Profits and the Economy
Businesses and the Economy
Stock investors may well wonder why they should bother with the U.S. economy. Once a fundamental analysis has been conducted and a fundamentally sound company with prospects for future growth is selected, then that's all that's required? While the stock investor can invest solely on fundamental analysis, this ignores the fact that companies are businesses which operate in an economic environment and their future prospects are directly affected by the state of the economy.
Stock prices are broadly tied to the ability of companies to increase their profits and the ability of companies to increase their profits is broadly tied to the state of the economy.
The U.S. Department of Commerce (Bureau of Economic Analysis) monitors the profitability of companies and this data is used to produce a chart that shows how the profitably varies over time. The chart is produced by the Federal Reserve Bank of St. Lousis using their FRED (Federal Reserve Economic Data) system. The chart is known as the Corporate Profits and is updated quarterly.
The Corporate Profits chart is shown below in Chart 1. plotted with a log scale.
Chart 1. Corporate Profits.
Understanding the interaction between businesses and the economy allows stock investors to make wiser and more profitable investment decisions. The savvy stock investor will also analyze the economy for its effect on the company's ability to generate future revenue and earnings growth. It is the state of the economy which will dictate whether the future revenue and earnings growth are enhanced or inhibited.
All products and services provided by businesses ultimately end up with the consumer whether directly or indirectly. Consumers are simply the general public who require these products and services. Businesses provide these products which can be anything from food to electrical appliances to motor vehicles. Businesses also provide services which can be anything from tax advice to hair dressing to medical care.
Consumers are the general public who use the
products and services provided by businesses
The consumer and the businesses that provide the products and services to the consumer are what makes up the economy.
The basic relationship between businesses and the economy is quite straight forward and can be summed up as follows;
Relationship between businesses and the economy:
- The more money consumers have, the more money consumers spend to acquire products and services.
- The more products and services that businesses provide to consumers, the more money these businesses make.
- The more money businesses make, the more money these businesses are worth.
- The more money these businesses are worth, the higher their stock prices will be.
- The higher the stock prices are, the wealthier the investors are.
- The wealthier the investors are, the more money they have.
- The more money investors have, the more money they spend and thus the cycle repeats.
No doubly what caught the attention of stock investors is that stock prices are tied to the state of the U.S. economy. To be specific, stock prices are tied to business profits and business profits are tied to the economy.
When the products and services that businesses are required to provide increases, they generally need to employ more staff which reduces the unemployment rate. These new employees now have an income and they will naturally spend money to acquire products and services which they previously could not afford. This additional spending adds additional demand for those products and services which further increases the products and services businesses must provide.
This general process is broadly known as an expanding economy. The expanding economy is what makes stock investing profitable and is part of the business cycle. This profitable investing phase is referred to as a Bull market.
Unfortunately for stock investors, the economy cannot keep expanding indefinitely and a correction occurs when the growth in the economy tops out.
When this happens, consumers tighten their spending which leads to less demand for products and services. Since businesses now need to provide less products and services they no longer need the additional staff. The consequence for the employees is that some of them are retrenched and therefore unemployment increases. To make things worse, these retrenched employees now have less money to spend for products and services which further reduces the demand for these.
While the economy is reversing its expansion, business profits are declining along with their worth. This general process is broadly known as a contracting economy and is also referred to as an economic recession if the economy contracts for more than two consecutive quarters. The contracting economy causes stock prices to drop which makes stock investing unprofitable and this phase is referred to as a Bear market.
Fortunately for stock investors, the U.S. economy spends considerably more time expanding than it does contracting.
The economy spends considerably more time
expanding than it does contracting
The contraction phase has averaged around three quarters since 1950 and is generally much shorter than the expansion phase which can be quite long and can be in the order of a decade or more.
By now the stock investor has probably realized why the economy is important to their investment decision making process. Certainly a contracting economy is not good for businesses or the stock market, but it is a natural part of the economic business cycle.
The expanding economy is what attracts the most interest from the general public who due to a buoyant stock market are eager to participate with growth investing being extremely popular with new market participants. While the economy is contracting there are stock investing strategies which capitalize on a temporarily weak business environment with value investing being popular amongst the savvy investors.
