Chapter 29
Tying It All
Together
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Learning Objectives
• Understand the role of economic indicators and
their importance to financial markets
• Realize the complexities of modern financial
markets and their importance to the economy
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Introduction
• This chapter ties all the concepts together
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Markets and instruments
Banks
Central banking
Monetary theory
• Discussion of the key economic indicators and
how these influence securities prices
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The Economic Indicators
• Economic indicators measure economic performance
• Some indicators are very important
– GDP growth, unemployment and inflation
– These embody the ultimate objectives or goals set by the
Federal Reserve
• However, other economic indicators are more focused
on specific measures and provide insight into how the
economy is performing
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The Economic Indicators (Cont.)
• Table 29.1 and Figure 29.1
– Lists and displays the most important economic
indicators with the source of the data and frequency
of release
– These indicators can also influence the price
movement of stocks and bonds
– Because of the importance of indicators, traders
know exactly when these indicators will be released
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TABLE 29.1 Key economic
indicators.
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FIGURE 29.1 Selected economics
indicators.
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FIGURE 29.1 Selected economics
indicators. (Cont.)
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The Economic Indicators (Cont.)
• Table 29.1 (Cont.)
– Understanding how the market reacts to a particular
indicator requires a two-step procedure
• Understand what the indicator is and its connector to
security prices
• Understand the way the indicator behaves relative to
changes in the economy
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The Economic Indicators (Cont.)
• The Employment Report
– Compiled monthly by the Bureau of Labor Statistics and the
U.S. Department of labor
– Contains information on employment, average workweek and
hourly earnings
– Primary focus from the press is on the unemployment rate
and the level of payroll employment
– Because this report is released monthly, the employment
statistics offer a frequent update on the state of economic
activity
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The Economic Indicators (Cont.)
• The Employment Report (Cont.)
– Household Survey
• Based on a monthly sample of about 6,000 households
• Estimates the unemployment rate based on two questions—1) are you
employed, and 2) if not, are you actively looking
• The unemployment rate is the ratio of the number of people
unemployed to the number of people in the labor force (those
working plus those not working, but looking)
• Possible bias is a person’s reluctance to admit they are no longer
actively looking for a job, but has dropped out of the labor force
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The Economic Indicators (Cont.)
• The Employment Report (Cont.)
– Establishment Survey
• This is the basis for payroll employment
• The source of data comes from canvassing business
establishments rather than households
• Excludes self-employed and domestic workers
• Persons who hold multiple jobs can be counted several
times
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The Economic Indicators (Cont.)
• The Employment Report (Cont.)
– Market brokers/dealers place more weight on the
payroll numbers compared with the unemployment
rate because the measurement problems are less
– Both reports are lagging indicators—follow behind
changes in overall economic activity
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The Economic Indicators (Cont.)
• Housing Starts and Building Permits
– This report reflects activity in a very important
sector of the economy
– Housing accounts for more than 25% of the
investment component of GDP and 40% of the
household budget
– This report is a leading indicator—housing
increases have a ripple effect in the economy
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The Economic Indicators (Cont.)
• Housing Starts and Building Permits (Cont.)
– Two components to this report
• Housing Starts—recorded when excavation begins for a
new house or apartment
• Building Permits—precedes housing starts since most
localities require building permits before excavation
begins
• Housing starts are about 10% greater than building
permits because some localities do not require permits
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The Economic Indicators (Cont.)
• Purchasing Management Index (PMI)
– Based on a survey conducted by the Institute for
Supply Management (ISM)
– Consists of six questions about production, orders,
prices, inventories, vendor performance and
employment
– Respondents are asked to characterize each activity
as either up, down, or unchanged
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The Economic Indicators (Cont.)
• Purchasing Management Index (PMI) (Cont.)
– A composite index is formed—A number over 50
represents an expanding manufacturing sector and
below 50 implies contraction
– This is a coincident indicator meaning that its
movements occur simultaneously with economic
activity
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The Economic Indicators (Cont.)
• Index of Leading Economic Indicators (LEI)
– A group of 10 components that form the basis for
predicting recessions and economic upturns
– This index is released each month by the Conference
Board
– As a general rule of thumb, the LEI turns down
before a decline in GDP and turns up before GDP
resumes its uptrend
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The Economic Indicators (Cont.)
• Index of Leading Economic Indicators (LEI)
(Cont.)
– Market participants view three consecutive monthly
changes in one direction as anticipating a change in
economic activity
– On average, the LEI seems better in terms of
accuracy and lead time in predicting downturns
compared with upturns, although neither set of
forecasts are all that accurate
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Valuation, The Fed, and Market
Reaction
• The basic question is: “How do the stock and bond
markets react to improvements in each of the
economic indicators?”
