Economic Indicators

Posted by PITHOCRATES - May 20th, 2013

Economics 101

To Better Understand the Economy we should Study the Economic Indicators Investors Study

If you’ve lost your job you have a pretty good idea about the state of the economy.  It’s bad.  An unemployed person is like a soldier in the trench.  He or she doesn’t need to examine any data to understand what’s happening in the economy.  They know firsthand how bad things are.  But generals far behind the lines don’t have that up close and personal economic experience.  So they have to examine data to understand what’s going on.  Just as government officials, investors and economic prognosticators have to examine data.  Giving them an understanding of the state of the economy.  So they can know what the unemployed know.  The economy sucks.

Government officials want positive economic data so they can say their policies are working.  Whether they are or not.  In fact, they will parse the data to serve them politically.  When necessary.  Such as during the run-up to an election.  So their reports on the economy are not always, how should we say, full of truthiness.  For they can take some bad economic data and put a positive spin on it.  Completely changing the meaning of the data.  The unemployed won’t believe the rosy picture they’re painting.  But those in the trenches may.  And those in the rear with the gear.  After all, they have jobs.  So things don’t really seem that bad to them.

No, for a better picture of the economy you should listen to the people with skin in the game.  Those who are making bets on the economy.  Investors.  And business owners.  Who are risking their money.  And if we look at what they look at we can get a better understanding of the economy.  See what bothers them.  What pleases them.  And what excites them.  So what do they look at?  Economic data we call economic indicators.  Because they indicate the health of the economy.  And give an idea of what the future holds.  There are a lot of economic indicators.  The government compiles most of them.  They each give a little piece of the economic puzzle.  And when you put them together you see the bigger picture.

With a Rise in Housing Starts a Rise in Durable Goods should Follow Creating a lot of New Jobs

As far as economic indicators go retail sales is a big one.  Because consumer spending is the vast majority of economic activity in the new Keynesian economy.  (John Maynard Keynes changed the way governments intervene in the private sector economy in the early 20th century.)  Keynesians believe consumer spending is everything.  Which is why governments everywhere inflate their money supplies.  To keep their interest rates artificially low.  To encourage people to borrow money.  And spend.  When they do retail sales increase.  Signaling a healthy economy.  When they fall it may mean a recession is coming.  Of course, if retail spending rises more than expected investors get nervous.  Because it could mean inflation is coming.  Which the government will try to prevent by raising interest rates.  Thus cooling the economy.  And hopefully sending it into a soft landing.  But more often than not they send it into recession.

Another economic indicator is housing starts.  A lot of economic activity comes from building houses.  Building them generates a lot.  And furnishing them generates even more.  So governments are always trying to do everything within their power to encourage new housing.  They keep interest rates artificially low.  Encouraging people to get mortgages.  And they’ve pressured lenders to lower their lending standards.  To get more people with bad credit (or no credit) into houses.  Which led to subprime lending.  The subprime mortgage crisis.  And the Great Recession.  So more housing starts can be good.  But too many housing starts can be bad.  Generally, though, if they are increasing it’s a sign of an improving economy.

Before Keynesian economics the prevailing school of economic thought was classical economics.  Which we used to make America the world’s number one economic power.  Unlike Keynesians in the classical school we looked higher in the stages of productions.  Where real economic activity took place.  Raw material extraction.  Industrial processing.  Manufacturing.  And wholesaling.  An enormous amount of activity before you reach the consumer level.  All of these higher order economic activities fed into the making of durable goods.  Those things we bought to fill those new houses.  Which is why we like rising housing starts.  Because a rise in durable goods should follow.  And when we’re producing more durable goods we’re employing more people.  Making the durable goods economic indicator a very useful one.

One should Always be Skeptical when the Government says their Policies are Improving the Economy

The Producer Price Index (PPI) tells us how the prices are moving above the consumer level.  So if the PPI is rising it tells us the costs to produce consumer goods are rising.  And these higher costs will flow down the stages of production to the consumer level.  Causing a rise in consumer prices.  So the PPI forecasts what will happen to the CPI.  The consumer price index.  When it rises it means inflation is entering the picture.  Which the government will try to prevent by raising interest rates.  To cool the economy down.  And lower the prices at both the consumer and producer level.  Again, trying to send the economy into a soft landing.  But usually sending it into recession.  Which is why investors pay close attention to the PPI.  So they can get an idea of what will happen to the CPI.  So they can buy and sell (stocks and/or bonds) accordingly.

