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.  In my daily commentary, I always try to assess the importance of each item, how it fits into the current economic situation, and often where you can go to see the original source. 

Of all the economic indicators, the three most significant to stock market investors are inflation, gross domestic product (GDP), and labor market data.  I try at all times to keep in mind where these three are in relation to the current stage of the economic cycle.  That then allows me to estimate how any piece of economic data will affect these three indicators, and then project its probable effect on the stock market.

INFLATION

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, most individuals require 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 the higher the inflation rate, the higher nominal return is needed for a stock price to remain the same. 

But the effect inflation has on the stock market is even 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 get, requiring 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, and why a proxy is required, with the Consumer Price Index (CPI) 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, like in Japan recently, the deflation rate).  That measured percentage, for instance 3%, means that in general the basic necessities of life cost 3% more today than they did last year.

There are of course some problems with this measure as well.  For one thing, the products rarely remain exactly the same, and it is 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, it is the best proxy currently available, and at least in the short- to medium-term, is the number that investors focus on when making their decisions.

GROSS DOMESTIC PRODUCT

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 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 major effect on investing sentiment.  If investors believe the economy is improving (and corporate earnings along with it) they are more likely to pay more for a given stock.  If there is a decline in GDP (or investors expect a decline) they would be willing to pay less for a given stock, leading to a decline in the stock market.

Those who have made it through this far are probably familiar with an alternative view that has been mentioned frequently in the news lately, that the stock market itself exerts a reverse effect on economic activity, the so-called “wealth effect”.  This theory says that a fall in the stock market makes individual’s personal wealth (or perceived wealth) fall.  They consequently stop spending as much, and 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, GDP also falls, which just further intensifies the downward pressure on the stock market.

THE LABOR MARKET

The final major factor influencing the economy is the labor market.  The key indicators most investors focus on 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 a retirees or just people who are discouraged and have 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 now in demand will be expanding.  This causes a flow of labor from losing to winning industries, and it is not an instantaneous process.  Others may leave their jobs by choice.  This means there is always some amount of unemployment built into our economic structure, what is often termed the “natural” level of unemployment.

The natural level of unemployment is that point where any drop below that figure creates conditions that will drive up inflation.  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% 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%, by removing from the labor force people who are less likely to be employed.

CONCLUSION: PUTTING IT ALL TOGETHER

There are many components that come together to calculate each of the major economic indicators, and unfortunately they all rarely point in the same direction.  In addition, each of these indicators are closely linked to one another.  That is what makes it difficult to interpret the likely result from any individual economic report.  To make things even more difficult, whether a certain piece of news is good or bad depends on what part of the cycle the economy is at. 

To further complicate things, there are many institutions and safeguards within an economy that are designed to mitigate or increase any of these effects.  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 two primary ways that government bodies influence the economy.  Certainly listening to Alan Greenspan, and trying to predict future moves by the Federal Reserve, keep more than one economist employed.  And actions taken by the Federal Open Market Committee do often move the stock market.

The economic evidence right now seems to indicate that the current output gap is quite large, with plenty of room for expansion without 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 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 would have the opposite effect on the market.

Let’s work through one last example and explain the chain of reasoning leads to what may seem on the surface a counterintuitive result, showing how a report that unemployment is low might be bad for the market.  Because the paradox of labor market data, at least as it relates to the stock market, is that when the unemployment rate is low the stock market is usually expected to go down.  The more people that are employed, the more consumer spending will increase, which leads to an increase in GDP.  So far, so good.  But as we saw earlier, when GDP increases, that means the output gap will decrease, which means the economy stands a greater risk of inflation.  And inflation is bad for the stock market.  So it goes down.

Inflation, GDP, and employment data all exert 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.  That is why I try to make sure when I write my daily commentary that I explain how important (I feel) a report is and how I interpret it in light of current economic conditions.  And since interpretation is as much an art as science, I often try to point you to the original source documents, so that you can take a quick look at the data, if only to see what the headlines, business articles, and I am leaving out.