Stock markets across the world are struggling due to serious selling pressure. One can ascribe reasons like China’s slowdown, devaluation of Yuan, Fed rate hike, increase in unemployment rate, fall in the purchasing managers’ index (PMI), etc. Fluctuations in security markets are related to changes in the aggregate economy.
The price of most bonds is determined by the level of interest rates, which are influenced by overall economic activity and Federal Reserve policy. Individual stock prices reflect investor expectations about firm’s performance in terms of earnings, cash flow, and investor’s required rate of return. This performance is likewise affected by the overall performance of the economy. So, it is essential to understand some of these indicators which signals the investors in advance before actual changes takes place in the financial markets.
Types of indicators
Financial economics literature examined the relationship of alternative economic series to the behaviour of the entire economy and has classified them into three groups: leading, coincident, and lagging indicator series. Let us look at the same in detail.
Leading indicators, as the name suggests, will signal the future events with reference to the business cycle peaks and troughs normally three to 12 months they actually occur. These indicators often change prior to large economic adjustments and can be used to predict future trends. Examples of leading indicators are manufacturing activity, inventory levels, retail sales, permission to build new houses, new businesses, etc. Leading economic indicators predict where the economy is headed in the near future, providing enormous assistance to investors, consumers, business leaders, and policy makers who need to anticipate and plan for future economic conditions.
Co-incident indicators are those which might occur almost simultaneously as the conditions they signify. Indicators such as personal income, industrial production fall under this category. Coincident economic indicators document the current state of business cycles.
Lagging indicators indicate business-cycle patterns such as peaks and troughs three to 12 months after they actually occur. Changes in gross domestic products, inflation, interest rates, unemployment rates, corporate profits, balance of trade will help investors to direct attention to the next phase of business cycle.
Business confidence index
Think tanks like NCAER and Confederation of Indian industries (CII) jointly compute an index which is known as Business Confidence Index (BCI). This index captures the expectations of business houses in India on a quarterly basis. It is based on responses received from a broad sample of firms across regions, sectors and sizes. BCI is based on responses to questions that relate to the overall economic conditions and financial position of firms.
Survey of sentiments
Consumer expectations play an important role as the economy approaches turning points in the business cycle. Globally, two surveys of consumer expectations are closely followed by the investors. The University of Michigan Consumer Sentiment Index and the Conference Board Consumer Confidence Index both query a sample of households on their expectations over the next six months (Conference Board) or over the next year (Michigan).
Although the two indexes sometimes deviate from each other month to month, over longer time periods they track each other fairly closely. Both indexes act as a leading indicator by rising and falling before the general level of economic activity does.
Where to look for indicators?
A vast majority of the indicators as discussed above are published by the central banks of the respective countries. For instance, majority of the US data on the above indicators are released by National Bureau of Economic Indicators and a similar Indian counterpart is National Council of Applied Economic Research. Survey of sentiments, expectations and business confidence index are released by the respective organisation who computes the same and it is available in public space.
To conclude that there is ample evidence of a strong and consistent relationship between economic activity and the stock market, although stock prices consistently seem to turn from four to nine months before the economy does.
Therefore, to project the future direction of the stock market using the macroeconomic approach, you must either forecast economic activity about 12 months ahead or examine economic indicator series that lead the economy by more than stock prices do.
Taking stock
* Leading indicators will signal the future events with reference to the business cycle peaks and troughs normally3 to 12 months they actually occur
* Either forecast economic activity about 12 months ahead or examine economic indicator series that lead the economy by more than stock prices do
The authors teach finance and accounting course in IIM, Shillong