Investing - Part IV

Welcome to the readers of the Carnival of the Vanities! Glad you stopped by. Please take a look around, enjoy yourself and please leave a comment or two! Also, keep in mind that this series in now a part part series in eight parts. Links to the other seven can be found at the bottom of this post. Thanks! Chris

The Economy and The Market

This is part four of my series on investing knowledge. Today, we're going to look at how some different economic indicators or situations can affect the market.

The two most popular economic indicators are the Consumer Price Index (CPI) and the Producer Price Index (PPI), which are actually related.

The CPI is designed to reflect a change in the prices of a certain basket of goods that are commonly bought by consumers. The idea is to give us an idea of how fast prices are rising, or what the rate of inflation is.

The PPI is designed to reflect a change in the prices that producers are paying to manufacture the goods that are bought by consumers. When the two indexes are used in conjunction, we can tell if profits should be increasing or decreasing. If PPI is rising faster than CPI, profits will fall. Conversely if CPI is rising faster than PPI then corporate profits will rise.

Ideally the market likes to see CPI rising just a tick faster than PPI. That would indicate an expansion of profits. But why would the market want to see the indexes rising when that indicates inflation? After all, everything we've ever been told about inflation is that it's bad and evil.

Actually, in moderation, inflation is good and even necessary for the growth of the economy. A little bit of inflation, encourages spending, which increases profits and powers the economy. Inflation isn't, in and of itself, bad. It's too much inflation that's bad.

But if inflation is a rise in prices, why is deflation - a decline in prices - a bad thing? The less money you spend, the more you can save and invest and the better off you'll be, right?

Wrong.

If prices are dropping, and you know that they will continue to drop for the foreseeable future, you aren't going to spend any more money than absolutely necessary. After all, if your dollar will buy more tomorrow, why spend it today? So spending stops. Soon prices drop again to try to stimulate spending and a vicious cycle ensues where prices drop and spending stays stopped waiting for the next price drop. Once the deflationary cycle starts, it is very, very difficult to pull out of it.

The other great bugaboo that's floating around with the threat of deflation right now is the depreciation of the dollar. Listening to our friends and many of the internationalist crowd we would think that depreciation is the greatest evil to befall our economy since the Depression. But what is depreciation, why does it happen, and what are its effects?

Depreciation is a decline of the value of a dollar in relation to other foreign currencies. In other words as the dollar depreciates, it costs more to buy foreign money. Over the last few months it has gone from costing 89 cents to buy 1 Euro to costing almost $1.20 for 1 Euro. That's depreciation. Our currency is worth less today than it was just a few months ago.

Why does that happen? Currency generally reflects the strength of the underlying economy. A strong currency also serves as a brake on excessive foreign speculation in an economy. How?

Most rational investors aren't going to accept an excessively high degree of risk from any investment, no matter how high the quality. So as the dollar strengthens, the potential risk of an investment goes up for foreigners. As a result, when the dollar is strong they tend to invest less in the US, keeping inflationary pressures in investment prices down. When the dollar weakens, the potential return increases for foreign investors, which helps to encourage additional investments in US markets, which in turn tends to push prices up, which encourages the American economy along.

Along with encouraging foreign investment in the US, the depreciating dollar also has the advantage of making our exports cheaper and it makes imports more expensive. The result is that everyone, here and abroad, ends up buying more American goods which helps to stimulate the economy.

So, if all that is true, why do some people want to protect the dollar? Why is there a great push for tariffs instead?

The main reason is political. A declining dollar is very likely to stimulate the economy, so the opponents of the powers that be nearly always scream about the "loss of prestige" caused by the declining currency. This holds true regardless of who is in power or what nation it happens in. Tariffs on the other hand are less effective for steering the economy and much more effective for punishing enemies or paying off constituents.

The economy is cyclical in nature and is really beyond the control of any small group of men. The economy is almost always based on confidence. In other words, one stupid action can cripple it in a heartbeat, whereas it takes time, sometimes a long time, to rebuild the confidence needed to really get it going. No single decision by the Fed will make the economy better, but a single decision can certainly cripple it.

So besides the CPI, PPI and the dollar, what other economic indicators are out there that people like to use?

My experience showed that there are really only two other indicators that people liked to use: unemployment and home sales.

Unemployment is important in that unemployed people tend not to spend much money. As more and more people become unemployed, spending begins to slowdown. Also, a long-term rise in the rate of unemployment can be forecasting a weakening in the economy. Companies that are doing well almost never are letting people go. An expanding business will need additional people.

Home sales are important because, outside of the fact that the home was sold, there will be other ancillary purchases. People will buy furniture, floors, paint and all kinds of other stuff. The sale of the home is only the beginning of a very deep economic event. And if that home sale is a new construction, the benefits extend even further as you now get construction, equipment and material suppliers involved. Plus home sales are a great indication of consumer confidence, the fuel that powers the economic engine.

So those are the main indicators that people used to look at when I was a broker. Everything economic will eventually translate into a change in stock prices.

Next we'll look at how the market actually works in regards to trading.

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part III - Options

Part V - Market Mechanics

Part VI - Mutual Funds

Part VII - Asset Allocation

Part VIII - Bonds