decline through October. Unofficially, by autumn, prices were said to be 15 to 20 percent below the July closing.It is ironic that the only extended period during which the New YorkStock Exchange was closed occurred when the United States was not yetat war or in any degree of financial or economic distress. In fact, when theexchange was closed, traders realized that the United States would be astrong economic beneficiary of the European conflict. Once investors realized that America was going to make the munitions and provide rawmaterials to the belligerents, public interest in stocks soared.By the time the exchange reopened on December 12, prices were rising rapidly. The Dow Industrials finished the historic Saturday sessionabout 5 percent higher than the closing prices on the previous July. Therally continued, and 1915 records the best single-year increase in the history of the Dow Industrials, as stocks rose a record 82 percent. Stocks continued to rise in 1916 and hit their peak in November, with prices morethan twice the level they were when the war had started more than twoyears earlier. But then stocks settled back about 10 percent when theUnited States formally entered the war on April 16, 1917, and fell another10 percent through November 1918, when the Armistice was signed.The message of the great boom of 1915 was not lost on traders ageneration later. When World War II erupted, investors took their cuefrom what happened at the beginning of the previous world war. WhenGreat Britain declared war on Germany on September 3, 1939, the risewas so explosive that the Tokyo Stock Exchange was forced to closeearly. When the market opened in New York, a buying panic erupted.The Dow Industrials gained over 7 percent, and even the European stockexchanges were firm when trading reopened.The enthusiasm that followed the onset of World War II quicklyfaded. President Roosevelt was determined not to let corporations earneasy profits as they had in World War I. These profits had been a sourceof public criticism as Americans felt that the war costs were not beingborne equally as its young men died overseas while corporations earnedrecord income. An excess profits tax enacted by Congress during WorldWar II removed the wartime premium that investors had expected fromthe conflict.
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The day before the Japanese attacked Pearl Harbor, the Dow wasdown 25 percent from its 1939 high and still less than one-third its 1929peak. Stocks fell 3.5 percent on the day following Pearl Harbor and continued to fall until they hit a low on April 28, 1942, when the UnitedStates suffered losses in the early months of the war in the Pacific.But when the tide turned toward the Allies, the market began toclimb. By the time Germany signed its unconditional surrender on May7, 1945, the Dow Industrials were 20 percent above the prewar level. Thedetonation of the atomic bomb over Hiroshima, a pivotal event in thehistory of warfare, caused stocks to surge 1.7 percent as investors recognized the end of the war was near. But World War II did not prove asprofitable for investors as World War I, as the Dow was up only 30 percent during the six years from the German invasion of Poland to V-J Day.
Post-1945 ConflictsThe Korean War took investors by surprise. When North Korea invadedits southern neighbor on June 25, 1950, the Dow fell 4.65 percent, greaterthan the day following Pearl Harbor. But the market reaction to thegrowing conflict was contained, and stocks never fell more than 12 percent below their prewar level.The Vietnam War was the longest and one of the least popular of allU.S. wars. The starting point for U.S. involvement in the conflict can beplaced at August 2, 1964, when two American destroyers were reportedly attacked in the Gulf of Tonkin.One and a half years after the Gulf of Tonkin incident, the Dowreached an all-time high of 995, more than 18 percent higher than beforethe Tonkin attack. But it fell nearly 30 percent in the following monthsafter the Fed tightened credit to curb inflation. By the time Americantroop strength reached its peak in early 1968, the market had recovered.Two years later, when Nixon sent troops into Cambodia and interestrates were soaring and a recession was looming, the market fell again,down nearly 25 percent from its prewar point.The Peace Pact between the North Vietnamese and the Americanswas signed in Paris on January 27, 1973. But the gains made by investorsover the eight years of war were quite small, as the market was heldback by rising inflation and interest rates as well as other problems notdirectly related to the Vietnam War.If the war in Vietnam was the longest American war, the 1991 GulfWar against Iraq in the Middle East was the shortest. The trigger occurred on August 2, 1990, when Iraq invaded Kuwait, sending oil prices
