APRIL 2007 :: CONSUMER ED

The Numbers That Drive Stocks
Government Reports on the Economy Give Investors Important Clues

Stock prices don’t go up and down by themselves. Each movement in price happens because of an actual deal between a buyer who offers to buy stock at a particular price, and a seller who chooses to sell to that buyer at that price.

The buying and selling of stocks—and therefore the daily movements of prices—are ultimately heavily influenced by the state of the economy.

For investors, the focus is on whether the economy is growing.

›Adapted from "The Wall Street Journal Complete Personal Finance Guidebook," by Jeff D. Opdyke. Copyright 2006 by Dow Jones & Co. Published by Three Rivers Press, an imprint of the Crown Publishing Group, a division of Random House.

A growing economy is in “expansion.” When the economy is shrinking, it is dubbed a “recession.” The movement from growth to recession and back to growth is known as the “business cycle.” Most economists believe that the economy moves through the business cycle over time. An expansion leads to excess capacity and excess goods. When there’s too much stuff out there, profits dwindle, corporations retrench and the economy slows and then shrinks. As the excesses are whittled away, the economy moves into recovery mode and then into expansion again. The business cycle can be viewed as a circle or a clock face, with growth at 12 o’clock and recession at 6 o’clock. Slowdown is at 3, and recovery is at 9. Round and round it goes.

The state of the economy at any given time, and how investors interpret it, plays a starring role in determining the direction of the market. Knowing what’s happening in the economy can help you understand if it makes more sense to buy shares of Wal-Mart Stores or Bank of America.

Divining the direction and strength of the economy isn’t easy, but there are a number of ways for investors to figure out what’s happening. Chief among them are economic data provided by the government, which offer important clues as to whether the economy is getting stronger or weaker, or experiencing a “Goldilocks” phase, not too hot or too cold.

The government issues oodles of economic data. But for our purposes, we’ll look at some of the most important reports that Wall Street monitors particularly closely (Lots of these economic data can be found in The Wall Street Journal or online at wsjmarkets.com):

JOBS DATA: On the first Friday of every month, the Labor Department releases its monthly payroll data. For investors, this is one of the most highly anticipated reports. The two main parts of the report are the number of jobs created in the last month and the unemployment rate. During an expansion phase, payroll figures grow in the hundreds of thousands. During a recession, the opposite can occur. The unemployment rate measures the percentage of the work force unable to find work. The basic reading of the monthly jobs report is that if the economy is growing, companies are adding jobs. If it’s not, payrolls are shrinking. A rising unemployment rate can also indicate that job seekers are having a tough time, another clue that the economy isn’t doing well. (When the unemployment rate gets too low, however, it raises fears of inflation, the idea being that too few workers means that companies have to pay more to get talent on board.)

Another jobs figure is the weekly unemployment-claims number. When people lose their jobs, they often file for government unemployment insurance. Those figures are reported on a weekly basis and can provide an additional clue about the economy’s strength from week to week.

INFLATION MEASURES: Stock investors care about inflation because rising inflation brings the threat of higher interest rates, which make it more expensive for companies and individuals to borrow money and more difficult for them to contribute to the economy.

The key player here is the Federal Reserve, which controls certain important interest rates. The Federal Reserve dislikes inflation because it can crimp economic growth, and so it will use its interest-rate setting powers to slow the economy down. Sometimes that means driving it into recession to curtail inflation. While reducing inflation is good, the recession cure is painful, leading to lost jobs and a shrinking economy.

The Department of Commerce releases inflation figures on a monthly basis. The Consumer Price Index, or CPI, is the main inflation gauge. It measures a basket of goods—food, energy, computers, movies—that consumers purchase on a regular basis. The CPI is used to calculate cost-of-living adjustments in government programs and is the main way for policy makers to determine if there’s troublesome inflation news.

The Commerce Department also releases the Producer Price Index, or PPI, monthly. This is a measure of wholesale prices—what things cost as businesses buy and sell goods among themselves, such as raw materials. This measure is often watched as a precursor to changes in the CPI. If companies have to pay more for their supplies and raw materials, they try to get consumers to pay more, too.

RETAIL SALES: The Department of Commerce reports total retail sales monthly. Since the U.S. economy depends heavily on consumers, retail sales have become a vital measure of economic strength. The retail sales report looks at what people have spent money on, from cars to cereal, tallies up the total amount spent and measures that amount against previous months. Weaknesses in the economy can often show up in this data measure. People who have lost their jobs, or worry that they will, start to curtail their retail purchases, especially of large-ticket items such as cars and appliances. Those hesitations drag down the retail-sales figures.

GROSS DOMESTIC PRODUCT: In essence, investors want to know if the economy is growing or shrinking, getting stronger or getting weaker. The gross domestic product, or GDP, is the measure that tells them the answer. The GDP report, issued by the Commerce Department, totals up everything the economy has produced in the quarter, and tells how that figure has changed, on a percentage basis, from the previous quarter. A positive percentage change means the economy is growing; a negative one means it’s shrinking. A GDP growth rate of 3% or more is considered robust.

Measuring the giant U.S. economy is no small task. So the government first issues an estimate shortly after the quarter ends and then proceeds to revise the figure three times before settling on a final figure a couple of months later. Although growth may be slow and erratic for a period of time, the accepted definition of a recession is two consecutive quarters of declining GDP.