If you turn on CNBC, typically within a few minutes you’ll hear something along the lines of “The Dow is up 100.” But is what the Dow did today really one of the main stock market indicators that you should be monitoring if you want to be a successful investor?
Also, recent history shows us that stock markets can be performing very well right before a major market move lower. This proves that just following what the market did on a given day doesn’t really tell us much about the health of the stock market itself. Or, whether or not we should be making any tactical adjustments to our portfolios. We need better stock market indicators.
Ideally we need stock market indicators that give us context to the overall market moves. Is the market getting ahead of itself in light of how the economy is doing?
Following more complex stock market indicators is an important part of becoming a successful investor. Understanding how the markets work, understanding how and why various stocks move up and down on a given day and understanding how policy, economic data and stock market performance work together are key things you need to be able to do if you are to invest successfully over time.
While this article aims to introduce a few key stock market indicators that will help you become a successful investor, nothing replaces time itself. It takes time investing, following the markets, and following these stock market indicators to get better at investing. It takes seeing the seemingly-random ups and downs in the markets to begin to get a feel for what moves matter and what moves are just normal market gyrations.
With that said, let’s get into five stock market indicators that you should begin following:
5 stock market indicators to begin following today
10-year Treasury Yield
Treasury bond yields are commonly tracked by many investors. Treasuries are instruments of debt issued by the U.S. government. The yield on the bonds refers to the interest rates paid by the government for borrowing the money. The importance of the 10-year treasury yield goes beyond just taking a snapshot of the U.S. government’s borrowing costs. So why is it an important stock market indicator?
At a high level, the 10-year Treasury yield tends to signal overall investor confidence in the stock market. When investors are confident in the stock market, in theory, money will rotate out of “safe” Treasuries and into stocks. This will cause Treasury prices to fall and Treasury yields to rise (when bond prices fall, the interest rates go up). So, simply put, a higher 10-year Treasury yield typically means the stock market is doing well.
On the flip side, when the stock market gets rattled, you will often see the Treasury yield start going down (caused by money moving out of stocks and into Treasuries). This is commonly referred to as a “flight to safety.” You’ll note that in major market crashes, such as the 2008 stock market crash, Treasuries were positive during that year (while the stock market was down over 40%).
Now, looking at Treasuries on a long-term time horizon can be misleading. Comparing yields today to those of 20 years ago can often make an investor think that yields have to go up. They’re so low! This is probably not the best way to utilize yields as indicators. Rather, looking at them on short-term comparisons is a better use. For instance, compare the yields from early 2008 to later 2008 as the economy and stock market went through a very tumultuous time.
Part of the reason that comparisons of Treasury yields over decades aren’t likely to lead to quality insights is because the Federal Reserve is engaging in policy decisions that are much different today than in previous time periods. The policy since the 2008 crisis has skewed markets quite a bit, especially anything related to interest rates. In this new era of ultra-dovish Fed policy, it’s best to compare Treasury yields over shorter time horizons.
Lastly, when you begin to understand and track Treasury yields (not just the 10-year), you’ll also understand what is occurring when you hear about an inverted yield curve. An inverted yield curve is often cited as an indicator of potential economic slowdown or recession. So what is it?
When you consider debt, borrowers typically have to pay higher interest rates if the term of the debt is longer. This is because investors want to be compensated more for having their money locked up longer. This applies to Treasuries as well. Typically the government can pay lower interest rates on short-term debt (e.g. 3-month Treasuries) and higher interest rates on long-term debt (e.g. 30-year Treasuries). The yield curve is essentially a plot of what the government is paying with respect to interest rates across the various terms (1 month out to 30 years). In a normal market, the yield curve slopes upward from lower interest rates to higher interest rates as you move further out on the length of terms (1 month out to 30 years).
When the yield curve inverts, it means that the yields/rates on the short term debt has increased to higher levels than some of the yields/rates on long-term debt.