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skyward and sparking a U.S. military buildup in Saudi Arabia. The risein oil prices combined with an already slowing U.S. economy to drivethe United States deeper into a recession. The stock market fell precipitously, and on October 11, the Dow slumped over 18 percent from itsprewar levels.The United States began its offensive action on January 17, 1991. Itwas the first major war fought in a world where markets for oil, gold,and U.S. government bonds were traded around the clock in Tokyo,Singapore, London, and New York. The markets judged the victors in amatter of hours. Bonds sold off in Tokyo for a few minutes followingthe news of the U.S. bombing of Baghdad, but the stunning reports ofthe United States and its allies’ successes sent bonds and Japanesestocks straight upward in the next few minutes. Oil prices traded in theFar East collapsed, as Brent crude fell from $29 a barrel before hostilitiesto $20.On the following day, stock prices soared around the world. TheDow jumped 115 points, or 4.4 percent, and there were large gainsthroughout Europe and Asia. By the time the United States deployedground troops to invade Kuwait, the market had known for two monthsthat victory was at hand. The war ended on February 28, and by the firstweek in March, the Dow was more than 18 percent higher than when thewar started.As noted at the outset of this chapter, the War on Terrorism beganwith the terrorists’ attacks on New York and the Pentagon on September11, 2001. The Dow Industrials were down 16 percent from their close of9,606 on September 10 to an intraday low of 8,062 reached on Friday,September 21. But the market rebounded sharply by the next week, andit had recovered to 9,120 by the time the United States began offensiveaction against the Taliban in Afghanistan on October 7.Because of aggressive easing policies by the Federal Reserve andthe successful execution of the Afghanistan war, the Dow surpassed itsSeptember 10 level on November 13 and continued rising to year-end.From its intraday low on September 21 to its intraday high of 10,184 onDecember 28, the Dow rose an astounding 26.3 percent in three months.The market continued its rise to 10,673 on March 19, 2002, but thebear market, which had begun two years earlier, was far from over. Asluggish economy, combined with the accounting scandals of Enron,WorldCom, and others, sent stocks into another dive that didn’t enduntil October 10, 2002, when the Dow hit an intraday low of 7,197.From the intraday high of 11,750 reached on January 14, 2000, throughthe October 10, 2002, low, the Dow Industrials fell nearly 39 percent, a
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decline far less than the S&P 500 Index that was bloated by overpricedtechnology stocks.The market subsequently rallied to over 9,000, but anxiety about asecond U.S. operation in Iraq sent the stock back down to 7,524 fivemonths later on March 11, 2003, just days before the invasion. But as itresponded 12 years earlier when the Gulf War started, the market ralliedon news of the invasion and continued to rise despite the growing insurgency in Iraq that made the war particularly unpopular.Notwithstanding the Republican defeat in Congress in November2006, stocks hit new all-time highs in the summer of 2007, more than recovering all the ground that had been lost during the 2000 to 2002 bearmarket. From the end of March 2003, the first month of the Iraq invasion,through June 2007, the annual return on the market was an extremelystrong 17.5 percent per year.
CONCLUSIONWhen investigating the causes of major market movements, it is sobering to realize that less than one in four can be linked to a news event ofmajor political or economic import. This confirms the unpredictability ofthe market and the difficulty in forecasting market moves. Those whosold in panic at the outbreak of World War I missed out on 1915, the bestyear ever in the stock market. But those who bought at the onset ofWorld War II, believing there would be a replay of the World War I gains,were sorely disappointed because of the government’s determination tocap wartime profits. World events may shock the market in the shortrun, but thankfully they have proven unable to dent the long-term returns that have become characteristic of stocks over the long run.
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CHAPTER
STOCKS, BONDS, ANDTHE FLOW OF ECONOMIC DATAThe thing that most affects the stock market is everything.J A M E S PA LY S T E D W O O D , 1 9 6 6
It’s 8:28 a.m. eastern daylight time, Friday, July 5, 1996. Normally a trading day wedged between a major U.S. holiday and a weekend is slow,with little volume or price movement. But not today. Traders around theworld are anxiously glued to their terminals, eyes riveted on the scrolling news that displays thousands of headlines every day. It is just twominutes before the most important announcement each month—theU.S. employment statistics.All week, stock, bond, and currency traders have anticipated thisday. The Dow has been trading within a few points of its all-time high,reached at the end of May. But interest rates have been rising, givingtraders cause for concern. The seconds tick down. At 8:30 sharp, thewords come across the screen:PAYROLL UP 239,000, UNEMPLOYMENT AT SIX-YEAR LOW OF 5.3PERCENT, WAGES UP 9 CENTS AN HOUR, BIGGEST INCREASE IN 30YEARS.
237Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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President Clinton hailed the economic news, claiming, “We havethe most solid American economy in a generation; wages for Americanworkers are finally on the rise again.”But the financial markets were stunned. Long-term bond prices immediately collapsed on both domestic and foreign exchanges as tradersexpected higher interest rates. Interest rates on long- and short-termbonds climbed nearly a quarter point. Although the stock market wouldnot open for an hour, the S&P 500 Index futures, which represent claimson this benchmark index and are described in detail in the next chapter,fell from 676 to 656, about 2 percent. European stock markets, which hadbeen open for hours, sold off immediately. The benchmark DAX index inGermany, CAC in France, and FT-SE in Britain instantly fell almost 2percent. Within seconds, world equity markets lost $200 billion, andworld bond markets fell at least as much.This episode demonstrates that what Main Street interprets as goodnews is often bad news on Wall Street. This is because it is more than mereprofits that move stocks; interest rates, inflation, and the future directionof the Federal Reserve’s monetary policy also have a major impact.
ECONOMIC DATA AND THE MARKETNews moves markets. The timing of much news is unpredictable—likewar, political developments, and natural disasters. In contrast, newsbased on data about the economy comes at preannounced times that areset a year or more in advance. In the United States, there are hundreds ofscheduled releases of economic data each year—mostly by governmentagencies, but increasingly by private firms. Virtually all of the announcements deal with the economy, particularly economic growth andinflation, and all have the potential to move the market significantly.Economic data not only frame the way traders view the economybut also impact traders’ expectations of how the central bank will implement its monetary policy. Stronger economic growth or higher inflation increases the probability that the central bank will either tighten orstop easing monetary policy. All these data influence traders’ expectations about the future course of interest rates, the economy, and ultimately stock prices.
PRINCIPLES OF MARKET REACTIONMarkets do not directly respond to what is announced; rather, they respond to the difference between what the traders expect to happen and
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what actually happens. Whether the news is “good” or “bad” for theeconomy is of no importance. If the market expects that 200,000 jobswere lost last month but the report shows that only 100,000 jobs werelost, this will be considered “stronger-than-expected” economic news bythe financial markets—having about the same effect on markets as again of 200,000 jobs would when the market expected a gain of only100,000.The reason why markets react only to the difference between expectations and what actually occurs is that the prices of securities already incorporate all the information that is expected. If a firm isexpected to report bad earnings, the market has already priced thisgloomy information into the stock price. If the earnings report is not asbad as anticipated, the price will rise on the announcement. The sameprinciple applies to the reaction of bonds, stocks, and foreign exchangesto economic data.Therefore, to understand why the market moves the way it does,you must identify the market expectation for the data released. The market expectation, often referred to as the consensus estimate, is gathered bynews and research organizations. They poll economists, professionalforecasters, traders, and other market participants for their predictionsfor an upcoming government or private release. The results of their surveys are sent to the financial press and widely reported online and inmany other news outlets.1
INFORMATION CONTENT OF DATA RELEASESThe economic data are analyzed for their implications for future economic growth, inflation, and central bank policy. The following principle summarizes the reaction of the bond markets to the release of datarelating to economic growth:Stronger-than-expected economic growth causes both long- and shortterm interest rates to rise. Weaker-than-expected economic growth causesinterest rates to fall.
Faster-than-expected economic growth raises interest rates for several reasons. First, stronger economic activity makes consumers feelmore confident and more willing to borrow against future income, increasing loan demand. Faster economic growth also motivates firms to1
Usually both the median and range of estimates are reported. The consensus estimate does vary abit from service to service, but the estimates are usually quite close.
