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Olebulls Economic Indicators: Part 2

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As I wrote about in Part 1, financial indicators are important. They often determine whether you will make money or not as an investor, how big house you will be able to buy and how you plan the growth of your private investments. Much is linked to measuring how economic growth turns out to be. In part 2 I will write about several economic indicators and why I follow them monthly. Today I will bring you three economic indicators; The Stock Market, The Industrial Production Index and Debt Growth, starting of with The Stock Market.

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1. The Stock Market

How should I invest is often a common question people ask themselves when they believe that the economy will worsen the next twelve months. Firstly, lets look at stocks, as this is the place where one often sees the biggest effects when it comes to economic development. As is well known, shares are a requirement for the company's equity, which means that shareholders only get paid after the city treasurer and the creditors have "taken" theirs.

It is therefore recommended to steer away from cyclical equities at the beginning of recessions, e.g., equities that are very volatile and fluctuate in line with the economic cycles. For instance, in shipping- and industry stocks or perhaps IT -stocks? In the period before the dotcom bubble burst, IT stocks were considered non-cyclical, as it was thought that the business community would always need new technology to maintain competitiveness. One where to believe that IT companies would apparently grow "into heaven" with little capital and by rapidly increasing its customer base. The crash in 2001 and the development thereafter showed, however, that IT stocks were at least as affected by a recession as more typical cyclical stocks. So, when economic growth disappeared, a lot of risk capital was also lost, and the dotcom companies' ambitious plans had to be put on hold.

The stock market is a leading indicator of the real economy and is worth following. Often, a sharp rise in the stock market is accompanied by positive economic development, while significant stock market declines often have negative effects on production and consumption. The reason may be that the stock market reflects the investor's expectations for the future. If investors think we are entering a recession, they will demand lower prices for the stocks they want to buy. Technically, a company's market capitalization is equal to the present value of its expected future cash flows, and changes in these expectations create changes in prices. Now, of course, the market is not always right. On Wall Street there is a joke saying, "the stock market has predicted nine of the last five recessions". Nor is it the case for individual companies that investors' expectations are always met. The insane pricing of IT stocks around the year 2000 was a good example of the latter. However, as you can see from reading historical developments, the market is more right than wrong.

That the stock market can be used to predict developments in the real economy is very useful. Everyone who takes part in investments should pay close attention to the main indices: If they plunge, it is time to be careful.

2. The Industrial Production Index [IPI]

The Industrial Production is an important indicator, as this activity provides income and work to a number of other sectors and partly because the contribution to GDP from the industrial sector fluctuates more than the corresponding service- and public sector. Imagine the industrial cities of the old days when the whole economy revolved around a factory. The employees in the factory spent a high proportion of their wages in the local community, where they built houses, bought food, clothes and so on. When these factories were closed, not only the industrial jobs disappeared, but also many in the service sectors, retail sectors, construction, and civil engineering. On top of that, these groups also paid taxes, to the extent that they were profitable, and these tax expenditures made it possible for the public sector to survive and grow. Such industrial cities still exist, and they can count for a great deal towards the economic development in parts of the country. The statistics for industrial production are usually published every month. In 2000-2003, production fell a lot every month, as it did from 2008 to 2010 as well. Industrial production numbers provide some indications that may be worth following before you start investing.

3. Debt Growth

"When you take out a loan, you become a slave," told US President Andrew Jackson in 1829-1837. Today, this quote is out of fashion. Debt growth is very crucial for a country's economic growth. The use of loan affects the demand for many goods. How would you buy a home or a red Ferrari without a loan from the bank? You can save, but it will take time for the dream to come true. In addition, loans are used for speculation and investment in the financial markets, which contributes to increasing prices of shares, commodities, and certain bonds.

The growth of debt gives an indication of where we are in the credit cycle. The cycle begins with high loan losses when banks have limited capital and are careful about who they lend to. As these less risky loans are being served, banks make more money and builds capital. This capital is then lent to me and you. At this point, the money is flowing into several markets, which in itself helps to push up prices. The increased prices give the banks more confidence and thus increase lending volumes. Gradually, the majority have been adequately provided with loans, and banks are turning to more risky segments, where the potential for growth is better. In this part of the credit cycle, we see increased investment in high-yield bonds, loans to developing countries and unsecured loans to people with an uncertain ability to pay back the debt. A classic example is the so-called subprime bubble in the United States, when young unemployed people could take out huge loans, often half a million dollars. The banks did not require proof of income or equity, as they were confident that the upswing in the housing market would continue.

As is well known, the above belief was not the case. The main reason for the rise in house prices was that there was good access to loans for almost all segments of the US growing population. The peak of the credit cycle is reached when it is difficult to find new buyers who could get loans and thus drive prices even higher. Then it goes without saying - the market stagnates. The banks loan losses exploded, capital shrank, real estate collateral became far less valuable, and it became very difficult to obtain loans. Voilà, the financial crisis is just around the corner.

I believe that debt growth is an important indicator to follow, especially when we had a financial crisis back in 2008. Also, I believe it is good following where in the credit cycle we are. The latter is crucial for many sectors, especially those that provide loans (banks).

I hope you got a little more insight into the economic indicators above. Keep them in mind when you decide to invest. In the next round of Olebulls economic indicators we will look at employment, labor migration and population growth, stay tuned!

Cheers -Olebulls

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