Market Indicators: Useful Tools

Indicators and their ilk

There are many market indicators, but the most widely followed may be the price/earnings ratio. The ratio of a stock's price to its earnings per share is a basic analytical tool applied both to individual stocks and overall markets. It tells you how much you must pay for every dollar of earnings per share. The P/E ratio also tells you how many years must pass before the company's total annual earnings per share equal the price of the stock, assuming earnings do not grow.

The Leuthold Group, a money management group, analyzed the P/E ratio of the Standard & Poor's 500 going back to 1950 and calculated that the average ratio is 17.8 and the ratio peaked at 35.1 in July 1999. Today, the ratio is well above average, but many (analyst Abby Joseph Cohen of Goldman Sachs, most prominently) argue that a higher P/E is reasonable during periods of low inflation and low interest rates.

The activity of investors can also provide an indication of market direction. For instance, short interest is the number of shares that have been sold short. When shares are sold short, a corresponding number of shares must be purchased for delivery to the buyers. The short ratio is the short interest divided by the average number of shares daily traded; as such, it reflects the number of days that would be required to purchase shares to cover all outstanding short positions, assuming all shares traded are used for this purpose.

If short interest or the short ratio is higher than normal, more speculators are betting that the market will decline. The short interest of the Nasdaq market is regularly released by the exchange and is available at numerous websites. It is also reported in The Wall Street Journal.

The flow of money

There's more. The flow of money into mutual funds is an indicator tracked by the Investment Company Institute (Ici), a mutual fund trade group, and is posted on the Ici's website. Usually, more money is invested in mutual funds each month than is withdrawn; thus, an inflow of money is not in itself a positive sign.

A drop in the rate of growth indicates a decline in market interest by individual investors. A decline in assets suggests that a significant number of investors are fleeing the market. A move in the opposite direction, of course, shows that confidence in the market is increasing.

The insiders buy/sell ratio, sell/buy ratio

The insiders buy/sell ratio is a measure of the dollar value of sales of a stock by corporate management and other "insiders" versus their purchases. Sales typically greatly outweigh purchases because of generous stock options and stock grants usually provided to management as part of their compensation. However, an increase in sales can indicate a lack of confidence by insiders in the company's prospects.

Thomson Financial has tracked this data for the S&P 500 since 1990 and concluded that a ratio over 20 indicates an increased probability of future declines and any ratio under 10 is a positive finding for future gains. In 2003, according to Thomson, insider sales totaled $29 billion and insider purchases totaled only $1.1 billion for a ratio of over 26. In February 2004, the ratio hit a monthly record of 51.48.

Although these figures are very high by historical standards, several market commentators have pointed out that the stock market price increases of 2003 and early 2004 followed a protracted bear market when many executives could not exercise their options because they were not "in the money" — that is, stock prices declined to levels below the exercise price of the options. The increased insider sales could represent the pent-up demand by insiders for sales following several years when it was not possible to exploit options.

Another possible explanation is that insiders have learned from bitter experience about the importance of diversifying their holdings in order not to be dependent on one company's performance for their financial security. As employees of WorldCom, Enron, and other corporations learned, it can be financially disastrous to have all of your eggs in one basket.

Of course, both of these explanations are variations on the theme of "this time is different" and, consequently, the old rules do not apply. This is the type of thinking that has led to disaster in recent years, with the bursting of the Internet and telecom bubbles.

Further, the insider's sell/buy ratio can be a more accurate indicator when it is bullish rather than bearish. While insiders may have many reasons for selling stock, such as diversification or to pay for a home or other large expense, there is generally only one reason that insiders buy: because they believe they will make money from future stock gains.

The paycheck cycle

An industry specific indicator is the paycheck cycle, which was developed by the Wal-Mart Corp. as a measure of consumer liquidity — the amount of discretionary spending that typical consumers can engage in. According to general economic theory, consumers who live paycheck to paycheck are more likely to make purchases the day after payday, which for many people is the 15th of each month, and they are less likely to spend money as they reach the end of a pay period. As a result, Wal-Mart tracks sales on the 16th of the month and compares this figure to sales on the 14th.

If sales decline significantly by the 14th of the month and then pick up on the 16th, the resulting "V" pattern (when the data is charted) suggests that mass market consumers have less discretionary income and are likely to spend less. If the decline by the 14th is less pronounced, with a corresponding shallower upturn, a "U" pattern is formed, indicating that fewer people are living paycheck to paycheck and that retail sales are likely to be stronger.

Wal-Mart periodically releases this information and also posts it on the company website.

Bellwether stocks

Sometimes a particular stock can serve as an indicator. The performance of such bellwether stocks can point to larger trends.

For example, the performance of Union Pacific (UNP) is considered by many economists to be a good gauge of industrial conditions. This venerable railroad company, whose past presidents have included legendary figures such as Jay Gould and E.H. Harriman, transports a range of bulk goods, including coal, lumber, iron, grain, and containers of manufactured products. An increase or decrease in freight volumes is indicative of corresponding changes in the outlook for industrial companies.

UPS and Federal Express (FDX) are newer bellwethers. Their performance reflects consumer spending because they dominate the business of shipping for retailers; it also reflects business activity, since many firms use these companies to send documents and supplies.

No correct answer

Countless indicators have been identified over the years, and many more no doubt will be recognized in the future. But it is important to remember that no indicator is foolproof. Some are more useful than others, while many cannot withstand the test of time. Even worse, indicators do not act in concert.

A grouping of indicators, no matter how sensible each component is, can produce vague or contradictory results. As always, investment success depends on individual judgment.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, the Massachusetts Law Review, and other magazines. He may be reached at jam@juno.com.

Suggested reading

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