Chapter 4: Measuring economic health & market performance.
As the economic cycle goes through alternating waves of expansion and contraction, it experiences five phases; peak, trough, recovery, expansion, and new peak. Economic indicators provide a means of measuring this cycle based upon the direction of current and future economic activity. As such, they are considered very important gauges of the economy and where it is headed. Being able to identify and quantify the future direction of economic activity is important to the individual investor, as well as the business community. In 1995, The Conference Board, an independent research organization, assumed from the U.S. Department of Commerce the responsibility for computing the composite indexes. The Conference Board's leading, coincident, and lagging indexes are essentially composite averages of between four and ten individual indicators. Together they are often referred to as the three "composite indexes."
Leading Index. Of all indexes, the U.S. Leading Index is the most widely watched business cycle indicator. It is also described as the "composite index of leading economic indicators" and "the Conference Board's index of leading economic indicators." However, use of the term "leading" is not intended to describe the importance of this indicator, but rather to describe its usefulness as a predictor of future economic activity (i.e., leading versus trailing). A rising index signals that in the near future economic activity can generally be expected to increase, whereas a falling index signals that economic activity can be expected to decrease. As a composite index, it is expected that the volatility of the individual components will be smoothed out, thereby revealing more clearly and more accurately the patterns of cyclical turning points in the business cycle. This index includes the following ten components:
(1) Average weekly hours, manufacturing.
(2) Average weekly initial claims for unemployment insurance.
(3) Manufacturers' new orders, consumer goods and materials.
(4) Vendor performance, slower deliveries diffusion index.
(5) Manufacturers' new orders, nondefense capital goods.
(6) Building permits, new private housing units.
(7) Common stock prices (S&P 500).
(8) Money supply (M2). See page 54.
(9) Interest rate spread, 10-year Treasury bonds less federal funds.
(10) Index of consumer expectations (University of Michigan).
The latest leading index can be found at: www.conferenceboard.org.
Coincident Index. In contrast to the leading index, the cyclical turning points in the coincident index generally occur at about the same time as those reflecting total economic activity. It is also described as the "Conference Board's coincident index." This index includes the following four components:
(1) Employees on nonagricultural payrolls.
(2) Personal income less transfer payments.
(3) Industrial production.
(4) Manufacturing and trade sales.
Lagging Index. The cyclical turning points in the lagging index generally occur after those reflecting total economic activity. Thus, the indicator is expected to reach a peak after the economy has peaked and to hit bottom after the economy has bottomed out. It is also described as the "Conference Board's lagging index." This index includes the following seven components:
(1) Average duration of unemployment.
(2) Inventories to sales ratio, manufacturing and trade.
(3) Labor cost per unit of output, manufacturing.
(4) Average prime rate.
(5) Commercial and industrial loans.
(6) Consumer installment credit to personal income ratio.
(7) Consumer price index for services.
Consumer Price Index. The CPI represents changes in prices of all goods and services purchased for consumption by urban households. User fees (such as water and sewer service) and sales and excise taxes paid by the consumer are also included, but income taxes and investment items (like stocks, bonds, and life insurance) are not included. Prices for the goods and services that are used to calculate the CPI are collected in 87 urban areas throughout the United States and from about 50,000 housing units and approximately 23,000 retail and service establishments (see table on page 444). The CPI is used for a variety of purposes, to include:
(1) As an economic indicator. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.
(2) As a deflator of other economic series. The CPI and its components are used to adjust other economic series for price changes and to translate these series into inflation-free dollars.
(3) As a means for adjusting income payments. Workers are frequently covered by collective bargaining agreements tied to the CPI. The index also affects the income of 48.4 million Social Security beneficiaries, 4.2 million military and federal Civil Service retirees and survivors, and the cost of lunches for 26.5 million children who eat lunch at school. (1) Some private firms and individuals use the CPI to keep rents, royalties, alimony payments, and child support payments in line with changing prices. The CPI is also used to adjust the federal income tax structure to prevent inflation-induced increases in taxes.