The rest of us can get an idea of what these investors think about the economy by following the Dow Jones Industrial Average (DJIA).  Which is the weighted ‘average’ of 30 stocks.  (We calculate it by dividing the sum of the 30 stock prices by a divisor that factors in all stock splits and changes of companies in the Dow 30).  As a company does well in a growing economy its stock price grows.  And if investors like what they see in other economic indicators they bid up the stock price even further.  So a rising DJIA indicates that investors believe the economy is doing well.  And will probably even improve.  But sometimes investors have a little irrational exuberance.  Such as during the dot-com bubble in the Nineties.  Where they poured money into any company that had anything to do with the Internet.  Making a huge bet that they found the next Bill Gates or Steve Jobs.  Of course, when that blind hope faded and reality set in those inflated stock prices came crashing down to reality.  Causing a long and painful recession in the early 2000s.  So even investors don’t always get it right.

When the dot-com bubble burst it threw a lot of people out of a job.  Increasing the unemployment rate.  Another big economic indicator.  But one that can be massaged by the government.  For they only count people out of a full-time job who are looking for full-time work.  The official unemployment rate (what we call the U-3 rate) doesn’t count people who gave up looking for work.  Or people who took a couple of part-time jobs to make ends meet.  A more accurate unemployment rate is the U-6 rate that counts these people.  For while the official unemployment rate fell below 8% during the run-up to the 2012 election the U-6 rate was showing a much poorer economic picture.  And the labor force participation rate showed an even poorer economic picture.  The labor force participation rate shows the percentage of people who could be working who were actually working.  So the lower this is the worse the economy.  The higher it is the better the economy.  So while the president highlighted the fall of the U-3 rate below 8% as a sign of an improving economy the labor force participation rate showed it was the worst economy since the Seventies.  Something the unemployed could easily understand.  But those who had a job believed the less than honest U-3 economic indicator.  Believed the president was making the economy better.  When, in fact, he had made it worse.  Which is why one should always be skeptical when the government says their policies are improving the economy.  For they are more concerned about winning the next election than the people toiling away in the trenches.

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Dow Jones Industrial Average

Posted by PITHOCRATES - May 6th, 2013

Economics 101

The Dow 30 is a Selection of Companies that gives an Idea of how the Economy is Doing as a Whole

The stock market rallied on Friday thanks to what investors viewed as a favorable jobs report.  Sending the Dow Jones Industrial Average into new territory.  Above 15,000.  But it couldn’t hold on to close above 15,000.  Instead, closing at 14,974.  Close but no cigar.  It even fell a little on Monday.  Reaching only 14,968.89 at the close of trading.

No doubt many wonder 14,968.89 of what?  Is it dollars?  After all, they call it the Dow Jones Industrial Average (i.e., the Dow).  And most know it has something to do with the stock prices of some group of companies.  Thirty, to be exact.  The Dow 30.  A selection of companies that gives an idea of how the economy is doing as a whole.  By looking at stock prices from all sectors of the economy.  So is the average price of these 30 stocks $14,968.89?  Well, let’s take a look at those 30 stocks and their closing prices at the end of trading today.

Bow Jones 30 Stocks and Closing Prices 5-6-2013

Hmmm.  Looks like IBM is the most expensive stock in the group at $202.78.  But an average can’t be higher than the highest price.  It has to be somewhere in the middle of the pack.  In this case the average is $64.97.  So the Dow certainly isn’t the average stock price of these 30 companies.   Is it the sum of these stock prices?  Well, if we add all of the stock prices in the above table we get $1,949.19.  That’s closer to 14,968.89 than 64.97.  But it sure isn’t 14,968.89.  So what exactly is this number?

A Company wants a Rising Stock Price and a High Trading Volume

The Dow Jones Industrial Average (DJIA) dates back to 1896.  Then it included 12 industrial stocks.  American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, General Electric, Laclede Gas, National Lead, North American, Tennessee Coal & Iron, U.S. Leather preferred and U.S. Rubber.  (General Electric has been a part of the DJIA for all its 117-year history except for the periods September 1898 – April 1899 and April 1901 – November 1907.)  And the DJIA was just that.  The average price of these 12 stocks.