GDP and the Stock Market
The GDP is the most widely followed economic indicator
By now the stock investor is aware that businesses operate in an economic environment and that the state of the U.S. economy varies over time by expanding and contracting.
The state of the economy is measured with the GDP which stands for Gross Domestic Product. The GDP is part of the National Income and Products Account (NIPA) which is prepared by the federal government and measures the nation's domestic output of goods and services to consumers.
The department responsible for producing the GDP data is the U.S. Department of Commerce (Bureau of Economic Analysis). This data is used to produce a chart that shows how the GDP varies over time and the data can be adjusted for the effects of inflation. The chart is produced by the Federal Reserve Bank of St. Lousis using their FRED (Federal Reserve Economic Data) system. The inflation adjusted chart is known as the Real Gross Domestic Product and is updated quarterly.
The long-term trend of the Real Gross Domestic Product (inflation adjusted GDP) is shown below in Chart 1.
Chart 1. Real Gross Domestic Product
The GDP is measured is dollar terms and generally increases over the years. The GDP is calculated every quarter and the percentage change from quarter to quarter is what is reported in the financial press.
In the long-term the GDP mostly records a percentage increase quarter after quarter. When this happens the economy is expanding.
Every so often the percentage change in the quarterly GDP is actually negative, meaning that the quarterly GDP figure is less than the previous quarter. When this happens the economy is contracting as fewer goods and services were provided than the previous quarter. Fortunately these contracting quarters are fairly infrequent. Sometimes there is only one quarter which contracts while at other times there several consecutive quarters contracting. The term recession is used when two or more consecutive quarters are contracting.
The contracting quarters are shown in Chart 1. above with the light grey vertical shaded bars. This gives a visual cue as to the duration and relative frequency of the contracting quarters. As can be visually observed fron Chart 1. the contracting quarters are both short and infrequent.
The ability of businesses to increase their profits is linked to the GDP. When the GDP continues to increase quarter after quarter it is relatively easy for businesses to increase their profits. However when the GDP declines for several quarters this makes it extremely difficult for businesses to increase their profits and in all likelihood their profits will also decline in line with the GDP.
Thus it is becoming clear why GDP is important to stock investors. If the GDP declines then so do business profits and the stock price usually follows the decline.
The GDP report for each quarter is produced by the U.S. Department of Commerce; Bureau of Economic Analysis. This report is released in three stages (The advanced report, the second report and the third report).
Economists working for banks and other financial institutions provide estimates for the upcoming quarter's GDP. The stock market is quite sensitive to GDP estimates and stock prices can move significantly if the GDP indicates that the state of the economy is changing.
Some of the typical stock market reactions to GDP estimates are as follows:
Typical stock market reactions to GDP estimates:
- When the economy is expanding at a slow rate and the GDP estimate indicates that the rate of expansion will increase, it is common for stock prices to rally.
- If the economy is contracting and the GDP estimate indicates that the economy will now expand, stock prices will typically rally.
- An economy that is expanding at a strong rate and the GDP estimate indicates that the rate of expansion will decline so that the economy will grow at a slower rate, will typically cause stock prices to decline.
- When the economy is expanding at a slow rate and the GDP estimate indicates that the economy will contract, it is common for stock prices to decline.
The stock market can also react when the quarter's GDP figures are released by the U.S. Department of Commerce. Since the stock market has already reacted to the GDP estimates, when the actual GDP figures differ from the estimates and indicate a different state for the economy, the stock market may well react to this new information. For example, if the GDP estimates were for a slowly growing economy to contract but the actual GDP figures indicate that the economy continued to expand; then the stock market will probably rally since it previously sold-off based on the GDP estimates.
The stock market is constantly adjusting to reflect new information which may alter the ability of businesses to increase their profits and the GDP is closely monitored by stock investors.
Inflation and the Stock Market
High inflation favors bonds, not stocks
Inflation is an important concept for stock investors to understand as it has a profound effect on the performance of investments. Inflation affects the decision making process and investors will accordingly allocate their capital in search of higher returns.
