The Big Three Economic Indicators
Jim Graham

Traders are always trying to understand the factors that cause the market to rise and fall. The truth is that there are a multitude of factors, and millions of investors make decisions that impact the market every day. Corporate earnings and news, political news, and general market sentiment can all move the market. But economic factors have the most influence on long-term market performance.
There is a lot of economic data available on the US economy, and almost every day some economic report or another is being released. When reading these releases I always try to assess the importance of each item and how it fits into the current economic situation. For the most important reports, especially those that may impact an industry that contains companies you are trading, it is often better to not rely solely on the analysis offered by financial journalists but to look at and try to understand the original sources.
Of all the economic indicators, the three most significant for the overall stock market are inflation, gross domestic product (GDP), and labor market data. I always try to keep in mind where these three are in relation to the current stage of the economic cycle. That gives me a framework to work with that allows me to estimate how any individual piece of economic data may affect these three indicators, and to then project its probable effect on the stock market as a whole.
Inflation is a significant indicator for securities markets because it determines how much of the real value of an investment is being lost, and the rate of return you need to compensate for that erosion. For example, if inflation is at 3% this year, and your investment also increases by 3%, in real terms you have just managed to stay even. And to take on market risk, you should receive a “risk premium” above and beyond the inflation rate. So investors who buy stocks do so expecting they will get a return equal to (or better than) that risk premium adjusted by the inflation rate. So a higher rate of inflation means you should get a higher return for investments in the equity markets.
But the effect inflation has on the stock market is more complicated than that. The main impact of inflation on stock prices actually comes from the effect it has on a company’s earnings. Low inflation keeps a company’s costs down, and increases profits. So all other things being equal, (a favorite phrase of all economists), low inflation is better for the market than high inflation.
There are many causes of inflation. From a supply-demand standpoint, it can be due to increased demand for a particular product, from an increase in a company’s cost of supplies, or from limited supplies (like OPEC members restricting oil supplies), or even just due to fear that supplies might be limited at some point in the future. But the single most important determinant of inflation is the output gap, which is the balance between supply and demand in the economy.
The output gap measures the difference between the economy’s potential, where all capital and labor resources are in use, and the actual level of output. When actual output is below its potential, inflation should be low because excess workers and unused plant and equipment are available. The actual level of output is easy to get, and is measured by GDP. But potential output is harder to calculate and requires estimates to determine its value. So while the output gap is important to always keep in mind when interpreting economic data, its exact amount is never known. For that reason it is not a realistic indicator for investors to use. That is why a proxy is needed, so that you have a single number to estimate it. In the US it is the Consumer Price Index (CPI) that is the most widely followed measure of inflation.
The Labor Department issues a CPI figure every month, measuring the increase in the price of a given "basket" of goods and services purchased by the average consumer. That basket supposedly includes a number of items commonly purchased by all or most consumers, such as food, housing, clothes, transportation, medical care, and entertainment. The total value of that basket is then compared to the same basket of goods a year later. The percentage increase in the price for these goods in one year is the inflation rate or, if the value drops as happened in Japan over much of the past decade, the deflation rate. That gives you a measured percentage such as 3%, which means that the basic necessities of life cost 3% more today than they did last year.
There are of course some problems with this measure. For one thing, the products rarely remain exactly the same, and it can be difficult to strip out how much of an increase is due to inflation, and how much is due to other factors such as improvements in quality. Also, the composition of what people buy changes over time. In fact, many of the goods now included were not even invented 20 or 30 years ago. Still remains the single best proxy available and, at least in the short- to medium-term, is the number that investors focus on when making their decisions.
While GDP is an important component in inflation, it is also important as an economic indicator in its own right. When compared to the previous year’s reading, it tells you how fast the economy is growing (or contracting). GDP is the dollar value of all goods and services produced by a given country during a certain period. It is measured by either adding all of the income earned in an economy, or by all the spending in an economy. Both measures should be roughly equal.
Gross domestic income includes wages and salaries, corporate profits, interest collected by lenders, and taxes collected by governments. GDP domestic expenditures includes consumer spending, housing investment, government spending, business spending (investment in factories, equipment, and inventory), as well as foreign spending on our exports minus our spending on their imports. With so many individual components affecting GDP (and through the output gap, inflation) you can see how easy it is for the number of economic reports to mushroom.
