-thirds of the national economy, bonds decline and stocks rise withreports of increased retail sales. This report reviews monthly sales for auto manufacturers, major retailers, and chain store sales. A rising retail sales component is goodfor retailers and gives an up-to-date indication of the consumer-spending mood.Current retail sales data is available online atwww.census.gov/mtis/www/current.html.
Gross Domestic Product (GDP)Gross Domestic Product is a measurement of the total production and consumption of goods and services in the United States, and is therefore an excellent
Figure 6.8 Gross Domestic Product (GDP) 1990–2000 (Courtesy ofEconomagic.com)
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gauge of economic growth. It’s released quarterly and obviously isn’t as timely asthe monthly data. The GDP provides probably the single most comprehensive picture of the economy. A GDP that advances at a healthy rate indicates a potentialfor a vigorous business atmosphere and ever-increasing profits. These reportsrarely include major surprises and only impact the stock market when the GDPfigures are significantly above or below the latest advance economic estimations.Figure 6.8 shows the year-to-year percentage changes of the GDP from 1990 tothe year 2000.
Housing Starts and Sales of New and Existing HomesHousing starts are the best indication of current residential construction activity.Permits are a good indication of residential construction activity in the next fewmonths. The housing indicators show the first signs of any new direction in theeconomy. These changes are usually set off by any changes in home mortgage rates,which are of course affected by high inflation and rising interest rates. The housingstarts and building permits indicator is watched by the stock market because highstarts indicate a healthy economy. The report also gauges building permits, as theycan give an indication of the housing starts of the future; but it doesn’t delineate thetypes of homes being built. Reported monthly, it’s very timely in its data. Anotherimportant way to judge future growth is to look at sales of new and existing homes.This gives analysts ideas about the future sales of things that go along with a newhouse, such as new appliances, furniture, and other durable goods.
Construction SpendingConstruction spending is an indicator of not only residential construction as inhousing starts, but also nonresidential and public construction projects. A strongnumber here represents a high degree of confidence in the private sector about theeconomy. It is considered to be a lagging indicator because the numbers are not reported until the structures are completed. Mortgage rates have a direct impact on alltypes of construction as well as national levels of construction spending. Though issued monthly by the Commerce Department, this report is usually taken into account by analysts only every three months, because these figures can be highlyvolatile month to month. The number of building permits is a better leading indicator of current economic activity, available from the Census Bureau. Check out thestate-by-state breakdown at www.economagic.com/cenc40.htm.
Industrial Production IndexThe Industrial Production Index gauges the aggregate output of all of the country’sutilities, factories, and mines. This is another indicator that can directly affect thestock market. Analysts generally see a slackening in this sector as a signal of an impending reduction in the nation’s economy.
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Capacity UtilizationThe capacity utilization component measures at what rate the manufacturing capacity of the nation is being utilized. A capacity utilization of 80% or lower can causeconcerns of underutilization, and excess capacity and can affect the economy withless demand for capital equipment and new plants and factories. A high (but not toohigh) capacity utilization brings up stocks and drives down bonds. A capacity rateof 85% can indicate the point at which inflationary stress begins. It’s considered thatas long as capacity rises at a more rapid rate than production, inflation will remainstable. Figure 6.9 shows the capacity utilization from 1990 to 2000.
Personal Income and Consumption ExpendituresPersonal income and consumption expenditures help measure and gauge theprospect of future consumer spending. The personal income component tracks increases in personal incomes—as incomes rise, so does the stock market. Consumption expenditures represent how much has been spent by individuals on all marketgoods and services for the past month and is another important way to measureoverall economic activity. Figure 6.10 details personal income from 1998 to 2000.
Factory Orders—Durable Goods and Nondurable GoodsThe factory orders report is released each month by the Commerce Department and ismade up of different accounts of each component of factory production. This reportIndustrial Capacity: Total industry (Seasonally Adjusted)Percentage change from same period last year
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Economic Chart Dispenserhttp://www.Economagic.com
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Capacity Utilization 1990–2000 (Courtesy of Economagic.com)
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Personal Income; Billions of Dollars (1995–1999)Change from same period last year
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Economic Chart Dispenser
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Figure 6.10
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Personal Income 1998–2000 (Courtesy of Economagic.com)
looks at factory shipments that are measures of current demands, new factory ordersfor durable and nondurable goods, inventories, and unfilled orders that are a measureof backlogs and built-up demand. Tracking orders for big-ticket items such as carsand refrigerators that are expected to last more than three years can help market analysts, investors, and traders calculate and determine changes in national productivity.Figure 6.11 provides a review of these important government reports and whattheir numbers mean to investors.The following web sites can help you keep up-to-date on the release ofgovernment reports:• Economagic.com (www.economagic.com): A free, easily available sitefilled with more than 100,000 data files, charts, and Excel files useful foreconomic research.• Briefing.com (www.briefing.com): This site posts a handy calendar ofupcoming announcements.• Economic Indicators.com (www.economic-indicators.com/EconomicNews.html): A slightly more in-depth web site—just click over to the Calendar section.• The Dismal Scientist (www.dismal.com/economy/releases/calendar.asp):An easy-to-use site that provides a guide to report announcements.• Infobeat.com (www.infobeat.com): This site will e-mail you directlyproviding timely announcements of government report releases.
