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The Gift of Economics

December 03, 2006
LaFoy

LaFoy

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How well a particular investment performs is generally influenced by the state of the economy. Before learning about a specific investment, I feel it is essential to learn about the economy and the impact it has on the world of investing. Also it is very important to know what economic cycle you are in, and therefore know how to adjust and react to each climate accordingly.

The economy is measured by several economic indicators that take the temperature of the economy, and some indicators even give a future forecast on what is expected of the economy in the future.

Of all the economic indicators, some are more important than others. The most important economic indicator is considered by many as the parent indicator, and that is the GDP or Gross Domestic Product. The GDP is the total dollar value of all goods and services produced by labor and property in the United States. A GDP that is increasing signifies an economic growth cycle that may cause inflation, were a GDP on the decline signifies an economy that is slowing down that has the potential to cause deflation.

The GDP report measures quarterly activity and has a heavy influence on how people invest and spend their money. The report is released three times each quarter, being revised each time to finally come up with a final report for the quarter during the last month of the next quarter. For example, the final revision of the GDP report for the first quarter (January-March) would be released in June, and can be found on the YAHOO! Finance page with all other indicators.

Keeping good track of the GDP growth (or decline) numbers should give you a good feel for the state of the economy and also let you know what phase of the business or economic cycle you are currently in. There are generally five phases in the business cycle as outlined below:

 

Business/Economic Cycle

 

  • Downturn: Starting from the peak (highpoint) in the economy, the downturn starts when the GDP has its’ first quarter of negative growth, and last for as long as the GDP report is signifying negative growth. Two consecutive quarters of negative GDP growth is officially considered a recession. During a downturn, investors generally get nervous and begin to dump quality investments for less than market value. At this time, investment bargains are usually easy to come by.
  • Trough: The trough signifies the end of the downturn or recession. It represents the lowest level in the business cycle. During a trough, because it is the lowest phase in the cycle, reports start to improve and the economy is getting ready to bounce back. In my opinion this is the best time to invest, especially in real estate and stocks. Due to a lack of consumer confidence at this point in the cycle, investments are usually at their lowest point. Once you’re at the bottom, the only way you can go is up, so I advise you buy all the quality real estate and stocks as possible.
  • Recovery: The recovery begins when the GDP growth is positive again. The recovery is over when the GDP level surpasses the previous peak in the previous business cycle, thus is the start of an expansion.
  • Expansion: An expansion occurs when the GDP rate is reaching new heights, and last until it reaches a new peak. At this point, investments normally are costing more than they are really worth. During this phase of the cycle, be careful in what you buy, because the peak is coming and on its way. If you buy too close to the top, you’ll have to sale on the way back down, thus taking a loss.
  • Peak: The peak is the highest point in the business cycle. In my opinion this is the worst time to start investing because once you’re at the top, the only way you can go is down.

 

Now that we have a good understanding of the economic cycle, we can now go in depth on all of my other favorite economic reports/indicators that generally give you a clue in what direction the economy is headed before the GDP report is even released.

Although there are many economic indicators viewed and adhered to by Wall Street, there are only six of them besides the GDP report that I find important as they are listed below:

 

Important Economic Indicators

 

  • Consumer Price Index (CPI): The CPI measures the level of inflation or increase in prices for goods and services in the marketplace. Inflation is generally high during times of expansion and lower during a downturn. During an expansion, people are spending money at new levels and the high demand for goods and services generally allows businesses to raise there prices. Generally, when inflation is growing too rapidly, the Federal Reserve will take action to raise interest rates, which will make money not as easy to borrow, and slow down the crazy shopping, that in return slows down the inflation. The CPI report is released monthly, approximately two weeks after the month ends.
  • Employment Report: The employment report contains information such as the unemployment rate, payrolls, and hourly wages. This report is very important as it is one of the first indicators each month of what direction the economy is going in. In times of an expansion or growing economy, payrolls are usually up, and the unemployment rate is usually down and vice versa for times of a downturn or a recession. This report is also released monthly on the first Friday of every month.
  • Retail Sales: The retail sales report is one of my favorite reports, as it gives us the level of consumer spending, which accounts for approximately 2/3rds of the Gross Domestic Product. Generally when retail sales are up, inflation shortly follows as it shows an increased demand in consumer goods. This report is usually released in the middle of every month.
  • Consumer Confidence: The consumer confidence index gives a reflection of how consumers feel about the current and future state of the economy or business cycle. A decrease in consumer confidence usually causes a decrease in retail sales, thus causing a decrease in the GDP. When consumers are not comfortable about the current or future state of the economy, they usually tighten their belts and decrease their level of spending due to worries that hard times may be coming ahead. During an expansion (good times), consumer confidence is generally high as the job market is generally good and most of their investments may have reached new highs. The consumer confidence report usually comes out the last week of every month.
  • Housing Starts: Along with the retail sales report, the housing starts report is one of my favorite reports. The housing starts report details the number of single and multifamily homes being built. As we all know, when a home is built and then purchased, it calls for further spending on appliances, fixtures, and other household related goods. This report gives us a pretty solid indication of where the economy is going approximately 3-6 months ahead of time. The housing starts report is released monthly and is heavily watched by Wall Street.
  • Durable Goods: Durable goods can be described as goods with a life expectancy of at least two to three years. Durable goods would include such items as washers, dryers, stoves, computers, and other long lasting items bought by consumers and businesses alike. Durable goods sales are generally up in an expanding economy and down in times of downturn and recession. This report is also released monthly, approximately three weeks after the reporting month ends.

For more knowledge on business, economics, and investing, please purchase my new business book “The Takeover: Everything You Need To Know About Business” from BarnesandNoble.com by clicking on the link below: http://search.barnesandnoble.com/booksearch/isbnInquiry.asp?z=y&EAN=9781425962210&itm=1

About the author:

LaFoy
GuruFocus - Stock Picks and Market Insight of Gurus

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