Get familiar with Treasuries in general, and the 10-year Treasury yield in particular, as worthwhile stock market indicators. They are important instruments that trade in the U.S. markets and they are important signals and indicators for both the stock market and the U.S. economy.
The CBOE Volatility Index – typically referred to as just “VIX” – is a tool that indicates how much volatility there is in the stock market. The volatility is specific to that of the S&P 500 index. If the VIX is high, traders and investors are anticipating dramatic moves in one direction or another in the stock market.
The VIX is based on the price behavior of call and put options on the S&P 500 index. It’s a fairly complex calculation based on options activity to come up with the value, but for regular investors, the key is that the VIX is widely monitored as an important stock market indicator. As such, it’s important for you to know what it is and why it is important. Even if options are completely off your radar, the VIX is still relevant.
The VIX can sometimes be referred to as the “Fear Index.” In theory, the VIX should move higher with dramatic moves both higher or lower in the stock market, but in reality it doesn’t really happen this way. The VIX tends to move higher with large moves lower in the stock market. This is partly due to the tendency that stock market moves lower tend to be more dramatic than market moves higher.
The VIX has limited usefulness with respect to analyzing single stocks. The VIX applies to the S&P 500, so it’s useful for understanding the market action of the large cap stocks in the stock market.
Start monitoring the VIX. Specifically, monitor it in conjunction with different stock market periods. By periods, we’re referring to weeks or months of time where the market has a certain character to it. For instance, sometimes, the market will do nothing but move slowly upward for weeks on end. It’s these time periods of stock market complacency where the VIX will hit its lowest numbers.
Then, when the market gets choppy, monitor the VIX. You’ll see it start creeping up into a new range until the volatility in the market settles down.
The wild stuff comes with true market crashes. You’ll see the VIX spike to gains many times over. The VIX will spike hard, then as the market settles, it’ll go back down. The VIX doesn’t like a typical stock, so monitoring it through various types of market periods will be instrumental in understanding how it works as a stock market indicator.
When investors inquire about what the market is doing, typically they’re asking what did the Dow Jones Industrial Index or the S&P 500 Index do today? While these are important indices simply due to the fact that millions of investors follow it, you can make the case that the Russell 2000 is the more interesting and useful index with respect to stock market indicators.
The Russell 2000 Index is a benchmark of small-cap stocks. It tracks the smallest 2000 companies within the larger market-tracking Russell 3000. The Russell 2000 is an important indicator of the American economy because it measures the performance of smaller, US-centric companies. Unlike the Dow companies and a bulk of the S&P 500 companies that operate globally, the Russell 2000 companies are much smaller and give a better reflection of the health of the U.S. economy.
Where the Russell 2000 can get pretty interesting as a stock market indicator is when you see the Russell 2000 and the S&P 500 diverge. This might indicate that a recent run in the S&P 500 (more widely followed) is not to be trusted. An example of this can be seen during the range from late 2018 into the first half of 2019. The stock market corrected hard in late 2018 from its September/October highs. Then, in early 2019, the S&P 500 rebounded and went all the way back to its previous highs. The Russell 2000 did not recover as much, however, and many analysts cited that the S&P rebound might be fool’s gold. As of writing, it’s too early to say definitively that this was the case, there is enough market volatility to say that the Russell 2000’s muted performance seems to have signaled things correctly.
Note: You can use an ETF such as the iShares Russell 2000 ETF (IWM) to invest in the Russell 2000 companies.
Fed Funds Futures
The Federal Reserve sets interest rate policy via its Federal Funds rate. The Fed Funds rate is a key piece of monetary policy that has dramatic effects on both the global economy and the stock market. As the stock market is a forward looking mechanism, the rate of change of the Fed Funds rate and projecting future rate changes are very important inputs into estimating stock market performance moving forward.