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Component
Release Date
Advancing Numbers
Declining Numbers
UnemploymentRate
First Friday ofthe month
A rise in unemploymentrate is a positive sign forthe bond market.
A decrease inunemployment numbersis a positive sign for theequity markets.
Nonfarm Jobs Growth First week ofthe month
Job creation is a goodthing. It is a sign thatcompanies are expandingand prospects are goodfor future growth.However, job creationmust be looked at inconjunction withunemployment andproductivity figures—ifthe number of new jobsis growing significantlyfaster than they can beabsorbed by theworkforce, then theelements are in place forinflationary wagepressures.
Declining jobs indicate acontraction of theeconomy and portendproblems for the stockmarket in general.
Wholesale Trade(Very accurateindicator, eventhough the lag istwo months.)
Second weekeach month
Wholesale tradeinventories—If thisnumber rises,consumption is slowingInventory-to-sales ratio—Rising numbers againreflect a slowdown in theeconomy.
Wholesale tradeinventories—If inventories are falling, consumption is on the rise.Inventory-to-sales ratio—If this number begins tofall, consumer spendingincreased, indicatingmore confidence.
Import and ExportPrices
Aroundmidmonth
Imports constitute 15% ofU.S. consumption anddirectly affect theprofitability of U.S.companies. Higher pricesfrom imports translate tohigher prices of domesticgoods. Good news forbusinesses; bad for theconsumer.
If import prices fall, U.S.companies must lowerprices to compete. Badfor businesses, good forthe consumer.
Figure 6.11 Government Reports Matrix
ECONOMIC TURNING POINTS AND GOVERNMENT REPORTS
Component
Release Date
Employment Situation(The single mostclosely watchedeconomic statistic.Offers timeliness andaccuracy, and is animportant indicator ofeconomic activity.)
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Advancing Numbers
Declining Numbers
First week ofthe month
Gives good indication ofemerging wage pressuresin average hourlyearnings component.This is a good proxy forGDP growth; risingnumbers mean economyexpanding. May or maynot be greeted as goodnews by the market.
Declining numbersindicate that wages andjobs are on the decline.May be interpreted eitherway by the market,depending on desiredinterest rate change.
Employment CostIndex (ECI)
Once a quarter,toward end ofmonth, forprecedingquarter
Analyzes wages andfringe benefits. Risingwages alone have lessmeaning, but are used inconjunction with otherreports, like housingstarts.
Lower wages mean aslowing economy, andare used in conjunctionwith other economicmeasurements to gaugethe economy’s strength.
Consumer PriceIndex (CPI)
Around the15th of eachmonth, 8:30A.M. EST
Since the CPI describesprice changes of a basketof consumer goods, arising number meansinflationary pressures atwork. Bad for the marketbecause inflation is heldin check with risinginterest rates.
A drop in prices isgenerally considered agood sign for consumersand good for the market.
Producer PriceIndex (PPI)
Second fullIncreases may or mayweek of month not be good news: Ifinterest rates aredeclining then a risingPPI number meanseconomy is reacting tothe rate cuts. If rates areincreasing, this is badbecause further ratehikes may be required.
Decreases mean theeconomy is slowing.Best to look at trends.Prolonged slowing maylead to recession.However, if rates havebeen increasing,decreasing numberswould mean no furtherhikes are necessary.Good news for themarket usually.
National Association First of monthof PurchasingManagement Index(NAPM)Figure 6.11 Continued
Increase accelerates the Decrease slows theeconomy.economy.(Continued)
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Advancing Numbers
Declining Numbers
If people are spendingmore and confidence ishigh, it’s a good signfor the market.
If people spend less andconfidence shrinks, it’s abad sign for the market,especially retail stocks.
