Principles of Macroeconomics - Section 8: Financial Markets and Business Cycles

Unit 8 - Financial Markets and the Business Cycles

Students can use the material that we have covered in this topic to understand the relationship between financial markets and the business cycle. Over time, there is a substantial linkage between economic growth and the performance of financial markets such as the stock and bond markets. One rule to follow is that after correcting for short-term volatility, the stock market will follow the economy. However, there is one critical point to emphasize: the stock market will respond to where the economy is going, not to where it has been.

What do we mean by this statement? In order to judge where the stock (and bond) markets are going we have to understand where the economy is heading. If the economy is becoming overheated and inflationary pressures are building, markets will factor in economic policy that will slow economic growth. On the other hand, if the economy is currently in a recession, the stock market will anticipate a recovery before it actually happens, and stock prices will rise before the recession ends.

If we interpret this last paragraph literally, you would conclude that things work the other way: that the stock market leads the economy. True enough; if the economy is in a recession, the stock market will begin its recovery before the GDP numbers. The reason for this discrepancy in the timing of the stock market and economic growth is due to the difference between trailing and leading economic indicators.

Trailing economic indicators include GDP and the inflation rate. GDP numbers are released four times a year and are based on economic growth during a calendar quarter. For example, the second quarter GDP number shows the percentage growth in GDP (usually reported at an annual rate) during the months of April, May, and June. GDP is a lagging indicator because the second quarter GDP number is often not released until early August of the same year. In other words, when GDP statistics are published, they tell us where the economy has been, but little about where it is going.

Of course financial markets are not going to respond to trailing economic indicators since they are forward looking. Professional money managers need to understand where the economy is going in order to attempt to maximize their returns. No intelligent money manager will make his or her decisions based on the past. Instead, by understanding where the economy is going and thus where financial markets are heading, money managers try to stay a nose ahead of the crowd.

The conclusion that we have here is that financial markets follow leading economic indicators that tell us where the economy is going. We will look at the mechanics of this shortly, but first let us take a look at some leading economic indicators emphasized thus far in the course. Although there are hundreds of useful indicators, we will focus on a few very important ones that paint a fairly solid picture of the economy's future.

A Review of Leading Economic Indicators:

The current unemployment rate in relation to full employment. As unemployment rates fall to a level consistent with what is considered full employment, wage pressures build (1). Savvy watchers of financial markets will also key in on reports of initial jobless claims, the employment cost index and others statistics related to labor markets. Since labor costs comprise roughly 70% of all production costs in the U.S., anything that points to increasing wages will translate into higher production costs and is likely to be passed on in the form of higher consumer prices for goods and services. Subtle, but unwelcome changes in any of the indices listed in this paragraph can send financial markets into an immediate meltdown.
The cost of production measures prices of inputs such as labor and raw materials costs.
The Capacity Utilization Index. This index and its closely related cousin, the Industrial Production Index, tell us how much of our economy's productive capacity is actually in use at any given time. Talk to someone who makes a living watching the Federal Reserve (2), and they will tell you that Fed policy makers become very agitated when the Capacity Utilization Index reaches and exceeds 84%. The Fed figures when the index for the economy as a whole reaches 84%, some industries such as commodity producers are operating at full capacity (100%).

Commodity Prices. When commodity industries (such as steel, paperboard, copper) reach full capacity, bottlenecks are the result of further increases in demand for these commodities. Once all of the available capital is in use, firms can only increase output by adding overtime and additional shifts. This increases production costs, that in turn are passed on to the buyers of the commodities and finally to the consumer of the finished good. As well as tracking commodity prices, indicators such as factory orders and durable goods orders can give clues to the direction of commodity prices in the near future.

Although the Consumer Price Index ( the CPI - our official inflation index) is a trailing indicator, the Producer Price Index (PPI) is a very useful leading price index. The PPI tells us about changes in input prices that firms are paying. Increases in the PPI may soon be passed onto the CPI.
Changes in inventories. Falling inventories indicate consumer demand for goods remains strong. In contrast, growing inventory levels may signal a weakening economy, production cutbacks and worker layoffs. Unless inventories are increasing during the fall as businesses build up their inventories in anticipation of a strong Christmas shopping season.