The latest CPI figure can be found at: http://stats.bls.gov.
Consumer Confidence Index. The Consumer Confidence Index is a monthly measure of the public's confidence in the health of the United States economy. Also described as the "Conference Board's Index of Consumer Confidence" and the "Consumer Confidence Survey," it measures how 5,000 United States households feel about the current state of the economy, as well as their expectations for the economy over the next six months. Questions are asked relating to both employment and income. If consumer attitudes and sentiment are high, then it is expected that their continued spending and borrowing will contribute to a healthy economy. The University of Michigan Institute conducts a similar survey monthly for Social Research (this survey includes consumer expectations regarding household income and willingness to purchase homes and vehicles).
The latest consumer confidence index figure can be found at: www.conference-board.org.
Gross Domestic Product (GDP). The GDP represents the total value of all goods and services produced by labor and property located in the United States. It is released quarterly by the U.S. Department of Commerce. In order to more accurately compare the levels of output over different periods of time it is adjusted for inflation. The adjusted figure is referred to as the real gross domestic product or constant-dollar gross domestic product. Note that there is a difference between the Gross Domestic Product (GDP) and the Gross National Product (GNP). GDP measures output and earnings within the United States without regard to the earner's nationality, whereas GNP is a measurement of output and earnings of American citizens, no matter where they live and work.
The latest estimates of the GDP can be found at: http:// bea.gov.
Industrial Production. Also referred to as "Factory Output," this is an index designed to measure changes in the level of output in the industrial sector of the economy. The index is grouped by both products (consumer goods, business equipment, intermediate goods, and materials) and industry (manufacturing, mining, and utilities). The Board of Governors of the Federal Reserve System releases it monthly. While the industrial sector of the economy represents only about 20% of GDP, because changes in GDP are heavily concentrated in the industrial sector, changes in this index provide useful information on the current growth of GDP. The level of capacity utilization in the industrial sector provides information on the overall level of resource utilization in the economy that may, in turn, provide information on the likely future course of inflation.
The latest industrial production figures can be found at: www.federalreserve.gov/ releases/G17/Current/ default. htm.
Business Inventories. This monthly report by the U.S. Department of Commerce, Bureau of the Census, gives the total current-dollar sales and inventories for the manufacturing, wholesale, and retail sectors of the economy. This release is the primary source of data on inventories. The rate of inventory accumulation plays a key role in determining the current pace of economic growth and often provides useful clues about the future pace of growth as well. For example, if inventories are accumulating at a rapid pace, such that inventory sales ratios are rising, it may portend a slowing of growth in the near future as firms cut production to bring inventories back into line with sales. Vice versa, if inventories are growing slowly or actually falling, it may signal a future pickup in production.
The latest business inventory figures can be found at: www. census.gov/mtis.
Retail Sales. This is a report of the results of a survey of about 12,000 retail businesses throughout the country and is released monthly by the U.S. Department of Commerce. One of the most closely watched economic indicators, the data is widely used throughout government, academic, and business communities. For example, the Bureau of Labor Statistics uses the estimates to develop consumer price indexes and productivity measurements, the Federal Reserve Board uses the estimates to assess recent trends in consumer purchases, the media use the estimates to report news of recent consumer activity, and financial and investment companies use the estimates to measure recent economic trends.
The latest retail sales figures can be found at: www.census. gov/mtis.
Other Economic Indicators. Government agencies, the Conference Board, and other organizations regularly report many other indicators. For example, there are indexes dealing with construction spending, housing starts, sales of new and existing homes, capacity utilization, personal income, and factory orders.
An excellent source of free and comprehensive data can be viewed at: www.economagic.com.