One month afterGrossend of quarterDomesticProduct (GDP)
Takes into accountconsumer demand,trade balance, and soon. Economyexpanding is goodnews, but not too fast—the Fed raises rateswhen that happens.
Decrease means economyslowing. If it continues Fedwill (possibly) lower rates;good for market.
Housing Starts Third week ofmonthand Sales ofNew andExisting Homes
Increasing startsindicate confidence—agood sign for themarket.
Decrease means economyslowing. Red flag for Fed tobe on lookout for downturnin economy. Market reactionis anybody’s guess.
ConstructionSpending
First of month
Lagging indicator.Reports come in onlyafter building isfinished. An increase innumbers is a good sign.
Since it’s a lagging indicator,may serve to confirm theeconomy is slowing andrates need to be lowered.Good for the market.
IndustrialProductionIndex
Midmonth, 9:15A.M. EST
Increases indicate theslack is being taken outof the economy; we’remaxing out.
Decrease means factoriesare slowing down. Might beconsidered bad for themarket, is considered badfor the economy.
PersonalIncome andConsumptionExpenditures
Third or fourthweek after themonth it reportson
Not much impact. Itreports after other keydata (employment andretail sales).
Prolonged decrease inconsumer demand isdefinitely bad for consumerstocks.
Leading indicator ofindustrial demand.Numbers going up aregenerally a positive forthe markets.
Slowing demand means aslowing economy, if it staysin a declining mode forseveral months. Mightadversely affect markets, butif it prompts interest ratereductions it could be goodfor markets.
Retail Sales
Release DateMidmonth
Four weeks fromFactoryend of reportingOrders—Durable Goods month (8:30 A.M.EST); however,andeveryone keys offNondurableof the advanceGoodsrelease one-weekearlierFigure 6.11 Continued
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SEASONAL FACTORSSeasonal factors have an impact on the performance of the markets year round. Although some stocks can be affected by the weather changes (e.g., oil in wintertime,utilities in summertime), seasonal factors are much broader than climate issues. Investors can’t plan all their trades around seasonal factors; but it would be unwise toignore them completely. For instance, it’s good to know that from 1950 to 1998,during the November through May period the average monthly gain in the marketswas 0.98% higher than the average monthly gain from June through October. Someof the quirkier seasonal factors have to do with the oddly coincidental behavior ofthe market during election years—they have been historically high-performingyears. Contrarily, for some reason, there is almost always a market drop in the firstyear of every reelected president’s second term. In all, it’s a good idea to prepare tomake stock acquisitions near the beginning of a favorable seasonal period and try todelay sales until the end of the favorable period.A popular publication called The Stock Trader’s Almanac, byYale Hirsch, identifies many of these quirky statistics. History tendsto repeat itself, and this book is a good tool for identifying seasonaltendencies (hirschorganization.com/almanac/almframe.htm).
January EffectThe January effect describes a pattern in which smaller-cap stocks outperform theirblue-chip brethren in January. Many have analyzed this effect, and there has evenbeen a book written about it: The Incredible January Effect by Robert Haugen andJosef Lakonichok (Irwin Professional Publishing). Statistically the pattern has beenevident since the introduction of income tax! However, in the past four years(1996–1999), the January effect has failed to materialize.
October JinxThe great crash of 1929 and its spooky repetition in 1987, as well as the minus-554point day in 1997, have made the October jinx seem to be more than just a superstitious legend. In the history of the Dow, 6 of the 12 largest daily drops have occurredin October. Yet October signaled the end of the line for nine bear markets (1946,1957, 1960, 1962, 1966, 1974, 1987, 1990, and 1998). Many good runs have begunin November. According to some market prognosticators, November is often a goodtime to be a buyer.
Quarter-End FluctuationsThe end of each quarter is of special significance to portfolio managers. The SECrequires mutual funds to post performances and holdings for shareholder review. If
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there are some real clunkers in the portfolio, these are often jettisoned in favor of astock or stocks that are the current favorite among the institutional crowd andtraders in general. This so-called window dressing creates some wild times on thelast trading days of March, June, September, and December.
