Financial Market Indicators

What are Financial Market Indicators?

Financial market indicators are used by analysts to assess current market conditions and forecast the future trajectory of markets – most commonly stock markets – and economic trends. The most commonly used metrics for the US economy include gross domestic product (GDP), the Consumer Price Index (CPI), the nonfarm payroll report, and the Consumer Confidence Index as well as interest rates. In the UK, GDP, unemployment, inflation, business confidence, consumer confidence, and interest rates are some of the most significant indicators. Benchmark stock market indices such as the S&P 500, Dow Jones Industrial Average (DJIA), and NASDAQ in the U.S. are also closely watched by investors.

Stock Market Indices

Stock markets have their own benchmark indexes, which are used to monitor changes in stock prices. For example, in the U.S. the S&P 500 (which is a broad stock market index) and the Dow Jones Industrial Average (which is a narrower stock market index) are the primary benchmarks. Five hundred blue-chip stocks constitute the S&P 500, while only 30 names make up the  Dow Jones Industrial Average. Similarly, in the UK the FTSE All Share Index is the primary index, while the FTSE 100 is a narrower benchmark.

Stock markets experience bullish and bearish phases. A bear market is when a stock market index, such as the S&P 500 in the U.S., drops 20% or more from recent highs. Conversely, a bull market typically rises 20% and touches record highs from the recent bear market lows.

Stock Markets – Real Rate of Return

Below we have calculated the real rate of return of a stock market index. To determine the real rate of return, you need the opening and closing price level of the index for the investment period as well as the inflation rate.  The real rate of return is what matters to investors. In this example, it is 6.8% (annual).

Inflation

Inflation is defined as a sustained increase in the overall level of prices for goods and services in an economy over time. More specifically, inflation is measured as an annual percentage (%) increase in some price index – such as the Consumer Price Index (CPI) – which adequately reflects overall inflation in an economy.

The Consumer Price Index (CPI) is the weighted average of prices of a representative basket of goods and services purchased by the average household  and reflects their spending patterns. Each item (goods and services) is weighted in proportion to its importance in the representative basket. These weights are usually based on surveys of family expenditures and are updated every five to ten years to reflect the changing importance of various goods and services.

Calculate the annual inflation rate (%):

if the CPI was 130 for 2013 and 120 for 2012, then use the following formula to calculate the annual inflation rate.
Annual inflation rate (%) = (2013 CPI – 2012 CPI)  X 100/ 2012 CPI
The annual inflation rate (%) in terms of the CPI for 2013 is calculated as:

Annual inflation rate (2013) % = (130 -120)  X 100/120 = 8.33%

From this calculation, we know that the average household or consumer had to pay 8.33% more in 2013 than in 2012 for the same representative basket of goods and services.

Interest rates

Interest rates have a significant impact on GDP growth and securities prices across asset classes and thus have a strong impact on financial markets.

For example, if an economy is overheating or inflation continues to rise above the central bank’s target rate, it is likely to raise its benchmark rate. This puts upward pressure on short and long-term lending rates across the economy. These rising rates have a negative impact on consumption, investment, and corporate profits, and consequently on the economy’s growth trajectory. This in turn has a negative impact on stock prices. As a result, market indices tend to fall and the stock market enters a correction.

For example, In the US, the Federal Reserve can raise the Federal Funds rate if it believes that the economy is overheating or inflation is rising.  If unchecked, this situation can result in a wage-price spiral later. A rise in the federal funds rate reduces liquidity and makes it more expensive to borrow. This tends to have an immediate downside impact on stock markets and a lagged downside impact on the economy. As a result, stock market indices tend to fall.

On the other hand, if an economy is experiencing a slowdown or is in a recession, the central bank may reduce or lower its key rate. This puts downward pressure on lending rates across the economy (both short and long term), which has a positive impact on consumption, investment, corporate profits, and ultimately economic growth. As a result, investors expect higher growth and corporate profits (markets are forward-looking). Consequently, stock market indices tend to rise.

Taylor Rule

The Taylor rule is an econometric model that is used to guide central banks, such as the Federal Reserve in the U.S.  According to this rule, central banks should manage interest rates based on changes in the inflation rate and/or GDP.  The formula relates the operating target for short-term interest rates to the deviation between the expected and desired rate of inflation and the deviation between expected and desired GDP (real) growth rates. The underlying aim of the Taylor rule is to create economic stability in the short-run, while still attempting to sustain long-term economic expansion.

This rule recommends that short-term interest rates should be raised by central banks (which affect a host of commercial interest rates across the spectrum) when inflation or GDP growth rises more than expected or desired.

Formula

R= p +0.5y + 0.5(GDPe – GDPt) + 0.5*(Ie – It)

R = Target rate –  the interest rate that a central bank should target in the short term

P = Neutral rate –  the current short-term interest rate when the deviation between actual and expected inflation and GDP growth rates equal zero.

Ye = Expected GDP growth rate

Yt = Long-term GDP growth rate

Ie = Expected rate of inflation

It = Targeted rate of inflation

Taylor Rule – Example

Below is an example of Taylor’s Rule, based on the following assumptions regarding long-term GDP growth rate, expected GDP growth rate, and the expected rate of inflation of an economy.

When compared to the targeted rates, the expected rate of inflation and expected GDP growth rate require the central bank to raise short-term interest rates to 4.75% to cool down the economy. As a result, financial asset prices and indices will decline in anticipation of slowed growth and corporate profits.

Conclusion

Financial market indicators play a pivotal role in making investment decisions.  For example, if indicators point to a bullish market, investors will go long. If a bearish market looks likely, investors will reduce their exposure. These financial market indicators also play a pivotal role in assessing the current state of an economy,  which influences trends in the stock market.

Solve the Following Question on Financial Market Indicators

Download the Excel sheet for the question & answer.