(1) Note that there is no exact knowledge of the full employment level of unemployment, but the current consensus is that it is a few ticks above 4%, perhaps 4.2%.

(2) A tremendous amount of money is spent by financial firms on analyzing and anticipating Federal Reserve policy - reading the tea leaves. As we have discussed, the Fed uses interest rate policy to change economic growth rates. If inflationary pressures are rising, the Fed will raise interest rates. Or, if economic growth is anemic and inflation low, the Fed will lower interest rates. Financial firms don't wait for the actual move by the Fed. Instead they try to make educated guesses and act as if the Fed will actually raise, lower or leave interest rates unchanged. Quite often, financial firms guess wrong and end up backtracking. Sometimes, this creates good buying opportunities for personal investors who have a steadier disposition and a longer term outlook than financial markets.

The Relationship Between Interest Rate and Asset Prices

We now look at the relationship between market interest rates and stock and bond prices. Although there are several factors that determine valuations we will focus on interest rates since they are closely tied to the business cycle.

Bonds (debt) are a loan from the purchaser to the bond issuer. Bonds are typically sold one of two ways:

With a fixed coupon. The coupon associated with a bond is determined by its yield. For example, assume that you have $10,000 in savings and you decide to buy a newly issued 20-year U.S. government Treasury Bond that has a yield of 7%. The following information is relevant to your bond purchase.

Par value = $10,000 (the cost of the new bond to you).

Yield = 7%, this implies the coupon is $700, and you will receive $700 annually in interest payments. The yield remains fixed throughout the life of the bond.

Time to maturity = 20 years. If you hold the bond until maturity, you will receive your original $10,000 back.

At a discount. Treasury bills, Treasury notes and other bonds that mature in a relatively short time period after being issued sell at a lower price than their par value. The yield earned is the difference between the purchase price and the par value or selling price.

In our example here, you have purchased a newly issued 20-year, $10,000 Treasury bond with a yield of 7%. The yield is determined by market interest rates at the time the bond is issued.

Now let us assume that after holding the bond for two years, you decide to sell it to finance a modest graduation party for yourself and a few friends. Let us also assume that the yield on a new 20-year Treasury bond has fallen to 6% at that time.

A bond purchaser has a choice between buying your bond with a yield of 7% or a new Treasury bond with a yield of only 6%. Of course, your bond will be more desirable since its yield is higher that the new bond. As a result, the price of your bond will rise in order to equalize the returns between your bond and new bonds. The purchaser of your bond will pay a premium (a price above $10,000) for your bond.

Financial markets will adjust the prices of outstanding bonds to equalize their fixed yield to current market interest rates.

If market interest rates fall, the prices of outstanding bonds will rise. And,

If market interest rates increase, the prices of outstanding bonds will fall.

For another example, assume that after two years of ownership you decide to sell your bond with a yield of 7%. But instead, interest rates have risen so that the purchaser of a new Treasury bond at that time will receive a yield of 8%. The rational purchaser will choose the new T-bond with its 8% yield over yours that only has a 7% yield. Unless, you lower the price of your bond to equalize yields. Even though the purchaser of your bond only receives a 7% yield, there effective return will be equated to the 8% yield on a newly issued bond, since they are buying your bond for less than its $10,000 par value. The value of your bond will fall until the associated yield equals that of newly issued bonds.

The rule is simple: bond prices are inversely related to market interest rates. Rising rates lowers the prices of outstanding bonds while increasing market interest rates reduces the prices of outstanding bonds.

Other determinants of bond prices and yields include:

Risk - the greater the risk the higher the yield, or for a given yield, the lower the bond's price.

Tax attribute - the interest on some bonds is tax exempt and these bonds will have a lower yield.

Time to maturity - as the life span of a bond increases, so does its yield.

While tax attributes are fixed throughout a bond's lifetime and if risk changes, it is usually incremental, market interest rates change by the minute. As a result, the major determinant of a bonds current price is market interest rates.