The Fed funds futures refers to futures contracts that trade on the Chicago Mercantile Exchange (CME) that represent the market opinion of where the fed funds rate will be at the time of the contact expiration. Why is this important? Based on economic data, market activity and the actual language used by the Federal Reserve policymakers, the Fed funds futures provide a window into where the market expects rates to be in the future. Or, in other words, the Fed Funds futures provides an indicator into where market expectation is on future Federal Reserve decisions.
The status of the Fed can often be described as dovish or hawkish depending on where inflation and economic conditions reside. Typically, a dovish Fed means that they are in an easing pattern, or a rate-cutting pattern. A hawkish Fed is in tightening mode, or a rate-raising pattern. Fed funds futures tell investors what mode or pattern most traders and investors believe the Fed to be in. Similarly, the futures can indicate how much the market believes rates will be raised or lowered within a specific time period.
Increasingly, the market hangs on every word from the Federal Reserve. With the drastic actions taken by the Fed and historically low interest rates since the 2008 crisis, everything regarding the Federal Reserve and its interest rate policies are very important for stock market investors. The Fed funds futures are a great tool to include in your batch of stock market indicators.
Note: The Fed funds futures aren’t always right. Just because the futures might signal a 50 basis point rate cut by end of year, it does not mean that that is what will happen. In fact, they’re often wrong. But that’s not necessarily the point. The point is that it shows you what the market expects at that given time, and that’s a powerful indicator when gauging stock market sentiment and activity.
GDP Growth / GDP Rate of Change
Gross Domestic Product (GDP) is probably the most widely cited indicator to gauge the economic health of a country. It represents the total value in dollars of the goods and services produced during a period of time. GDP is usually referred to as the growth over the same quarter year-over-year. For example, you might heard that GDP grew 2.5% this quarter. This means that GDP was 2.5% higher than the same quarter one year prior. When an economy registers negative GDP growth, this is typically what causes economists to identify that a country is in a recession.
GDP is a crucial indicator for understanding how fast or slow the economy is growing, and this can have a major impact on stock market performance.
The growth number itself is important, but since the stock market is forward looking, it’s important to look closely at the rate of change of the growth rate. Is GDP growth accelerating or decelerating? If accelerating, owning stocks is a good idea. If decelerating, you might have worse performance in the stock market.
It’s important to understand that a decelerating GDP means that the economy is still growing, just not as fast as it was previously. Nailing the pivot points in time when the economy shifts from decelerating to accelerating can give you some really nice windows for buying stocks before some bull market runs. As usual, GDP is just one of many stock market indicators to consider.
How to Use Stock Market Indicators
The biggest problem that individual investors run into with regards to stock market indicators is that they forget that the stock market is forward looking. An investor buying stocks right after a 3% GDP growth quarter is announced might be confused as to why stocks start going down. The reality is that the 3% quarter already booked is irrelevant to what stocks do moving forward. This is why examining rate of change can be useful. 3% growth is great, but if it’s coming after a quarter of 3.2% which came after a quarter of 3.5%, the stock market might get rattled that growth is slowing.
GDP is just one example. It’s important to remember that there’s no perfect formula you can create that tells you exactly what to do given a few stock market indicators used as inputs. These indicators are meant to provide context, but there is no perfect system to perfectly describe what is happening or about to happen in the stock market.
Are these indicators useless then? Definitely not. By following them along with what the overall market is doing, you’ll begin to really understand how various pieces of economic data, Fed policy and stock market indices work together and how each can affect one another. Understanding the larger context of investing is a crucial part of investing.
Investors who fail to look at the wider context can often be confused as to the performance of a company over a span of time. An expert business analyst might conclude that company XYZ is in excellent shape and poised to keep growing, but then find himself befuddled as to why the stock is going down. The truth is that even the best run companies can have a stock that is going down due to a number of external factors such as Fed policy, macro economic signals, and more. Hardcore company analysis is an excellent tool, but it’s just one of many tools. Learning how to blend the macro with the micro will make you a better investor over time.