In the world of investments, there are many highly educated people who spend their days studying every data point you can think of. They look at things like bond yields, stock correlations, sector performance and factor investing.
They study economic factors such as unemployment and gross domestic product, as well as monetary factors like interest rates and inflation. Then they combine these factors and others into complicated predictions that most of us have trouble understanding. Fortunately for the rest of us, it doesn’t take an advanced degree in economics or finance to figure out how the economy is doing and what that means for the stock market.
Sometimes simple ideas are the best ones.
Stock market indexes like the S&P 500 and the Dow Jones Industrial Average track the performance of baskets of individual companies. These companies make money by selling products and providing services. Long-term investment returns are driven by the ability of these companies to make money. When the economy is good, it’s easier for these companies to make money and long-term investors should do well.
The best way for individual investors to understand how the economy is doing is to use “walking around sense”. Spending some time watching what people and companies are doing can give you a good sense of how the economy is doing. When people are optimistic about the future and willing to spend money, companies will have higher profits. Higher profits ultimately benefit the investors who own those companies.
Economists talk about the unemployment rate, the labor force participation rate, payroll numbers and productivity measurements. The walking around sense alternative is to ask yourself how many people you know who are out of work? Are you more likely to get laid off or jump to another company offering better pay or benefits? It also helps to look around and see whether companies are hiring or planning layoffs. When companies must work hard to find hard workers, it’s generally a good indicator that the economy is strong.
Another measurement economists talk about is the “velocity of money”. Velocity describes how quickly money earned is put back into circulation by being spent or invested. When people are confident in their ability to earn a living, they will spend more. Similarly, when businesses have an optimistic outlook, they will invest more. Both of these activities increase the velocity of money and overall economic activity is higher. More velocity means more economic growth, which is good for the stock market.
Investors can get a good idea of how the economy is doing by using “walking around sense” and looking at what people and businesses are doing. When restaurants are full, shopping malls are packed and companies have to advertise their job openings, it’s easy to understand that the economy is doing fairly well. A strong economy is good for everyone – especially long term investors.