Stocks (equities) allow for ownership in a corporation. By purchasing shares of a stock, you become a partial owner of that company (although a relatively minor owner). Important determinants of the market price of a stock include:

Dividends - When a corporation earns profits they can:

pay bonuses to employees,

reinvest in corporate expansion, purchase other companies and use the money for research and development.

pay dividends to shareholders.

As dividends increase, share prices often rise.

Earnings growth - as earnings grow, share prices often appreciate.

Market forces - even the best of companies may not stand up to a bear market, and a bull market may lift even weaker corporations. Sometimes stock markets fall for no other reason than profit taking by money managers and large investors.

Market interest rates - most stocks pay low dividends relative to bonds and other assets, and yields average around 2% to 3% for the average stock. As interest rates rise the dividends on stocks look less appealing and money managers shift part of their stock portfolio into higher yielding bonds, certificates of deposit and into the money market.

Focusing on market interest rates, we can observe an inverse relationship between stock prices and market interest rates, although the relationship is not fixed as it is with bonds. Periods of sustained increases in market interest rates will certainly depress stock markets.

Pricing Stock Shares

The price of a companies stock is determined by four primary factors:

earnings growth,

interest rates,

the magnitude of dividends, and

market forces.

When an investor buys stock in a company he or she becomes a partial owner of that company. In the most basic sense, share prices reflect the business conditions of the corporation. If the company is doing well, it is likely that the prices of its shares will rise, and they will certainly fall when the company faces a prolonged period (perhaps six months, usually less) of weak business conditions. Stock prices reflect how a business is doing and even more importantly, what the corporation is expected to do in the near future.

Earnings growth reflects the business conditions of a corporation. If quarterly and annual revenues and earnings are consistently rising (earnings = revenues - costs) then investors will want to own a part of that company. On the stock market, net purchases will increase and the price of a share will also rise. In contrast, beware the company that faces slowing earnings growth, its share price will be punished as investors flee for more promising corporations.

Stock prices are often based on the "consensus" of professional analysts that study the company in question and project earnings and earnings growth.

Unless that market is going into the tank, everyone loves a company that surpasses its quarterly earnings estimate. But the company that surprises investors and fails to meet expectations may see the price of its shares fall dramatically (perhaps 25% to 50%) within minutes of the news as institutional investors rush to sell. Earnings growth is often highly correlated to economic conditions. If macroeconomic growth is rising, so is the demand for a typical company's products and thus revenues and earnings should also increase - leading to an appreciation of the company's share price.

A common measure of an individual stock's price in comparison to the prices of other stocks is to use the Price to Earnings Ratio (P/E ratio). Price in the equation refers to the current market price of a stock. Earnings equals the earnings per share of the same stock. To calculate earnings per share, you take the dollar amount of profits that the firm has earned in the latest reported quarter and divide the earnings by the number of shares the firm has outstanding and thus are held by shareholders. For example, if the price of IBM as traded on the New York Stock Exchange equals $120 a share and the company is earning $4 a share, then IBM's P/E ratio equals 30.

Firms that have rapidly growing earnings are usually rewarded with high P/E ratios A high P/E ratio reflects expectations that future profits will increase significantly and steadily. You can do the basic math. If future earnings are expected to increase substantially then the value of earnings per share (E in the P/E equation) will also increase and the future P/E ratio will not be inflated. For example, assume that the current price of Dell Computer results in a current P/E of 50 while other comparable stocks of computer manufacturers (e.g. Compaq) trade at a P/E of 25. It would appear that the price of Dell's shares are overvalued and due for a correction to reflect the average P/E of stocks in the computer manufacturer sector. However, Dell's P/E is calculated based on trailing earnings. If Dell's future earnings are expected to grow twice as fast as those of its competitors, then the current market price reflects a fair valuation of Dell.

During the 1990s, Dell Computer was the best performer of any stock traded. Investors who purchased 100 shares of Dell stock for about $2,500 ($25 a share) in the early 1990s and held on found the value of their Dell holdings had risen to roughly $250,000 by the beginning of 1999 (Dell split a number of times during the decade). However, in early 1999 Dell's rate of earning growth began to slow (from about 100% annually to the 40% range). As a result, the price of Dell Computer shares took a tumble and as a result, the P/E of Dell fell substantially as well to reflect new earnings expectations. Long-term Dell shareholders were still doing very well regardless.