Inflation is a natural process of any economy and comes about as businesses strive to increase their revenue. When consumers are confident they are more willing to spend money to acquire their desired products and services. This increases the demand for these products and services and the first response of businesses is to raise prices rather than increase supply. These price increases continue for as long as consumers are demanding the products and services and are also willing to pay the price for them.
This process of prices increasing for products and services is known as inflation. The consumer price index (CPI) measures the percentage changes in inflation. The CPI is frequently published in the financial press.
The department responsible for producing the CPI data is the U.S. Department of Labor (Bureau of Labor Statistics). They produce the CPI report each month and the data is used to produce a chart that shows how the inflation varies over time. The chart is produced by the Federal Reserve Bank of St. Lousis using their FRED (Federal Reserve Economic Data) system and the chart is updated quarterly.
The long-term trend for the CPI is shown below in Chart 1.
Chart 1. CPI Trend
The CPI chart can also be shown as a percentage change rather than the index values. The percentage change is how the CPI data is normally reported in the financial press.
The CPI chart below in Chart 2. shows the data plotted as the percentage increase from a year ago rather than the index values. .
Chart 2. CPI %Change
The Federal Reserve Bank (Fed) has the responsibility of controlling this inflation and responds by altering interest rates.
When inflation rises the Fed raises interest rates. This has the effect of lowering the surplus spending of consumers as more of their income is now required to pay their interest bills on any loans they may have (such as home loans). Since consumers now have less money to spend for their desired products and services, the demand on businesses is lowered. Businesses respond by lowering prices since consumers are now no longer willing to pay these higher prices. This has the effect of lowering business profits.
When inflation drops towards zero this causes problems for businesses as increasing their profits now becomes extremely difficult. Also wages no longer increase and the consumers are no longer receiving an increase in their income and they respond by reducing their spending. This causes the expansion in the economy to stall and is reflected in the gross domestic product which is now no longer increasing.
The movements in inflation have an impact on investment returns as the Fed adjusts interest rates to manage inflation. Too high an inflation is not good and neither is inflation which is too low.
In a low inflationary environment interest rates are low and thus the yields from bonds are low. This motivates investors to seek better returns and they naturally look to the stock market to achieve better returns. The low yields basically force investors to take on more risk or else they must remain content with their low returns.
The increased demand for stocks is beneficial to stock prices with investors willing to bid up prices and this is reflected in the higher PE ratios that are typical in a low inflationary environment. This does not necessarily mean that stock prices will increase, but that stock investors are willing to pay high prices for the stocks earnings.
When inflation is running high the Fed naturally increases interest rates in an attempt to control inflation and this increases the yields obtained from both short-term bills and long-term bonds.
In a high inflationary environment investors are receiving good returns from their relatively safe treasury bills and bonds and are less interested in the higher risks associated with the stock market. They have a tendency to reduce their stock holdings and reallocate their capital to treasury bills and bonds. This has the effect of reducing demand for stocks and increasing demand for treasury bills and bonds.
With reduced demand for stocks, investors are less likely to bid up prices and this is reflected in the lower PE ratios that are typical in a high inflationary environment. This does not necessarily mean that stock prices will not increase, but that stock investors are more reluctant to pay excessively high prices for the stocks earnings.
The average PE ratios of stocks are not constant but actually vary with inflation or more specifically interest rates. The general rule is that high inflation leads to lower PE ratios and low inflation leads to higher PE ratios.
Due to the variable PE ratios of stocks, they should be analyzed with regard to the inflationary environment. This is something for stock investors to keep in mind when analyzing stocks based on PE ratios for a relative valuation.
Expansion and contraction
The expansion phase of the economy followed by the contracting phase repeats over and over and is known as the business cycle. Generally the expansion phase is much longer than the contraction phase. The expansion phase typically lasts for many years while the contraction phase generally only lasts several quarters. This is largely due to the Federal Reserve Bank (Fed) managing the economy by altering interest rates.
The business cycle has direct consequences for stock investors. During the expansion phase of the business cycle, business profits are rising along with their fundamental valuations and stock prices tend to follow this trend. This is when investing is profitable and is known as a bull market. However, during the contraction phase business profits are falling along with their valuations and stock prices follow suit. This is when investors' portfolios are declining in value and this is known as a bear market.
