THREE KEY ECONOMIC INDICATORS TO GAUGE STOCK MARKET DIRECTION

Published by Sharekhan Education | March 15, 2020

THREE KEY ECONOMIC INDICATORS TO GAUGE STOCK MARKET DIRECTION

If you are active or working in capital markets, there is a high probability that when you bump into a relative or a friend they would ask you the most clichéd question “markets kya lagta hai?” (meaning “what do you think about the market’s direction – up or down?”). There are multiple factors that can determine the market’s direction. From corporate earnings, economic data, important events (domestic as well as international), and geopolitical developments, to investor sentiment, many factors can influence the general trend of the market in the short term. But, economic factors have the biggest influence on the long-term direction of the stock market.

The economy moves in a cycle with phases of expansion and contraction commonly referred to as boom and bust cycles. The length of the boom and bust cycles vary from time to time. Economic indicators provide a framework for assessing which phase of the economic cycle you’re in and where it’s headed.

What are Economic Indicators?

Economic indicators are nothing but statistics about various aspects of the economy’s health, which when analysed can give you some sense about the direction of the economy and its impact on the stock market. There are various economic indicators such as GDP, industrial production, interest rates, inflation, fiscal deficit, trade deficit and many more, which need to be interpreted correctly to forecast broad economic trends and their implications on the market.

Three key indicators for gauging the stock market’s direction are:

  • Inflation – data released every month
  • Interest rates – data released daily
  • PMI (Purchasing Managers Index) – data released every month
Let us understand each of these in more detail.
Inflation:

Inflation data shows the increase in the prices of essential goods and services. It is an important measure for the stock market, as it determines how much value of the investment is being depleted due to loss of purchasing power. For example, if the rate of return on an investment is 5% and the inflation is 3%, then the real rate of return is just 2%. In order to receive a higher real rate of return, the same has to be much higher than the prevailing rate of inflation. The actual impact of inflation on stocks comes from its influence on corporate earnings. Low inflation keeps corporates’ costs down and increases profits while high inflation can reduce profits. Companies can effectively manage high inflation by passing on the increased input costs and controlling overall operational expenses.  However, prolonged inflation spikes can overheat the economy, dampening spending and devaluing the currency. To curb inflation, the central bank raises interest rates to stabilize prices.

Interest rates:

When the central bank keeps its lending rates low, banks pass on the benefit to companies and individuals by cutting their own lending rates. This leads to increased earnings and improved spending power. On the other hand, if the central bank increases interest rates, banks will raise lending rates for companies and individuals. This results in decreased profits and spending power, ultimately impacting the stock market.

PMI:

PMI is a measure of economic growth. It takes into account the production level, new orders, supplier deliveries, stock of purchases and employment level of all the companies. A PMI number above 50 indicates that the economy is on a firm footing and doing well. If this number goes below 42, it indicates a recessionary scenario and affects corporate earnings estimates, which ultimately lead to a fall in the stock market.

There are many more economic indicators which one needs to analyse before arriving at a precise judgment on the long-term direction of the stock market. If you like to know where to find these details and know what these economic indicators mean, and how to interpret them, then register for one of our free “Power Money Workshops” and join our investing education program “Stock Investor” to polish your investing skills.

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