STOCK MARKET INDEXES
Indexes contain a group of stocks from within a particular financial market, from within a number of related markets, or from the economy as a whole. Indexes that measure major or senior averages are broad-based and designed to reflect the movements of an entire market. Other indexes are intended to track the performance of companies based upon their market capitalization. Still other indexes are tailored to represent a particular group of companies in the same economic sector or industry (e.g., transportation or utilities). Indexes that are weighted place more significance on some elements than on other elements (e.g., market capitalization versus stock price). Price changes, sales volume, and volatility are reported and tracked over different periods of time (e.g., hourly, daily, weekly, or yearly). Each stock index is different.
Dow Jones Industrial Average (DJIA). Of all the stock indexes, "the Dow" is clearly the oldest, best-known, and most widely followed market index in the world. It is a price-weighted average of 30 very large and significant stocks traded on the New York Stock Exchange and the NASDAQ. (2) The component stocks of the Dow Industrials changes periodically. The editors of The Wall Street Journal select companies that comprise the three Dow Jones Averages and it is solely at their discretion that companies are either added or deleted. While there are no rules for component selection, a stock typically is added only if it has an excellent reputation, demonstrates sustained growth, is of interest to a large number of investors, and accurately represents the sector(s) covered by the average. The Dow Jones averages are unique in that they are price weighted rather than market capitalization weighted. Their component weightings are therefore affected only by changes in the stocks' prices, in contrast with other indexes' weightings that are affected by both price changes and changes in the number of shares outstanding. Each stock in the Dow Jones Industrial Average represents 1/30th of the overall average. In order to better compare the stock index values across time, the Dow is calculated by totaling the prices of the 30 individual stocks and then dividing the total by a divisor that adjusts for stock splits, spin offs, and other changes (as of December 2010, the "divisor" stood at 0.132129493). The advantages of the Dow are seen as its longevity and stability of its companies. However, with its narrow focus on only 30 companies it does not serve all that well as a benchmark for the market as a whole.
The Dow averages for Industrials, Transportation and Utilities are published under Market Data in The Wall Street Journal.
Dow Jones Transportation Average. This index is comprised of 20 airlines, railroads, and trucking companies. (3) Each stock in the Dow Jones Transportation Average represents 1/20th of the overall average.
Dow Jones Utilities Average. This index is comprised of 15 gas, electric, and power companies. (4) Each stock in the Dow Jones Utilities Average represents 1/15th of the overall average.
Dow Jones Composite Average. This is a composite of all of the companies in the Industrial, Transportation, and Utilities averages.
Dow Jones U.S. Total Stock Market Index. This index is comprised of 3,894 (as of December 31, 2010) United States companies representing more than 100 industries that are traded on the New York Stock Exchange, the American Stock Exchange (renamed NYSE Alternext U.S.), and the NASDAQ Stock Market (it is intended to represent 95% of the U.S. market capitalization). The index is capitalization weighted, meaning that a stock's effect on the index is in proportion to its current price multiplied by the total of shares outstanding.
Dow Jones Wilshire 5000 Index. Often referred to as the Total Stock Market Index, this index was maintained by Wilshire Associates until April of 2004, when Wilshire and Dow Jones Indexes began cobranding it and other Wilshire indexes. The index contains more than 5,000 stocks that trade in the U.S. and is designed to represent the performance of all U.S.-headquartered equity securities with readily available price data. To be included in the index, generally a security must be traded on the New York Stock Exchange, American Stock Exchange, or NASDAQ Stock Market. Two versions of the index are maintained, one weighted by full market capitalization and the other weighted by float-adjusted market capitalization. The full-market-cap version is intended as a "wealth" measure, representing the total dollar value of funds entering or leaving the U.S. equity markets. The float-adjusted version is meant to be a more realistic benchmark, because it reflects securities that are actually available to investors.
The Dow Jones Wilshire 5000 Index is published as the Stock Market Index under Market Data in The Wall Street Journal.