The correlation between Business Profits and the performance of the stock market is illustrated in the following two charts.
The first chart shows the Corporate Profits (using data from the U.S. Department of Commerce) plotted with the Federal Reserve Bank of St. Lousis FRED (Federal Reserve Economic Data) system.
The second chart shows the S&P 500 stock market plotted since 2003. Both charts show the 2008 recession (also known as the 2008 financial crisis) highlighted with the light grey shaded box.
Chart 1. Corporate Profits
Chart 2. S&P 500
The two charts above illustrates the business cycle. During 2003 to 2007 the Corporate Profits basically increased along with the S&P 500 index. During 2008 and into early 2009 the Corporate Profits declined along with the S&P 500. When the recession ended, the Corporate Profits recovered and the S&P 500 resumed its upward trend.
While the business cycle affects businesses overall, the affect is not the same for all businesses. Also the business cycle has different effects on the investment class such as stocks, short-term bills and long-term bonds.
The broad economic sectors that the economy is split up into have some sectors that are relatively immune to business cycles. The Utility sector is largely unaffected which is due to the fact that consumers still require their services even during a contracting economy. Basically everybody still needs electricity, gas and water.
Consumers may well cut back on their spending on other services but they will still require these utility services. Also any basic goods required by consumers such as food and clothing will still be purchased. These are the consumer staples and the industries supplying them are less affected by a contracting economy.
The industries most affected by a contracting economy are those that supply a product or service which is considered to be a luxury item. When consumers have less money to spend, they inevitably cut back on anything that is not absolutely required. Unfortunately for a lot of businesses, they provide some if not all of these products and services and so they are the most affected by a downturn in the economy.
This means most sectors are affected during the contraction phase of the business cycle. The exceptions are consumer staples and utilities.
The term "Cyclical stocks" is used to describe any stock whose business is affected by a downturn in the economy and the term "Defensive stock" is used for consumer staples and utility stocks.
During a downturn in the economy it is common for stock investors to sell their cyclical stocks and buy defensive stocks along with bonds and even short-term bills. This has the effect of lowering the stock prices of the cyclical stocks while supporting the stock prices of the defensive stocks. The defensive stocks may still decline in price as investors may even sell these to buy bonds, however if the defensive stocks do decline, the amount is usually minor relative to the decline in cyclical stocks.
Stock investors are probably wondering what causes the business cycle in the first place and why the economy does not simply track along at a steady growth rate.
Economists have all sorts of theories with the simplest one for stock investors to understand being that of supply and demand.
The simplest explanation for business cycles is that consumers naturally require products and services to suit their lifestyles. When consumers have spare money they will use this to acquire their desired products and services. This places demand on businesses to provide these. While the demand is strong businesses will naturally attempt to increase their profits. This can be achieved in two ways.
The first is to increase prices and this puts pressure on wages to increase. Once wages increase then consumers can continue to pay these higher prices. This leads to a cycle of price increases and wage increases. As wages increase consumers place more demand on products on services and business respond by increasing prices on their limited supply. This process of price increases is known as inflation and is tracked with the consumer price index (CPI).
The second way for businesses to increase profits is to provide more products and services by increasing their staff levels. When businesses increase their staff level this reduces the unemployment rate. These new employees now have an income and the first thing they do is spend money to acquire the products and services they desire. This in turn again places additional demand on businesses to provide these and they respond by increasing their staff level again. This leads to a cycle of increasing employees who place an increasing demand. As the unemployment rate drops this increases the demand for products and services and business respond by increasing their staff levels to supply this increasing demand.
Businesses will generally incorporate both of the above methods of increasing their profits.
At some point in the future this expansion comes to an end. What was keeping the expansion going was the consumers' ability and willingness to spend money to acquire their desired products and services. Anything that would cause the consumer to reduce their spending has dire consequences on the businesses ability to continue to increase their profits.
Sometimes businesses tend to try too hard to increase profits and start to reduce staff in order to reduce costs (usually by replacing staff with automation). If the staff reduction becomes too widespread, this starts to reduce the number of consumers who have the ability to spend, which in turn lowers demand. Any lowering of demand causes businesses to respond by supplying less products and services, which in turn means they now require less staff. This leads to a cycle of reducing demand and reducing staff numbers. The problem is that the retrenched staff now no longer have an income and therefore they are reluctant spenders which further reduces demand.