 GDP affects the stock market through its effect on inflation, as well as through its use as a key indicator of economic activity and future economic prospects by investors. Any significant change in the GDP, either up or down, can have a big effect on investing sentiment. If investors believe the economy is improving (and corporate earnings along with it) they are likely to be willing to pay more for any given stock. If there is a decline in GDP (or investors expect a decline) they would only be willing to buy a given stock for less, leading to a decline in the stock market.
On top of this effect, there is also an economic theory that suggests the stock market itself exerts a reverse effect on economic activity, usually called the “wealth effect”. This theory says that a fall in the stock market makes an individual’s personal wealth (or perceived wealth) fall. They consequently stop spending as much. Since consumer spending represents around two-thirds of GDP, a small change in consumption exerts a significant effect on GDP. This means that as the stock market falls, it causes GDP t9 fall even further, which further intensifies the downward pressure on the stock market.
The last major factor influencing the economy is the labor market. The key indicators most investors focus on here are total employment and the unemployment rate. US citizens who are already working represent the employed, while those who are actively looking for work, but haven’t found it yet, are the unemployed. The unemployment rate does not include people without jobs who are not looking for jobs, such as students, retirees, or people who are discouraged and have simply given up trying to find a job.
The Employment Report is published monthly by the US Department of Labor, and provides both the employment and unemployment numbers. There is always some unemployment. As the allocation of resources change in the economy, based on what people are buying, some companies go out of business while others that produce the things that are in demand will be expanding. This allows a flow of labor from losing to winning industries but it is not an instantaneous process. Others may leave their jobs by choice. That means there is always some amount of unemployment built into the economic structure, which is often termed the “natural” level of unemployment.
The natural level of unemployment is the point where any drop below that figure creates conditions that will drive up inflation (as companies bid up wages to attract the scarce workers). There is always some disagreement as to what the “natural” level of unemployment is for the US economy. For one thing, it changes over time as the nature of the economy changes. For most of the 1980’s, it was often estimated at about 6%, although most economists now feel it is probably around 5%, or even the high 4’s.
What might cause this kind of change? A paper a couple years ago from the Brookings Institute cited some factors that they estimated have reduced the natural rate by about 1%. Accounting for about 0.4% of that is the aging of the population; older people tend to be more fully employed. The growth of temporary staffing firms that rapidly match job-seekers with employers could account for 0.2-0.4%. Finally, the doubling of the prison population probably accounts for about 0.2% of the reduction, by removing from the labor force people who are less likely to be employed.
There are many components that are used to calculate each of the major economic indicators, and rarely all point in the same direction. To make it even more complicated, each of these indicators are closely linked with one another. That is what makes it difficult to interpret what impact any individual economic report is likely to have on the stock market. To make things even more difficult, whether a certain reading is good or bad can also depend on what part of the economic cycle the economy is currently at.
There are many institutions and safeguards within an economy that are designed to mitigate or increase any of these effects that you also need to take into account. Their probable reaction to news and events must be factored into any predictions for the future behavior of the economy. Monetary policy and fiscal policy are the two primary ways that the government influences the economy. Following the actions of the Federal Reserve, analyzing the comments made by its members (particularly the Chairman), and trying to predict what their future moves will be keep many economists employed. And actions taken by the Federal Open Market Committee often do move the stock market.
The economic evidence right now seems to indicate that the current output gap is still large enough to allow for additional expansion without increasing the rate of inflation. Therefore reports showing an increase in GDP, or unemployment decreasing, are good news and the market should go up. Any report that shows inflation is higher than expected is bad, because it may indicate that we are overestimating the size of the output gap, and that should cause the stock market to drop. But in a later stage of the economic cycle, when the output gap is smaller or non-existent, those same news items could have the opposite effect on the stock market.
Let’s work through one last example and explain the chain of reasoning that can lead to what may seem, on the surface, a counterintuitive result. Consider how a report that unemployment is low might be bad for the stock market. When labor market data shows that the unemployment rate is low, the stock market is usually expected to go up. Since more people are employed, consumer spending will increase, which leads to an increase in GDP. But as mentioned earlier, if the output gap is small or nonexistent an increase in GDP means the output gap will decrease even more which means the economy stands a greater risk of inflation. And inflation is bad for the stock market so it goes down on what would normally be considered good news.
Inflation, GDP, and employment data all exert a significant influence on the stock market. All three are closely interrelated and a change in any single factor can have a significant trickle-down effect. And since interpretation is as much an art as science, it can also be helpful to try and look at the original source reports on occasion, if only to see what the headlines, business articles, and pundits may be leaving out.