"There's a connection between the way the markets have behaved and the way the economy has behaved. Not only is inflation down, inflationary expectations are down, and that will have an impact ultimately on the pace of economic growth."
Abby Cohen of Goldman Sachs - Fortune, June 9, 1997
In this section we build on our knowledge of business cycles to better understand long-run movements in stock and bond markets. Note the emphasis on a long run time horizon. There is no consistent explanation or predictor of day-to-day or week-to-week movements in stock markets, but over longer time horizons, three to six months, or perhaps a year, the stock market will generally follow the economy. Of course, experts on Wall Street will advise that to understand where the economy is going, we only need to follow the stock market. In this section we will explain the apparent paradox that can be stated as:
some argue that the economy leads the stock market, while others maintain the stock market leads the economy. Actually, they are both correct.
First, let us begin with a brief review of some critical information from the previous section. We studied business cycles, or the fluctuation in economic growth over time. The phases of a complete business cycle could be condensed into the follow major parts:
In this section we turn our attention to how financial markets react to the above. Presently, the key link of financial markets to the economy is the Federal Reserve Board (Fed) and its policy towards interest rates. We will cover the details later in this course, but for now we just need to know that the Fed can, at its discretion, either raise or lower interest rates. And if the Fed feels that inflation is on the rise, it will raise interest rates to slow economic growth, and just the opposite if it feels that economic growth is too weak. A critical point to comprehending this material is to understand the difference between a reactionary policy and a policy that anticipates events.
A reactionary policy implies that the Fed will react to economic events and then take action. If inflation has risen to an undesirable level, the Fed will slow the growth in aggregate demand by raising interest rates. The idea is that the Fed will wait until the event occurs (inflation rises) before taking action (raising interest rates).
During the 1980s, the Fed developed complex computer models that help it better understand the economy. With its much improved understanding of economic conditions the Fed has been able to successfully switch from a reactionary economic policy to one that anticipates changes in the economy.
An anticipatory policy involves the use of leading indicators to forecast changes in the economy. An example of a leading indicator is the prices of different commodities. Commodities are items such as oil, copper, aluminum, steel and other materials used in the production of goods. Consider the case where inflation as measured by the CPI remains steady. As you recall, the CPI measures the prices that consumer pay for finished goods such as cars, televisions, and clothing. In contrast to the steady CPI, assume that commodity prices are increasing. Higher commodity prices increase the production costs of final consumer goods. Higher production costs leads to an inward shift of the firm's supply curve and eventually higher prices for final goods and a rise in the CPI as firms pass higher input prices on to the consumer of the final good.
The Fed now tries to anticipate future changes in the CPI and inflation rates by closely tracking leading indicators such as commodity prices and other discussed in this section. If by the judgment of the Fed, the consensus of leading indicators points to a serious potential for future rises in the inflation rate, the Fed may take action to slow economic growth and dampen inflationary pressures before inflation actually increases. The Fed's goal is to smooth out the business cycle, avoiding inflationary spikes and the more extreme reactionary policy that is necessitated when inflation rates do rise.
Now back to financial markets. The key to understanding long run movements in financial markets is to realize that financial markets respond to changes in leading indicators, since changes in leading indicators may prompt the Fed to take action. There is a direct linkage between bond prices and market interest rates. Higher interest rates lead in turn to lower bond prices. And although the linkage between stock prices and interest rates is not a direct one, in general expect stock prices to fall when interest rates rise. Even more importantly, bond and stock prices will tumble when they expect or anticipate a rise in future interest rates.
Financial analysts and the Fed are basically tracking the same data. As a result, financial analysts are trying to read the tea leaves and predict how the Fed will respond in its next policy meeting to the economic data. It is a guessing game. Financial analysts try to predict Fed behavior, and take action before the Fed actually does. For example, if the leading indicators point to higher inflation rates down the road, a financial analyst will conclude that the Fed is likely to raise interest rates in the next month. Knowing that higher interest rates will lead to a correction in bond and stock prices, the analyst goes ahead and sells part of his or her portfolio immediately. Since all financial analysts have access to the same information, and most will reach the same conclusion (the penalty for being left behind the pack can be expensive), stock and bond markets may react violently to a single bit of economic news.
This helps to explain part of the volatility of stock markets - expectations change from hour-to-hour and day-to-day as new economic information becomes available. Each piece is used to partially complete the puzzle of what the Fed is going to do at its next meeting.
"One area where individual investors have an advantage over us professionals is that we drive ourselves crazy trying to figure out what the latest 8:30 a.m. report means. We analyze it and overanalyze it."
Abby Cohen of Goldman Sachs - Fortune, June 9, 1997There are thousands of mutual funds, pension funds, banks and other institutions where an individual may be responsible for a portfolio worth billions of dollars. With so much at stake, these people tend to be extremely reactionary.
In this section we will take a more detailed look at the linkage between the business cycle and financial markets. Remember the key to understanding movements in financial markets is to make sense of the leading indicators (that often give contradictory indications of future economic activity). Most of our major economic statistics discussed in earlier sections such as the CPI and GDP are trailing numbers. They tell where the economy has been or is at, but not where it is going. For example the second quarter (April, May and June) GDP number is usually released in late July (during the third calendar quarter), giving a picture of where the economy was recently.
LINK TO MAIN SECTION OF UNIT 8 - Financial Markets and Business Cycles