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expand production. As a result, both firms and consumers will likely increase their demand for credit and push interest rates higher.A second reason why interest rates rise in tandem with a strongerthan-expected economic report is that such growth might be inflationary,especially if it is near the end of an economic expansion. Economicgrowth associated with increases in productivity, which often occur inthe early and middle stages of a business expansion, is rarely inflationary.Going back to the example above, inflationary fears were the principal reason why interest rates soared when the Labor Department released its report on July 5, 1996. Traders feared that the large increase inwages caused by the tight labor markets and falling unemploymentwould cause inflation, a nemesis to both the bond and the stock markets.Reports on economic growth also have significant implications forthe actions of central banks. The threat of inflation from an overly strongeconomy will make it likely that the central bank will tighten credit. Ifthe aggregate demand is expanding too rapidly relative to the supply ofgoods and services, the monetary authority can raise interest rates toprevent the economy from overheating.Of course, in the case of a weaker-than-expected employment report,the bond market will respond favorably as interest rates decline in response to weaker credit demand and lower inflationary pressures. Recallthat the price of bonds moves in the opposite direction of interest rates.An important principle to understand is that the market reactsmore strongly after several similar reports move in the same direction.For example, if an inflation report is higher than expected, then the following month the market will react even more strongly to anotherhigher-than-expected reading. The reason for this is that there is a lot ofnoise in the individual data report and a single month’s observationmay be reversed in subsequent data. But if the subsequent data confirmthe original data, then it is more likely that a new trend has been established and the market will move accordingly.
ECONOMIC GROWTH AND STOCK PRICESIt surprises the general public and even the financial press when a strongeconomic report sends the stock market lower. But stronger-than-expected economic growth has two important implications for the stockmarket, and each tugs in the opposite direction. A strong economy increases future corporate earnings, which is bullish for stocks. But it alsoraises interest rates, which raises the discount rate at which these futureprofits are discounted. Similarly, a weak economic report may lower ex-
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pected earnings; but if interest rates decline, stock prices could possiblymove up because of the decline in the rate at which these profits are discounted. It is a struggle, in asset pricing terms, between the numerator,which contains future cash flows, and the denominator, which discountsthose cash flows.Which effect is stronger—the change in the interest rate or thechange in corporate profits—depends often on where the economy is inthe business cycle. Recent analysis shows that in a recession, a strongerthan-expected economic report increases stock prices since the implications for corporate profits are considered more important than thechange in interest rates at this stage in the business cycle.2 Inversely, aweaker-than-expected report depresses stock prices. During economicexpansions, and particularly toward the end of an expansion, the interest rate effect is usually stronger since inflation is more of a threat.Many stock traders look at the movements in the bond market toguide their trading. This is particularly true of portfolio managers whoactively apportion their portfolio between stocks and bonds on the basisof changes in interest rates and expected stock returns. When interestrates fall after a weak economic report, these investors are immediatelyready to increase the proportion of stocks that they hold since the relative returns on stocks or bonds have, at that moment, turned in favor ofstocks. On the other hand, investors who recognize that the weak employment report means lower future earnings may sell stocks. The stockmarket often gyrates throughout the day as investors digest the implications of the data for stock earnings and interest rates.
THE EMPLOYMENT REPORTThe employment report, compiled by the Bureau of Labor Statistics (BLS),is the single most important data report released by the governmenteach month. To measure employment, the BLS does two entirely different surveys, one that measures employment and the other that measuresunemployment. The payroll survey counts the total number of jobs thatcompanies have on their payrolls, while the household survey counts thenumber of people who are looking for jobs. The payroll survey, sometimes called the establishment survey, collects payroll data from nearly400,000 business establishments, covering nearly 50 million workers,2See John Boyd, Jian Hu, and Ravi Jagannathan, “The Stock Market’s Reaction to UnemploymentNews: Why Bad News Is Usually Good for Stocks,” National Bureau of Economic Research (NBER)Working Paper No. W8092, NBER, Cambridge, Mass., January 2001.