• The final column in Table 29.1 shows the “conventional
wisdom” about how prices react to good news about an
indicator
• In general, good news about any of the indicators
related to expenditure drives stock prices up and
bond prices down
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Valuation, The Fed, and Market
Reaction (Cont.)
• Good News Versus Bad News: The Role of
Expectations
– This would suggest that the stock market should go up if GDP
goes up
– However, the important issue is not whether it goes up, but
how the movement relates to the expectations in the market
– Upward movements that are larger than expected will
generally increase stock prices, whereas movements upward
less than expected will tend to lower stock prices
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Valuation, The Fed, and Market
Reaction (Cont.)
• Good News Versus Bad News: The Role of
Expectations (Cont.)
– If the expectations are fully realized, there should be
no change in stock prices since the market has
already fully discounted the movement in GDP
– Thus markets react only to unanticipated news—
only to new news
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Valuation, The Fed, and Market
Reaction (Cont.)
• Good News Versus Bad News: The Role of
Expectations (Cont.)
– The LEI, for example is mostly old news because
most of the component indicators have been released
earlier
– Some indicators are less reliable than others because
they are subject to substantial future revision
– An indicator that is less vulnerable to revision will
be more powerful in moving the market
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—
A Refresher
– To understand why stocks and bonds react in
opposite directions with unanticipated news in the
economy, need to reflect on the basics of bond and
stock valuations
– These concepts were covered in chapters 4 and 8,
respectively, and are reviewed below
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—A Refresher (Cont.)
– Bond Prices
• Assume a ten-year zero-coupon government bond with a face value of
“F”
• Therefore the bond price is as follows:
Bond Price = F/(1 + r)10
Where “r” = the yield on 10 year government bonds
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—
A Refresher (Cont.)
– Bond Prices (Cont.)
• Since the numerator in the formula (F) is a fixed
obligation, bond prices will decline with increase in
interest rates (r)
• What causes movements in the yield on 10 year
government bonds?
• An expanding GDP and expectations of increasing future
inflation will cause an increase in “r”
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—A Refresher (Cont.)
– Bond Prices (Cont.)
• In addition, The Federal Reserve may elect to tighten monetary policy
to restrain inflation which drives up interest rates through the term
structure of interest rates
• Higher interest rates means that the future cash flow from the ten-year
bond will be discounted at a higher rate
• Therefore, fears of emerging inflationary pressure plus concern
that the Fed will drive up the federal funds rate will decrease the
value of the ten-year zero-coupon bond
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—
A Refresher (Cont.)
– Stock Prices
• Assume a stock paying out all of its earnings in dividends
(D) and that these cash flows will last forever
• These cash flows are discounted at a rate (k) which
consists of the risk-free rate plus an adjustment for the
riskiness of the stock
• Therefore the stock price is as follows:
– Stock Price = D/k
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—A Refresher (Cont.)
– Stock Prices (Cont.)
• Valuation of stocks is more complicated since good news will likely
affect both the numerator and denominator of the formula
• The denominator behaves as it does in the bond formula, good news
will increase interest rates which lowers value
• However, good news about the economy means that companies will
earn more, implying they will pay higher dividends in the future
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—A Refresher (Cont.)
– Stock Prices (Cont.)
• This indicates that the numerator will increase with good news,
driving up the value of the stock
• Thus in the stock valuation formula there are two effects which
work in opposite directions
• Which one of these effects dominates--Conventional wisdom on
Wall Street is that the effect on the numerator is usually stronger than
the denominator, so that stock prices rise on good news
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Valuation, The Fed, and Market
Reaction (Cont.)
• Stock and Bond Valuations—A Refresher (Cont.)
– Figure 29.2
• Summarizes the effects of goods news on stocks and bonds and the
linkages just discussed
• One notable departure from the pattern that stocks and bonds move in
different directions is the reaction to inflation
• Unanticipated good news about inflation (lower than expected)
drives the interest rate down and has a positive effect on both the
stock and bond market
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FIGURE 29.2 Economic indicators
and market behavior.
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Putting It All Together
• Economic indicators are at the center of a
feedback mechanism operating through
economic activity, economic policy, and investor
behavior
• These indicators measure how the economy is
currently performing and suggest how it will
perform in the future
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Putting It All Together (Cont.)
• Investors, forecasters, and analysts all observe
the indicators and make assessments about the
future—mainly future dividends and interest
rates
• Because the Federal Reserve monitors the
economy through these indicators, favorable or
unfavorable news can alter monetary policy
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Putting It All Together (Cont.)
• Can individual investor make money on newly released
economic indicators—buying stocks and selling bonds
on good news or vice-versa
– Hinges on the “newness” of news—by the time we read about
an economic indicator, it is old news
– Professional stock and bond brokers/dealers probably see the
“new” news immediately after the indicators are released and
act accordingly
– U.S. economy is intertwined with international events which
impact domestic economic activity
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