Monthly Options ExpirationsThe third Friday of every month means options expire on the close (technically theydon’t expire until the next day, but Friday is the last day you can trade them). The final hour or two of trading can bring some wild price gyrations to stocks that have alot of options with open interest. Money managers and traders will often create sophisticated hedge positions that must be unwound before the close. Sometimes thismeans buying the stock and selling the option, and sometimes it’s the opposite—selling the stock and buying the options back (buying to close). If you like to trade,this is perhaps the wildest time to do it because price swings can be dramatic. Morethan likely, it’ll be back to business as usual by Monday.Max Pain is a web site that theorizes a very interesting concept: On the dayan option’s front month contracts expire, an optionable stock will close at aprice that will lose the most people the most money. Let’s say there’s a stocktrading in the upper $60 range. There’s large open interest at $65 for bothputs and calls, and another block of open contracts at the $70 strike.Max Pain predicts the stock will close around the midpointbetween these strikes, in the $67–$68 range. Go to the site andsee for yourself how it works (www.ez-pnf.com/ezpopt_1.htm).
SUPPLY AND DEMANDAt any time, it can be stated that the total number (supply) of shares is fixed. Demand for the fixed supply of shares will vary continuously depending on the investment community’s interpretation of all the data available on the company, itsindustrial sector, and prevailing economic trends. If the consensus is bullish, moreinvestors will want to purchase shares; if the consensus is bearish, more investorswill want to sell shares. In many ways, a stock exchange is like an auction. If thereare more buyers than sellers, prices will rise. If there are more sellers than buyers,prices will fall. Thus, the dynamic flow of supply and demand for shares has a solidimpact on the price of the shares.A firm can increase or decrease its total number of shares, but it is a ratherlengthy and involved process involving the board of directors, amendments to thearticles of incorporation, and general stockholders meetings.
INTERNATIONAL AND POLITICAL FACTORSAlthough a laissez-faire approach to business tends to bolster the markets andkeep investors happy, politics doesn’t always reinforce business interests. In fact,
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sometimes a tug-of-war develops between business interests and and political maneuverings that call for laws that restrict business by imposing environmentalstandards and protective labor laws. These laws are often viewed as a threat toeconomic prosperity by the business community and vigilantly fought againstthrough the use of lobbyists and political action committees.These days it’s not enough to understand domestic economics.A general understanding of world developments is critical,especially when a balance of trade issue or a currency exchangerate exerts an effect on a company you happen to own stock in.
In recent years, worldwide economic dependency has indeed moved to the forefront, especially now that we’re digitally linked, with fewer trade barriers than everbefore. In 1998, Brazil and Russia were experiencing terrible financial woes thatthreatened to do serious harm to the U.S. economy. That was due to U.S.-basedbanks having huge loan exposure, especially in South America. Had Brazil goneunder or defaulted on its debt and let hyperinflation consume its economy, it wouldhave caused a very serious liquidity crisis here. The ripple effect would have gonethrough our economy like a hot knife through butter, with interest rates dropping inorder to provide liquidity. The Fed, in turn, would have been holding its collectivebreath, hoping in vain that inflation wouldn’t rear its ugly head. The mere threat ofthis scenario sent the Dow into a nasty bear market. When the crisis had apparentlypassed, the Dow rallied strongly, and the Nasdaq really began to move as global demand for technology increased exponentially.With the opening of China’s borders, the single biggest untapped market on Earthhas created a stampede by U.S. corporations to establish business connections there. Inaddition, Hong Kong’s reversion back to Chinese rule after Great Britain had allowedit to grow into an economic supercity has investors everywhere watching anxiously.Elsewhere, countless manufacturers are using the cheaper labor available inthird-world countries to cut costs and increase profits. The North American FreeTrade Agreement (NAFTA) has made border cities in Mexico (like Juarez, Tijuana,and Nuevo Laredo) swell in size, dwarfing their U.S. counterparts. Many U.S. corporations have set up factories in Mexico and warehouses in the United States. Interstate 35 runs from the upper Midwest to Laredo, the highway changing namesonly as it continues on into Mexico City. It truly is the NAFTA Highway.North America is now one market as it competes with the European Union. Africahas even been the target for new economic development. U.S.-based technology companies are attracting brilliant minds from all over the world as they come here to trainin American universities, and then stay to develop new Internet-related businesses.As worldwide participation in our economy increases, it is absolutely vital tokeep as aware as possible regarding global business practices. Tensions around thecountry and the world are heating up as questions concerning human rights violations and environmental negligence supported by the World Trade Organization(WTO) are brought into public view. In the years to come, it will be interesting tosee how the politics of profits versus people affect all of our lives.