Standard & Poors 500 (S&P 500 Index). In contrast to the Dow's 30 companies, the 500 large-cap companies in the S&P 500 provide great diversification. As a leading benchmark of the United States stock markets, it is frequently used as a measure of a mutual fund's performance (e.g., "the XYZ fund has outperformed the S&P 500 in three of the last four years"). The S&P 500 attempts to cover all major areas of the United States economy and contains widely held companies that are chosen for their market size, liquidity, and industry representation (industrial, transportation, utility, and financial sectors are all represented). As a market-value weighted index, each stock's weight in the overall index is proportionate to its market value (i.e., market value equals price times outstanding shares). However, this results in the top 45 companies representing more than 50% of the index's value. Many mutual funds are offered that reflect the S&P 500. Other S&P indexes include:
(1) S&P Mid-Cap 400 Index. This index consists of 400 domestic stocks chosen for market size, liquidity, and industry group representation. It is also a market-value weighted index and was the first benchmark of mid-cap stock price movement.
(2) S&P Small-Cap 600 Index. This index consists of 600 domestic stocks chosen for market size, liquidity (bid-asked spread, ownership, share turnover and number of no trade days) and industry group representation. It is a market-value weighted index, with each stock's weight in the index proportionate to its market value.
(3) S&P Composite 1500 Index. Combining the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indices, this index represents 90% of U.S. equities. It is considered to be an effective measure of the U.S. equities market.
(4) S&P 500 Dividend Aristocrats Index. This index series measures the performance of large, blue chip companies that follow a policy of consistently increasing dividends. These stocks have both capital growth and dividend income characteristics, as opposed to stocks that are pure yield, or pure capital oriented. Stocks within the index are derived from an underlying S&P index. Stocks within each index are equally weighted, with constituents re-weighted each quarter.
The S&P 500, S&P Mid-Cap 400, and S&P Small-Cap 600 Indexes are published under Market Data in The Wall Street Journal.
NASDAQ Composite Index. This index contains over 5,000 large-cap, mid-cap, and small-cap stocks that are traded on the NASDAQ Stock Market (acronym for National Association of Securities Dealers' Automatic Quotation system). Although it contains a wide range of financial, consumer, and industrial stocks, it is most heavily weighted in technology and Internet stocks that tend to heavily influence the index. It is market value weighted, with each company weighting being proportionate to its market value. Because these companies are generally more speculative and risky, the NASDAQ Composite Index is much more volatile than other indices. However, the high growth potential of the NASDAQ listed companies make it one of the most widely followed indexes.
The NASDAQ Composite Index is published under Market Data in The Wall Street Journal.
NASDAQ-100 Index. The NASDAQ-100 Index includes 100 of the largest domestic and international non-financial companies listed on the NASDAQ Stock Market based on market capitalization. The index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade, and biotechnology. It does not contain financial companies, including investment companies. The NASDAQ-100 Index is calculated under a modified capitalization-weighted methodology.
Russell 3000 Index. The Russell 3000 Index measures the performance of the 3,000 largest United States companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
Russell 2000 Index. The Russell 2000 is a small-cap index that consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 8% of the total market capitalization of the Russell 3000. It is often used as a performance measure of small-cap stocks. It measures the performance of smaller stocks from various industries that are typically left out of the larger indices. Excluded are stocks under $1 and those listed on the pink sheets (see Over-The-Counter Market, page 58). Although it is a well diversified index for smaller companies that have high growth potential, the performance of the Russell 2000 Index tends to be very uneven.
The Russell 2000 Index is published under Market Data in The Wall Street Journal.
Russell 1000 Index. The Russell 1000 is a large-cap index that consists of the largest 1,000 companies in the Russell 3000 Index, representing approximately 92% of the total market capitalization of the Russell 3000. It is often used as a performance measure of large-cap stocks.
Value Line Composite Index (VLG). Contains approximately 1,700 stocks that are traded on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ Stock Market. This index assumes equally weighted positions in every stock covered in The Value Line Investment Survey; that is, it is presupposed that an equal amount of dollars is invested in each and every stock. The VLG is averaged geometrically every day across all the stocks in the index, and consequently, is frequently referred to as the Value Line Geometric Index. It is intended to provide a rough approximation of how the median stock in the Value Line Universe performed.