Consumers will naturally reduce their spending whenever there is something which will threaten their future income. This has the consequence of reducing demand and this leads to the contraction phase of the business cycle. The contraction phase will continue until consumers regain their ability and willingness to spend, thus the start of the next expansion phase can begin and the business cycle repeats.
Tracking the Economy
Gross Domestic Product
The broadest indicator used to track the state of the economy is the GDP (gross domestic product). This popular indicator is closely monitored by the stock market for any indication that the state of the economy might be changing.
The U.S. Department of Commerce (Bureau of Economic Analysis) produces the annualized GDP report for each quarter and each report is released three times (the advanced estimate, the second estimate and the third estimate). The report in PDF format can be viewed at www.bea.gov/newsreleases.
The stock market is very sensitive to changes in the GDP. Should the GDP indicate slowing growth this has an adverse affect on the ability of businesses to increase their profits and investors might react by reducing their stockholdings and buying bonds.
The GDP report produced by the Bureau of Economic Analysis also includes the estimated Corporate Profits for the reported quarter. Corporate Profit data is provided within the GDP reports second and third estimates for Q1, Q2 and Q3. For Q4 the Corporate Profit data is only provided with the third estimate GDP report.
The Industrial Production report measures volume of output in the manufacturing, mining and utilities industries. These provide an indication of the demand for their products and services
The Industrial Production report is available from the Fed (Board of Governors of the Federal Reserve System). The report is produced monthly and measures the output of U.S. industries. The current report can be viewed at www.federalreserve.gov.
The Nonfarm Employees (also known as Nonfarm Payroll) is a measure of the number of U.S. employees that are not involved in farming industries.
The U.S. Department of Labor (Bureau of Labor Statistics) produces the Employment Situation report each month which includes the Nonfarm Payroll. The current report can be viewed at www.bls.gov/news.
Inflation is measured with two main indexes. The first is the CPI (consumer price index) which measures changes in the prices of goods and services used by consumers. The second measure of inflation is the PPI (producer price index) which only includes products and excludes services.
A variation to the CPI is to deduct Food and Energy prices and is usually referred to as the core inflation rate.
The U.S. Department of Labor (Bureau of Labor Statistics) produces the CPI report each month. The current report can be viewed at www.bls.gov/news.
These inflation measures are published in the financial press and stock investors can get a sense of the current inflationary environment.
Basically inflation affects the stock market. High inflation generally leads to lower PE ratios for stocks and low inflation generally leads to higher PE ratios.
The consumers' ability and willingness to spend is dependant on their income and unemployed consumers are reluctant spenders.
An important and closely followed indicator is the Nonfarm Employees report mentioned above which provides statistics on the unemployment rate. A decreasing unemployment rate means that there is an increase in consumers who have the ability and willingness to spend, which is positive for the economy and business profits and hence stock prices.
Another indicator of consumer activity is the domestic automobile sales, which provides a guide to consumer spending.
The housing starts and building permits report is another indicator which is closely followed by the stock market which shows the level of consumer commitments for large expenditures.
Basically when consumers are confident they tend to purchase larger items and when they are less confident they tend to restrict their spending to low cost items.
The Conference Board Index of consumer confidence is another useful indicator which gives an indication of consumer attitudes towards the state of the economy and provides a guide to the consumers' future intentions regarding spending.
The ability of businesses to increase their profits is what drives the stock market and any indications that this will not be achieved can lead to stock prices declining.
A commonly followed indicator of business activity is the industrial production index mentioned above which reports on the volume of output in the manufacturing, mining and utilities industries. These provide an indication of the demand for their products and services and the stock market closely monitors this indicator for any decline in output.
Any change in industrial output is generally reflected in a change in the size of the workforce which is generally reflected in the Nonfarm Payrolls report.
Generally, as the production output increases then the number of workers needed to produce that output also increases.
Another useful report is the purchasing agents' survey. This report is used to anticipate cyclical changes in business and the report includes new orders, deliveries and inventories. The stock market follows this report for signs that new orders, deliveries or inventories may be declining.