Economic Indicators: Definition and How to Interpret?

Introduction:

Remember when you decided to make your first stock market investment? Going through several fundamental and technical indicators, researching the company, consulting experts, and finally arriving at the conclusion sums up the usual approach to market investments. However, economic indicators are another element that helps interpret the market’s direction. 

Technical analysis, fundamental statistics, and economic indicators form the base of stock market analysis. The economic indicators act like a measuring stick for the economy’s overall health, providing valuable insights into the factors driving the Indian economy.  

In this article, we’ll explore the different types of economic indicators and how you can use them to navigate the exciting and sometimes challenging world of the stock market.

What is an economic indicator?

Economic indicators are data sets or statistics that show a nation’s financial health based on macroeconomic factors like inflation, unemployment rates, and economic output. Understanding these indicators helps you interpret the economic direction and improves your decision-making. 

These indicators track various aspects of a nation’s production and consumption of goods and services.  They tell you if the economy is expanding (growing) or contracting (shrinking). Economic indicators like the Consumer Price Index (CPI), Gross Domestic Product (GDP), and unemployment rates are computed based on government and non-profit organizations’ regularly uploaded data points. Each indicator is categorized into three groups that help give it a weightage for analysis. 

Types of economic indicators:

1. Leading Economic Indicators:

Leading indicators, as the name implies, precede shifts in the economy. You can interpret the signals before they appear in the officially released economic data. An example is the yield curve (which shows the gap between short-term and long-term government bond interest rates). 

A steep yield curve—where long-term rates are higher than short-term rates—can suggest optimism about the economy. So, you can assume that businesses borrow more to invest in growth, which may lead to a stronger stock market.

Leading indicators reflect market forecasts and predict future economic performance. While not foolproof due to their predictive nature, you can closely analyze leading indicators for insights to capitalize on market movements for gains. Popular leading indicators include the yield curve, consumer durables, net business formations, and share prices.

2. Lagging indicators:

Unlike leading indicators, lagging indicators reveal data after market events have already taken place. This delay can result in inaccurate information since it does not reflect current market activity. For example, corporate profit is only updated annually or quarterly, making it difficult to know it daily. Despite these drawbacks, government agencies and certain institutions utilize lagging indicators to analyze the present market conditions. Common lagging indicators include Gross National Product (GNP), Consumer Price Index (CPI), and interest rates.

3. Coincident Economic Indicators:

Coincident indicators focus solely on present market conditions and provide real-time data. The data points keep updating continuously to reflect market fluctuations. They enable you to make swift decisions and adjust your portfolio accordingly. Common coincident indicators include GDP, retail sales, and stock prices.

What are the Commonly Used Economic Indicators?

You may prefer coincident indicators over the other two to know the real-time changes and trends. On the other hand, policymakers may consider lagging indicators to be more critical. Economic indicators serve different purposes for businesses, governments, economists, and investors. Let’s see some of these widely used indicators in detail-

1. Gross Domestic Product (GDP):

Gross Domestic Product (GDP) is a key lagging indicator of economic health. It reflects an economy’s overall production output and size. GDP is computed using two primary methods-

• The income approach considers all the income earned in the country – business profits, employee salaries, and even taxes collected.
• The expenditure method looks at all spending—how much people buy, how much the government spends, and even how much is invested in new businesses. 

The data is compared with the previous quarter or year to interpret GDP and checked for growth or shrinkage. For instance, if a country’s GDP rose by 2% in 2018, the economy expanded or grew by 2% since the last GDP measurement in 2017. 

There are two types of GDP figures:

• Real GDP: This considers inflation, so it shows the actual growth in the economy, not just price increases.
• Nominal GDP: This is the raw number without adjusting for inflation.

A growing GDP generally means businesses are making more money, and people might have a higher standard of living. A shrinking GDP suggests things are slowing down. So, when you hear about GDP going up, it’s generally good news, and vice versa. However, how the market reacts depends on how much it has changed compared to expectations and past performance.

2. Stock Market:

The stock or securities market is one of the leading economic indicators that reflect anticipated company earnings. If companies are expected to make more money, it often signals a strong economy on the horizon. On the other hand, if companies are expected to make less money, it can indicate a looming recession.

However, the stock market’s signals are only sometimes reliable. The earnings estimates can go wrong, and the market is susceptible to manipulation. In some cases, stock prices can even inflate into bubbles, completely misleading you about what’s happening. So, while the stock market can offer clues, it’s not always the most reliable indicator of the future economy. So before shortlisting the short and long-term stocks to buy, check other technical and economic indicators in detail along with the stock market sentiment.

3. Consumer Price Index:

Another important market indicator in the lagging category is the Consumer Price Index(CPI), which is crucial for studying inflation. CPI measures changes in the cost of living within a state over time by tracking how much people spend to buy the same things they bought before.

4. Inflation Rates:

Inflation is the rise in the overall price level of goods and services in an economy over a period. Standard inflation measures include the Consumer Price Index (CPI), tracking retail price changes, and indicators like the GDP deflator and Wholesale Price Index.

Inflation impacts investment returns, interest rates, and business operations. While moderate, steady inflation around 2% is generally favorable, high inflation poses challenges. Thus, monitoring monthly inflation is essential to assess economic conditions affecting companies and your investments.

Apart from these, analysts also keep track of the changing interest rates, monetary policy, employment rates, industrial production, consumer spending, the balance of trade of the country, and currency value while interpreting indicators of economic growth. But how exactly does an economic indicator complement your analysis?

Advantages of Economic Indicators:

• Economic indicators offer insights into future market trends.
• Investors can profit significantly by interpreting these indicators correctly.
• Economic indicators are usually free, making them accessible for analysis and use.
• The calculation method for these indicators is consistent, ensuring reliability regardless of who uses them.

Limitations to Economic Indicators:

Though the economic indicators help give a direction to investment decisions, they cannot be relied on solely due to the following drawbacks-

• Economic indicators’ predictions can be inaccurate, leading to unexpected outcomes if relied upon too heavily.
• Economic indicators can be complex for new investors to understand.
• These indicators rely on numerous factors, increasing the likelihood of inaccuracies.

Bottom line:

Economic indicators are crucial for forecasting a state’s economy. Though they have drawbacks, they can guide investment decisions well when carefully studied. Understanding economic indicators might be challenging for beginners, but grasping their significance is essential. The fundamental rule is to invest wisely and heed the market’s signals. Approach a SEBI-registered stock market advisory to gain in-depth know-how of infusing economic indicators into your analysis mechanism. Consulting them would guide you on long-term stocks to buy and help you identify the space-tech impact on the economy and other factors driving the Indian economy.

FAQs on Economic Indicators