Interest Rates have an inverse effect on the stock market. Rising rates almost always lead to lower stock prices as the overall market sinks. In this case, few companies will be able to maintain their share price in the face of a unraveling stock market. There are two reasons why the stock market is hard hit by higher market interest rates. For the macroeconomy, higher interest rates will lead to slowing economic growth. Slower economic growth impacts the typical corporation with lower sales, revenues and profits. Thus higher interest rates leads to an expectation of lower earnings growth and stock prices adjust downward to reflect the new outlook.

Interest rates also affect stock prices for the reason of opportunity cost. As interest rates rise, the return on alternative investments increases. Yields on bank certificates of deposit, bonds, and other interest bearing assets rises, making the dividend yield of stocks lower in comparison. Yield sensitive savers may move some of their money out of stocks and into interest bearing assets. Sometimes expected interest rate movements are as important in determining investor behavior as do actual changes in interest rate. If there is a common belief that interest rates will rise in the future, then present stock prices will reflect the expectations and the market will fall.

It should not come as a surprise that falling interest rates (or the expectation of a decrease in interest rates in the near future) often results in a stock market boom as the earnings growth outlook improves.

For everything else being equal, the higher the dividend, the higher a company's share price. Many companies may not pay any dividend and instead use the majority of profits for research and development and to increase their capital stock. The goal is for higher future earnings growth.

Market forces represent a critical item in determining a stock's price. If the market as a whole is falling due to a poor economic outlook or because institutional⁽¹⁾ investors are engaged in another one of their frequent irrational panics, even the best stocks may not be able to withstand the force of the overall market. Or, a strong bull market may lift the prices of the majority of stocks despite constant fundamentals for individual companies.

Market forces may also represent a segment of the market. Certain stock groups may become very popular and show tremendous price appreciation simply because investors are trading on momentum. In this case, economic and company fundamental are basically ignored in favor of making a rapid capital gain. The most recent example is the mania for Internet stocks that began in 1998. Individual investors known as day traders bid up the prices of Internet stocks to stratospheric levels.

(1) An institutional investor is a person who manages large sums of money. For example, the managers of popular mutual funds may control billions of dollars and manage large blocks of stock in hundreds of companies.

Common Measures of a Stock’s Value

To better describe the relationship between the stock market and the economy, we can refer to two formulas that help us to better understand the valuation of stocks.

The first is known as the Price to Earnings Ratio (the P/E Ratio). To calculate the P/E ratio we take the current market price of the stock (P) and divide it by Earnings Per Share (E).

P E		Current Market Price of the Stock
	=
		Earnings Per Share

where:

E (Earnings Per Share) =	Total Earnings

	Number of Shares Outstanding

For example if a stock is trading for $30 per share (P) and earnings per share equal $5 (E), then the stock’s P/E ratio is equal to 6 (30/6).

The P/E ratio gives us a measure of a stock’s current valuation. In general, the lower the P/E/ ratio, the better. If you have two comparable stocks in a similar industry, a very general rule is that the stock with the lower P/E is a better buying opportunity. So if you are comparing two airlines (United and Delta) , auto manufacturers (Ford and GM), entertainment companies (Time Warner and Disney), etc. the P/E ratio might help in making the decision about which stock is relatively cheaper. Even though a stock may have a higher market price than a competitor, if it also has a lower P/E ratio, it may be more desirable to purchase.

This idea is a major oversimplification of the analysis of a stock of even comparable companies. When we broaden across different industries, the P/E ratio alone becomes even more meaningless. For example, let us compare two companies:

Intel’s P/E = 20,

General Motors’ P/E = 6.

From this simple example, GM looks like the better purchase since it has a P/E of 6 and Intel in comparison looks very expensive with an inflated P/E of 20.