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about 40 percent of the total workforce. It is this survey that most forecasters use to judge the future course of the economy. Of the greatest importance to traders is the change in the nonfarm payroll (the number offarm workers is excluded since it is very volatile and not associated withcyclical economic trends).The unemployment rate is determined from an entirely different survey than the payroll survey. It is the unemployment rate, however, thatoften gets the top billing in the evening news. The unemployment rate iscalculated from a “household survey” in which data from about 60,000households are accumulated. It asks, among other questions, whetheranyone in the household has “actively” sought work over the past fourweeks. Those who answer yes are classified as unemployed. The resulting number of unemployed people is divided by the number of peoplein the total labor force, which yields the unemployment rate. The laborforce in the United States, defined as those employed plus those unemployed, comprises about two-thirds of the adult population. This ratiohad risen steadily in the 1980s and 1990s as more women have successfully sought work, but it has stabilized recently.The BLS statistics can be very tricky to interpret. Because the payroll and household data are based on totally different surveys, it is notunusual for payroll employment to go up at the same time that the unemployment rate rises, and vice versa. One reason is because the payrollsurvey counts jobs, while the household survey counts people. So workers with two jobs are counted only once in the household survey buttwice in the payroll survey. Furthermore, self-employed individuals arenot counted in the payroll survey but are counted in the household survey. Finally, increases in the number seeking work in the early stage ofan economic recovery may increase the unemployment rate due to theinflux of job seekers into an improved labor market.For these reasons, economists and forecasters have downplayed theimportance of the unemployment rate in forecasting the business cycle.But this does not diminish the political impact of this number. The unemployment rate is an easily understood figure that represents the fraction of the workforce looking for but not finding work. Much of thepublic looks more to this statistic than any other to judge the health ofthe economy. As a result, pressure to shift policy mounts on politiciansand policymakers whenever the unemployment rate rises.Since 2005, the Automatic Data Processing (ADP) corporation hasreleased its own payroll data, called The ADP National Employment Report, two days before the BLS labor report. The ADP report is a measureof nonfarm private employment, based on approximately three-fourths
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of ADP’s 500,000 U.S. business clients and approximately 23 million employees. Because ADP processes the paychecks for 1 out of every 6 private sector employees in the United States every pay period across abroad range of industries, firm sizes, and geographies, ADP’s numbersprovide a good clue for the upcoming labor data. Early indications arethat the ADP number may give a better estimate of payroll changes thanthe consensus forecast, although more data are needed to confirm this.
THE CYCLE OF ANNOUNCEMENTSThe employment report is just one of several dozen economic announcements that come out every month. The usual release dates for the variousdata reports that the BLS, the Conference Board, and other entities generate in a typical month is displayed in Table 14-1. The number of asterisksrepresents the importance of the report to the financial market.The payroll report is the culmination of important data on economic growth that come out around the turn of the month. On the firstbusiness day of each month, a survey by the Institute for Supply Management (ISM, formerly the National Association of Purchasing Managers, the NAPM) called the purchasing managers index (PMI) is released.The institute’s report surveys 250 purchasing agents of manufacturing companies and inquires as to whether orders, production,TABLE
14–1
Monthly Economic CalendarMonday
Tuesday
Wednesday
Thursday
Friday
1
10:00 Purchasing Mgrs.Index** (PMI)
28:30 Leading EconomicIndicator* (2 months lag)
38:15 ADP Employment Est.**10:00 Service PMI**
48:30 Jobless Claims**
58:30 EmploymentReport****
8
9
10
118:30 Jobless Claims**
128:30 Retail Sales**8:30 Producer Prices****
15
168:30 Consumer Prices****
178:30 Housing Starts***9:15 Industrial Production*
188:30 Merchandise Trade*8:30 Jobless Claims**
22
238:30 Durable GoodsOrders**
24
258:30 Jobless Claims**
1910:00 Cons. Sentiment(Univ. of Mich., Prelim.)**12:00 Phila. Fed Rep*268:30 Gross Dom. Prod.***8:30 PCE Deflator***
29
3010:00 Cons. Confidence(Conference Board)***
3110:00 Chicago PurchasingManagers**
Stars Rank Importance to Market (**** = most important)
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employment, or other indicators are rising or falling, and it forms anindex from these data. A reading of 50 means that half the managers report rising activity and half report falling activity. A reading of 52 or 53is the sign of a normally expanding economy. A reading of 60 representsa strong economy in which three-fifths of the managers report growth. Areading below 50 represents a contracting manufacturing sector, and areading below 40 is almost always a sign of recession. Two days later, onthe third business day of the month, the ISM publishes a similar indexfor the service sector of the economy.There are other releases of very timely data reports on manufacturing activity. The Chicago Purchasing Managers report comes out on thelast business day of the month, the day before the national PMI report.The Chicago area is well diversified in manufacturing, so about twothirds of the time the Chicago index will move in the same direction asthe national index.And if you want an even earlier reading on the economy, there arethe consumer sentiment indicators: one from the University of Michiganand another from the Conference Board, a business trade association.These surveys query consumers about their current financial situationand their expectations of the future. The Conference Board survey, released on the last Tuesday of the month, is considered a good early indicator of consumer spending. For many years, the University of Michiganmonthly index was not published until after the Conference Board release, but pressure for early data reports has persuaded the university torelease a preliminary report before the Conference Board.
