The Art of Stock Market Trend Estimation
Learn interrelation between volatility, interest rates, inflation, bonds, commodities & stocks.
What do investors respect the most ? - Clearly it is Economic Trends.
Fortunes are made and lost in the blink of an eye at the stock market. While most investors are bullish overall, many seasoned investors get skittish in certain economic trends.
What do I mean by economic trends, why they hold so much value in the eye of investors? Let's take a look -
There are 5 basic and most important aspects of the economy investors need to consider before choosing any investment and they are market volatility, interest rates, inflation, bond yield, and commodity prices.
Further in this article, I will try to explain each of these and their effects on the stock market.
1. Volatility (VIX)
Volatility often refers to the amount of uncertainty or risk related to a particular investment. A higher volatility means that an investment’s value can potentially be spread out over a larger range of dollar value. This means that the price of the investment can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically and tends to be more steady.
All types of investments (Stocks, Sector ETFs, and Index funds) have volatility associated with it and it represents how much risk is associated with the particular stock, sector, and market. Extending it to the price observations of the broader market level index, like the S&P 500 index, will offer a peek into the volatility of the larger market.
The index which tracks the volatility is more commonly known as ‘VIX’.
Chicago Board Options Exchange (CBOE) formulated the mathematical calculation for VIX (Volatility Index) to measure the market’s expectation of future volatility. It is an important index in the world of trading and investment because it provides a quantifiable measure of market risk and investor’s sentiments (fear or confidence).
VIX is a forward-looking index, it is constructed using the implied volatilities on S&P 500 index options (SPX) with near-term expiration dates and it represents the market’s expectation of 30-day future volatility of the S&P 500 index.
Usually, the VIX index value moves up when the market is on a downward trend. VIX moves down when the market is on an upward trend. Particularly VIX is useful before making any short-term investment or trading decisions.
2. Bond Yield
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you’re giving the issuer a loan, and they agree to pay you the interest. The interest payments stay the same for the life of the loan. You receive the principal at the end of the term if the borrower doesn’t default.
Bonds affect the stock market by competing with stocks for investor’s dollars.
Bonds are safer than stocks, but they offer a lower return. As a result, when stocks go up in value, bonds yield go down. The easy way to track bond yield is using ticker TNX (Treasury Yield 10 Years) and TYX (Treasury Yield 30 Years).
If bond yield (return on investment) rises then bonds become an attractive investment; investors sell their stock holdings just to create extra liquid cash to invest in bonds, this selling of stocks results in falling stock prices.
Sometimes, both stocks and bonds can go up in value at the same time. This happens when there is too much money or liquidity, chasing too few investments. It happens at the top of the market. There also are times when stocks and bonds both fall. That’s when investors are in a panic and selling everything.
3. Interest Rates
The Federal Reserve controls interest rates through its open market operations. When the Fed wants interest rates to fall, it buys U.S. Treasuries that are government bonds which makes their values rise. As with all bonds, when the bond value rises, bond yield (return on investment) falls.
Lower interest rates causes stock prices to rise for two reasons.
First, bond buyers receive a lower interest rate and less return on their investments. It forces them to consider buying stocks to get a better return.
Second, lower interest rates make borrowing less expensive. It helps companies who want to expand. It assists homebuyers to afford larger houses. It also helps consumers who desire cars, furniture, and more education. As a result, low-interest rates boost economic growth. They lead to higher corporate earnings and hence higher stock prices.
4. Commodity Prices
Changes in commodities prices create a trickle-down effect that ultimately influences prices in the stock market. Since commodities represent the basic building blocks of all products in an economy, the prices of commodities affect the operational costs of corporations. This can force corporations to change the prices they charge consumers, and this ultimately leads to a different financial picture. This prompts stock market investors to make different decisions that affect the prices of individual stocks and larger trends in entire industries and stock market segments.
Commodities are at the apex which affect stock market.
Although there are a variety of factors that can move markets, commodities can have a major influence on businesses, individuals, stocks, and portfolios. When you’re looking to invest in a particular sector or company, take a look at relevant commodity prices and what this might mean for your investments going forward. For example, Timber prices affect real estate companies, Copper prices affect construction & electronic product companies, Oil prices affect airlines, logistic companies, etc.
5. Inflation
Higher inflation is not in favor of stocks because it increases borrowing costs, increases input costs (materials, labor), and reduces standards of living.
Due to higher inflation companies need to spend more for new investment, pay higher salaries to employees which results in higher operational costs and reduces expectations of earnings growth, putting downward pressure on stock prices.
The investors, of course, anticipate that there is a certain amount of inflation each year and adjusts what the expected returns should be against the expected inflation. But unexpected inflation is a problem.
If, for example, investors expect a net return of roughly 6% a year after inflation, and inflation is 2% a year, investors will look for an 8% gross return when inflation is factored in. But if inflation suddenly goes from 2% to, say, 4% very quickly, history indicates the overall market will react negatively. That’s because investors will now demand a higher return to compensate for the now-higher risk. Instead of an 8% return, investors may demand a 10% return. Investors will sell those stocks which are not capable of giving the expected return and hence stock prices will likely drop. But not all stocks are affected equally.
Value stocks tend to outperform growth stocks during high inflation times.
Growth stocks tend to underperform when inflation is higher. That’s because growth stocks have much of their earnings expectations farther out in the future, and when inflation rises, it hurts those expectations. Some time emerging sector high-growth companies are not even generating profit. High inflation puts their revenue expectations at severe risk hence investors tend to cash out the investments. Whereas the value stocks have a consistent history of profit each year, making it a safe bet during high inflation time. More about picking the right growth and value stocks in this post.
When inflation or interest rates start going up more than expected, it reduces the current value of earnings. As a result, money starts flowing into risk-free government bonds, making bonds more appealing against stocks.
High dividend stocks, like utilities and REITs, usually suffer as well because investors have higher-yielding government bonds as a less risky alternative, and because dividends often do not keep up with inflation levels.
Let’s Recap
Picking the right stock is not simple as looking at the most profitable companies. Market trends need to be favorable for the industry you are investing in. I will encourage you to look into these economic factors at least once a quarter before making any investment decisions.