The Value Line Composite Index is published under Market Data (listed as "Value Line") in The Wall Street Journal.
NYSE Composite Index. The NYSE Composite Index is designed to measure the performance of all common stocks listed on the NYSE, including American Depositary Receipts, REITs and tracking stocks (closed-end funds, ETFs, limited partnerships and derivatives are excluded from the index). It is adjusted to eliminate the effects of capitalization changes, new listings and delistings. The index consists of more than 2,000 U.S. and non-U.S. stocks.
The NYSE Composite Index is published under Market Data in The Wall Street Journal.
MSCI Barra. MSCI Barra calculates over 100,000 equity, REIT and hedge fund indices daily. It is estimated that over 3 trillion dollars are currently benchmarked to these indices on a worldwide basis. (MSCI stands for Morgan Stanley Capital International.)
(1) As provided by the Bureau of Labor Statistics at http://www.bls.gov/dolfaq/bls_ques1.htm.
(2) The 30 stocks of the Dow Jones Industrial Average are (last changed June 8, 2009):
Company Stock Symbol 3M Co. MMM Alcoa Inc. AA American Express Co. AXP AT&T Inc. T Bank of America Corp. BAC Boeing Co. BA Caterpillar Inc. CAT Chevron Corp. CVX Cisco Systems Inc. CSCO Coca-Cola Co. KO E.I. Du Pont de Nemours & Co. DD Exxon Mobil Corp. XOM General Electric Co. GE Hewlett-Packard Co. HPQ Home Depot Inc HD Intel Corp. INTC International Business Machines Corp. IBM Johnson & Johnson JNJ J. P. Morgan Chase & Co. JPM Kraft Foods Inc. KFT McDonald's Corp. MCD Merck & Co. Inc. MRK Microsoft Corp. MSFT Pfizer Inc. PFE Procter & Gamble Co. PG Travelers Cos Inc. TRV United Technologies Corp. UTX Verizon Communications Inc. VZ Wal-Mart Stores Inc. WMT Walt Disney Co. DIS
(3) The 20 stocks of the Dow Jones Transportation Average are (as of January 2011):
Company Stock Symbol Alexander & Baldwin, Inc. AXB AMR Corp. AMR C. H. Robinson Worldwide Inc. CHRW Con-way Inc. CNW CSX Corp. CSX Delta Air Lines Inc. DAL Expeditors International of Washington Inc. EXPD FedEx Corp. FDX GATX Corp. GMT J.B. Hunt Transport Services Inc. JBHT JetBlue Airways Corp. JBLU Kansas City Southern KSU Landstar System Inc. LSTR Norfolk Southern Corp. NSC Overseas Shipholding Group Inc. OSG Ryder System Inc. R Southwest Airlines Co. LUV Union Pacific Corp. UNP United Continental Holdings UAL United Parcel Service Inc. Cl B UPS
(4) The 15 stocks of the Dow Jones Utility Average are (as of January 2011):
Company Stock Symbol AES Corp. AES American Electric Power Co. Inc. AEP CenterPoint Energy Inc. CNP Consolidated Edison Inc. ED Dominion Resources Inc. (Virginia) D Duke Energy Corp. DUK Edison International EIX Exelon Corp. EXC FirstEnergy Corp. FE NextEra Energy Inc. NEE NiSource Inc. NI PG&E Corp. PCG Public Service Enterprise Group Inc. PEG Southern Co. SO Williams Cos. WMB
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|Title Annotation:||2011 FIELD GUIDE TO FINANCIAL PLANNING|
|Author:||Cady, Donald F.|
|Publication:||Field Guide to Financial Planning|
|Date:||Jan 1, 2011|
|Previous Article:||Chapter 3: Regulators, agencies & financial institutions.|
|Next Article:||Chapter 5: Time value analysis.|