INFLATION REPORTSAlthough the employment report forms the capstone of the news abouteconomic growth, the market knows that the Federal Reserve is equallyif not more interested in the inflation data. That’s because inflation is theprimary variable that the central bank can control in the long run. Someof the earliest signals of inflationary pressures arrive with the midmonthinflation statistics.The first monthly inflation release is the producer price index (PPI),which was known before 1978 as the “wholesale price index.” The PPI,first published in 1902, is one of the oldest continuous series of statisticaldata published by the government.The PPI measures the prices received by producers for goods sold atthe wholesale level, the stage before the goods are resold to the public.About one-quarter of the PPI comes from the price of capital goods sold
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to manufacturers, and about 15 percent of the PPI is energy related. Thereare no services in the producer price index. At the same time the PPI is announced, indexes for the prices of intermediate and crude goods are released, both of which track inflation at earlier stages of production.The second monthly inflation announcement, which follows thePPI by a day or so, is the all-important consumer price index (CPI). TheCPI does cover the prices of services as well as goods. Services, which include rent, housing, transportation, and medical services, now compriseover half the weight of the CPI.The consumer price index is considered the benchmark measure ofinflation. When price level comparisons are made, both on a historicaland an international basis, the consumer price index is almost alwaysthe chosen index. The CPI is also the price index to which so many private and public contracts, as well as Social Security and government taxbrackets, are linked.The financial market probably gives a bit more weight to the consumer price index than to the producer price index because of the CPI’swidespread use in indexing and political importance. But many economists regard the producer price index as more sensitive to early pricetrends as inflation often shows up at the wholesale level before it showsup on the retail level.
Core InflationOf importance to the market is not only the overall inflation rate but inflation that excludes the volatile food and energy sectors. Since weatherhas a great influence on food prices, a rise or fall in the price of food overa month does not have much meaning for the overall inflationary trend.Similarly, the fluctuations of oil and natural gas prices are due to weatherconditions, temporary supply disruptions, and speculative trading thatdo not necessarily persist into future months. To obtain an index of inflation that measures the more persistent and long-term trends of inflation,the government also computes the core consumer and producer price indexes, which measure inflation excluding food and energy.The core rate of inflation is more important to the central banks asit identifies underlying inflation better than changes in the overall indexthat include food and energy. Forecasters are usually able to predict thecore rate of inflation better than the overall rate since the latter is influenced by the volatile food and energy sectors. An error of three-tenths ofa percentage point in the consensus forecast for the month-to-month rateof inflation might not be that serious, but such an error would be con-
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sidered quite large for the core rate of inflation and would significantlyaffect the financial markets.Another inflation indicator that both Fed chairmen Alan Greenspanand Ben Bernanke have supported is the personal consumption expenditure(PCE) deflator, which is the price index calculated for the consumptioncomponent of the GDP accounts. The PCE deflator differs from the consumer price index in that the PCE deflator uses a more up to dateweighting scheme and includes the cost of the employer-paid as well asthe employee-paid medical insurance.
Employment CostsOther important releases bearing on inflation relate to labor costs. Themonthly employment report issued by the BLS contains data on thehourly wage rate. This report sheds light on cost pressures arising in thelabor market. Since labor costs average nearly two-thirds of a firm’s production costs, increases in the hourly wage not matched by increases inproductivity increase labor costs and threaten to cause inflation.Every calendar quarter, the government also releases the employmentcost index (ECI). This index includes benefit costs as well as wages, and itis considered the most comprehensive report of labor costs. The FederalReserve considers this a more important indicator of inflation than thehourly wage, so the financial markets closely scrutinize these data.
IMPACT ON FINANCIAL MARKETSThe following summarizes the impact of inflation on the financial markets:A lower-than-expected inflation report