To simplify this let’s look at three fictitious companies and their stock prices.  ABC at $300/share.  XYZ at $200/share.  And 123 at $100/share.  If you add these three stock prices together you get $600.  And if you divide this number by three you get the average stock price ($200).  This is how they calculated the first DJIA.  Only with those 12 stocks.  Which gave a good idea about the market.  If companies were doing well their stock prices went up.  Raising the average price.  Telling us the economy was doing well.  Doing this today, though, would give you a distorted view of the economy.  Why?  Because of stock splits (as well as the changing of companies in the Dow 30).

When a company has growing sales and growing profitability the value of the company increases.  Which the stock price reflects.  As people bid up the price of the stock.  Because everyone wants to buy it.  So the laws of supply and demand raise the price.  But a higher price will reduce the number of shares an investor can buy.  Which will reduce the trading volume.  Showing a falling interest in the stock.  Which may cause the stock price to fall.  Something a company doesn’t want.  What they want is a rising stock price AND a high trading volume.  Two seemingly contradictory things.  Which is where the stock split comes in.  Which works like this.  If there are 1 million shares outstanding at $300/share that’s a market capitalization of $300 billion (1 million shares X $300/share).  To increase the trading volume the company may announce a 2-1 stock split.  That is, they will cut the stock price in half and double the shares outstanding.  So after the stock split there’s a market capitalization of $300 billion (2 million shares X $150/share).  The value of the company is the same BEFORE and AFTER the stock split.  But the stock price is lower which encourages investors to buy and sell more of the stock.  Thus increasing the trading volume.  While the stock price can continue to rise.  Thus meeting those two contradictory objectives.

They divide the New Sum of the Closing Stock Prices for the Dow 30 by the Current Divisor to get the DJIA

The DJIA shows the relative strength of the economy.  As companies grow more valuable their stock prices rise.  If they rise a lot the company may announce a stock split.  Anyone holding stock at the time of the stock split will be very happy.  As the number of their shares may double.  Triple.  Even quadruple.  And even though the market capitalization remains the same before and after the stock split the split itself is a sign of a strong and growing company.  Which tends to drive the stock price—and the market capitalization—higher.  So stock splits are good things.  Which is why they had to change the way they calculated the DJIA.  For the average of stock prices after a split will fall even though the economy as a whole is getting stronger.  As we can see with our three sample companies.

Adjusting Index after Stock Split

This is the problem of using a straight average of stock prices.  It would show a weakening market when it was, in fact, growing stronger.  So they had to add a little math.  To make the market capitalization before and after the stock split the same.  And they do this with a divisor.  They divide the sum of stock prices after the split by the sum of stock prices before the split (450/600=0.75).  So if we divide the sum of stock prices after the split by 0.75 the ‘DJIA’ equals 600.  Just what it was before the stock split.  Which makes the market capitalization before and after the split the same.  As it should be between the close of one day’s trading and the beginning of the following day’s trading.  As there are more and more stock splits this divisor gets smaller.  As the sum of stock prices gets smaller with each stock split.  Which makes the divisor grow smaller with each stock split.  And as we divide the sum of closing stock prices in the Dow 30 by a divisor that is continually getting smaller the resultant ‘DJIA’ gets larger.  As we can see here.

Adjusting Index after Stock Split 2

These companies are doing exceptionally well.  So well that they all announced stock splits.  ABC and XYZ quadrupled the number of shares outstanding and divided their stock price by 4.  123 tripled their outstanding shares while dividing their stock price by 3.  The average stock price fell by 73%.  If this was reported as the ‘DJIA’ it would probably cause a stock market crash.  Which is why the DJIA is no longer an average of stock prices.  Because an average of stock prices does not show the true economic picture.  But adding a divisor into the mix does.  And every time there are stock splits (or new companies replace old companies in the Dow 30) they calculate a new divisor.  They divide the new sum by the old sum of stock prices.  Then multiply this number by the old divisor to get the new divisor.  Which they divide into the new sum of closing stock prices in the Dow 30 to arrive at the DJIA at the close of each trading day.

At the close of trading today the DJIA was 14,968.89.  While the sum total of the closing stock prices for the companies in the Dow 30 was $1,949.19.  If we divide 1,949.19 by 14,968.89 we get 0.130216081.  This is the divisor.  Which they publish every day.  Showing any revisions in the divisor whenever there is a stock split or a change in the companies in the Dow 30.  And every day at the close of trading they divide the new sum of the closing stock prices for those companies in the Dow 30 by the current divisor to get the DJIA.  And today they divided 1,949.19 by the current divisor to get 14,968.89.  The Dow Jones Industrial Average at the end of today’s trading.

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