A final useful bit of information is known as the PEG (price-to-earnings growth) ratio. The PEG ratio is especially useful in calculating the valuation of stocks for companies that are expecting rapid rates of earning growth in the upcoming year. The PEG ratio is calculated by taking a stock's P/E ratio and dividing by estimates of the next twelve months earnings growth.

A rule of thumb for stock traders is growth stocks with PEG ratios below a value of 1.0 are good buys - the lower the ratio, the better. As the PEG ratio for a stock climbs past 1.0, the more overvalued the company may be and the greater the potential for a rude correction if the company does not report actual earnings above expectations - just meeting expectations is often not satisfactory for companies with high PEG ratios. Reporting actual earnings below estimates is disastrous, as share prices may fall anywhere from 10% to 50% and even more, within a matter of minutes as institutional traders dump their shares in the company.

The Good, the Bad, and the Goldilocks

As we have discussed, the ultimate objective of policy makers is to guide the economy to full employment, and if possible, keep it there without kicking up inflation. Financial markets are very sensitive to overall economic conditions. Positive economic growth will lead to greater business sales, corporate profits and appreciation of stock prices. However, if growth is too strong, then inflationary pressures can lead to a rise in interest rates that is detrimental to the fortunes of financial markets.

In this section, we will focus on the relationship of the business cycle to the overall trend in financial markets. Of the five possibilities listed in the table below, we will look at the first three scenarios that relate economic activity to financial markets.

Scenario

(Economic - Financial)

Economic News

Response of Financial Markets

Good - Good

(GG)
Economic growth remains strong or is increasing. No significant inflationary pressures. Disposition and outlook is positive. Stock markets are making strong gains, bond markets are steady.

Good - Bad

(GB)
Economic growth remains strong or is increasing. Inflationary pressures are building. Markets are extremely agitated. Expected higher interest rates are factored into bond prices. Bond prices are tumbling, stock prices are slipping, with a few very traumatic days.

Goldilocks

Economy is at or near full employment and full capacity utilization. Aggregate demand growth is consistent with the steady increase in aggregate supply. Disposition and outlook is calm on the surface, turbulent underneath. Markets are vigilant for any news of overly strong economic growth.

Bad - Bad
Economy is heading south. Production and demand is falling, unemployment rates are rising. There is nothing like bad economic news to delight bond traders. Bond markets anticipate the Fed to take countercyclical policies and have factored in lower interest rates into bond prices.
Falling corporate profits depress the stock market. Even falling interest rates can't stop the bear market and declining stock prices.

Bad - Good
The economy is stagnant or in a recession but the worst is over and it should soon begin to recover. Bond markets still warmed by the poor economic situation and falling interest rates.
Anticipation of an economic recovery and earning growth helps stock prices to begin rebounding from their recent lows.

Let us examine each of the first three scenarios in turn. There are two important distinctions that separate one scenario from the other:

The amount of slack in the economy, or how close the economy is to full employment and full use of its productive capacity (at capacity utilization = 84%).

The growth rate of aggregate demand in relation to aggregate supply growth. Remember, aggregate supply growth is constant from year to year and reflects the economy's supply side growth of approximately 3%. Aggregate demand equals:

GDP = AD = C(Y-T) + I(r) + G + NX

and the growth rate of aggregate demand is altered by changes in fiscal policy (taxes (T) and government spending (G)), and monetary policy that changes interest rates (r). We will only look at changes in monetary policy in this section.

Scenario 1: Good (economic news) Good (financial news) (GG)

Click on a part of the graph for further information.

Figure 8-1 shows the circumstances when good economic news often leads to good financial circumstances. Aggregate demand growth (from AD_GG to AD'_GG) is robust, even greater than the steady annual increase in aggregate supply (from AS₀ to AS₁) . However, even with strong increases in aggregate demand, there is still a good deal of slack remaining in labor markets and plenty of productive capital is still waiting to be put into use. Unemployment rates are higher than a level consistent with full employment, capacity utilization is comfortably less than 84%, and commodity prices remain stable.

In this scenario, the lack of inflationary pressures indicates that there are no interest rate increases by the Fed on the horizon. Increases in corporate earnings translates into significant appreciation in the prices of many stocks.