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BROAD MARKET ANALYSISCountless websites offer investors clues to politics, trade negotiations,and economic corollaries, including:• U.S. Census Bureau (www.census.gov/ftp/pub/foreign-trade/www): Maintains a site devoted to international trade with a lot of good information.• World Trade Organization (www.wto.org/index.htm): The official site ofthe World Trade Organization details its take on trade negotiations andglobalization.• WTO Watch (www.wtowatch.org): Advocating “a human face for globalization,” this site provides press-related resources and information on theWTO, global trade policy, and sustainable development from the activistpoint of view.• Corporate Watch (www.corpwatch.org/trac): Known as the “Watchdog ofthe Web,” this site actively pursues corporate and political wrongdoings.
STRATEGIC MARKET ASSESSMENT USING INDEXESInvestors who own a portfolio of stocks may notice a tendency for the stock pricesof individual companies to move together, up and down in price. There are eventsthat have an impact on entire industries, sectors, or at times, the market as a whole.Take America Online and Yahoo! Both companies are leaders in the Internet. As aresult, news events pertaining to developments within the Internet sector—say information related to the rise or fall in the cost of Web-based advertising—is reflected in the bottom line of each individual company and ultimately impacts theshare prices of companies in the entire sector. The degree to which stocks move together in a similar manner is referred to as comovement, or covariance. Since mostof the companies I consider to be worthwhile investments are engaged in variousareas of the technology world, the individual stocks within my portfolio tend tohave a significant amount of comovement.Instead of thinking in terms of each individual stock, it is often useful to thinkof the aggregate or composite performance of stocks. Indexes serve such a purpose. An index, as mentioned in Chapter 1, is a list of stocks that represents across section of an economy or market sector. Its value is calculated by variousmethods so that it can display the relative price movement or strength of thatgrouping. On the one hand, indexes help investors see stocks as a whole. On theother, understanding indexes offers an effective way of subdividing the stockmarket into groups or sectors.Various financial firms and publications have developed indexes to monitor theoverall performance of the stock market. Instead of using the price-weightedmethod, many have turned to a market- or capitalization-weighted system; that is,the larger the company’s market value (common shares trading times stock price),the more the company will weigh in the index. The total market values of all companies are added together. Then, as with a price-weighted index, a divisor is used todetermine the index value and to achieve continuity throughout time. Once indexes
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are created, they are continually modified to reflect changes in the economy andevents within the stock market.Price-weighted: An index that is constructed by adding up all of the stock pricesof the components of the index and then dividing by a divisor. The Dow JonesIndustrial Average is the most familiar. In computing the Dow Jones IndustrialAverage, the stock prices of all 30 stocks are added together and divided by adivisor (current divisor = 17.67761842) to arrive at an index value.Capitalization-weighted: Computed by adding up the total market capitalization (common shares traded times market price) of all of the components of theindex and then dividing by the divisor. The S&P 500 is an example of a capitalization- or market-weighted index. The market caps of all 500 stocks are addedtogether and then a divisor is used to arrive at a value for the index.
THE DOWThe fact that stock prices tend to move up and down together, or exhibit comovement, is not a new insight. Back in 1884, Charles Dow published the average closing prices of 11 U.S. companies in the Customer’s Afternoon Letter, the forerunnerto today’s Wall Street Journal. In computing the average, Dow simply added theclosing price of each stock and divided by 11. This method of creating a priceweighted average, although it has been slightly modified, is still used today. Until1896, the average was printed sporadically, but after that, two new averages werepublished daily. The first was the average closing price of 20 railroad stocks; thesecond consisted of 12 industrial stocks. They became known as the Dow JonesRailroad Average and Dow Jones Industrial Average. In effect, Dow simplified thecumbersome activity of monitoring a large number of stocks individually by compiling and publishing the average performance of a list of popular stocks.Although Charles Dow is known as the father of stock market indexes, he is alsoa predominant figure in stock market history for a number of other reasons. Firstand foremost, he was the original editor of the Wall Street Journal. In addition, heused market averages, not as a means of studying the daily price changes in thestock market, but as a way of gauging trends within the U.S. economy. Dow emphasized the fact that the daily price changes in the stock market reflect the views ofthousands of investors, including those gifted with the greatest foresight and information. The stock market was therefore, a reliable measure of business conditions.In the words of Charles Dow:The market is not like a balloon plunging hither and thither in the wind. As a whole, itrepresents a serious, well-considered effort on the part of far-sighted well-informedmen to adjust prices to such values as exist or which are expected to exist in the nottoo remote future . . . . The man who as a woolen merchant sees the demand for hisgoods suddenly disappear, or who as an iron dealer finds prices uncertain and bills receivable becoming somewhat doubtful in quality, will not be quickened thereby totrade on the long side (buy) of