Scenario 2: Good (economic news) Bad (financial news) (GB)

Click on a part of the graph for further information.

In Figure 8-2 we can see conditions where good economic news often leads to poor financial circumstances. In this case, aggregate demand growth (from AD_GB to AD'_GB) is greater than the steady annual increase in aggregate supply (from AS₀ to AS₁), and inflationary pressures are building or inflation has already risen. With the strong increases in aggregate demand, labor markets have reached full employment and capacity utilization is pushing or has exceeded 84%.

The Federal Reserve is considering raising interest rates in order to dampen the growth of aggregate demand. Financial markets have already factored higher interest rates into bond and stock prices. The only question they ask at the time is how high will the Fed raise rates at its next policy meeting and how many times will they need to raise rates to tame aggregate demand growth.

As you can see this situation creates a paradox for stock markets. Strong increases in aggregate demand lead to healthy growth in corporate earnings, while projected interest rate hikes will depress stock prices. Usually the interest rate effect receives much greater weight from financial markets, since they see earnings growth slowing along with aggregate demand when interest rates rise.

Often stock markets will take a significant dip in these circumstances, perhaps losing well over 10% of their value in a few months (or sooner). A good tip off that they have fallen too far is when financial news programs start to bring in market forecasters who use astrology (I kid you not) to predict stock prices. You will hear statements that rely on the confluence of important planets and stars that predict the stock market will soon eclipse the crash of 1929 and fall to levels not seen since the nineteenth century. When things become this stupid, it is probably a good bet that the markets will soon recover from their swoon.

Scenario 3: Goldilocks (GOLD)

By this time Goldilocks was hungry so she went to the kitchen, and there on the table she spied the three bowls of porridge. She tasted the porridge in the great, huge bowl but it was too hot. She tasted from the middle-sized bowl but it was too cold. As last she tried the porridge in the wee, small bowl and that was just right. So she ate it all up!

Click on a part of the graph for further information.

Sometimes economic circumstances are just right as shown in Figure 8-3. After the economy has arrived in the neighborhood of full employment, aggregate demand growth settles to a growth rate consistent with the annual increase in aggregate supply.

Of course, hitting this target consistently over time is unprecedented. As a result, financial markets will remain extremely jumpy, ready to react to the slightest economic news that indicates the economy is heating up. If aggregate demand growth rates are rising, higher inflation and interest rates could be just around the corner.
Given the daily onslaught of new and often conflicting economic data available for financial markets to digest, it is best to ignore the noise of daily market movements and sector rotation within the market until a definite trend of building inflationary pressures is established. If the Goldilocks scenario persists over time, bond prices will remain stable and stock markets should make steady, although unspectacular, increases in valuations.

Copyright (C) 2002, Jay Kaplan
All rights reserved

Scenario (Economic - Financial)	Economic News	Response of Financial Markets
Good - Good (GG)	Economic growth remains strong or is increasing. No significant inflationary pressures.	Disposition and outlook is positive. Stock markets are making strong gains, bond markets are steady.
Good - Bad (GB)	Economic growth remains strong or is increasing. Inflationary pressures are building.	Markets are extremely agitated. Expected higher interest rates are factored into bond prices. Bond prices are tumbling, stock prices are slipping, with a few very traumatic days.
Goldilocks	Economy is at or near full employment and full capacity utilization. Aggregate demand growth is consistent with the steady increase in aggregate supply.	Disposition and outlook is calm on the surface, turbulent underneath. Markets are vigilant for any news of overly strong economic growth.
Bad - Bad	Economy is heading south. Production and demand is falling, unemployment rates are rising.	There is nothing like bad economic news to delight bond traders. Bond markets anticipate the Fed to take countercyclical policies and have factored in lower interest rates into bond prices. Falling corporate profits depress the stock market. Even falling interest rates can't stop the bear market and declining stock prices.
Bad - Good	The economy is stagnant or in a recession but the worst is over and it should soon begin to recover.	Bond markets still warmed by the poor economic situation and falling interest rates. Anticipation of an economic recovery and earning growth helps stock prices to begin rebounding from their recent lows.