Daily Aid 26: How to understand how the economy is really doing

Eye on the Economy

I want to do a special today to give you some tools for understanding the market a little better, some things to keep an eye on, and some explanations so that when you see financial news in the headlines, you know whether it’s serious or hype.

When news outlets talk about the market, they’re most often talking about 3 different stock market measures – the Dow Jones Industrial Average, the Standard & Poor’s 500, and the NASDAQ. These are all stock measures. The Dow is a blend of 30 different companies that are prominent like Coca Cola, Google, GM, etc. It’s considered a bellwether of how corporate America is doing.

The S&P 500 is a measure of, unsurprisingly, 500 different companies around the country, some large, some growing to be large. It’s considered a bigger picture of corporate America since it includes smaller companies.

The NASDAQ is a measure of more than 3,000 smaller companies around the country, with an emphasis on smaller, growing businesses and especially technology companies. Since the first dot com bubble, the NASDAQ is considered a measure of how the more ambitious companies in America are doing.

The numbers themselves are weighted averages of the stock prices of each of the companies in the measures. For example, if you were to buy one share of stock in each of the 30 Dow Jones companies, it’d cost you whatever the Dow Jones Industrial Average was that day – so if the Dow is at 11,000, you’d need $11,000 to buy roughly 1 equal measure of ownership in each of the companies in the Dow Jones. It’s a little more complicated than that, but that’s close enough for the average non-economics nerd.

Typically, all three measures – called indexes – move together, meaning that when one declines – headlines saying the Dow lost 4% – the others probably did the same.

All three indexes are part of the stock market. The stock market itself doesn’t directly affect your financial aid except for investments that you have in things like 529 savings plans. The stock market is generally regarded as a measure overall of how the investors in our economy feel about how things are going.

However, the stock market is only one part of the economy. Remember that stocks are essentially a form of gambling – you place a bet that a company will grow by buying stock in that company, and if the company grows, the price of the stock goes up. Assuming all goes well, you sell the stock later at the higher price and pocket the difference.

There’s a second part which more directly affects your financial aid, and that’s the credit market. The credit market, instead of measuring companies like the stock market does, measures instead how easy or hard it is to borrow money. There are three measures in the credit market that are important as well.

The Federal Funds Rate is the rate at which banks can borrow money from the Federal Reserve Bank. If the Fed cuts rates, as you see in the headlines from time to time, it means that banks can borrow money from the government at a lower cost, which presumably gets passed on to you. The Prime Rate, which is what you see on a lot of mortgages, some private student loans, and student credit cards, is the Federal Funds Rate + 3%. If the Fed cuts rates, anything you’ve borrowed based on the Prime Rate gets a reduction in interest rates as well.

The 3 month LIBOR rate is the London Inter Bank Offering Rate. LIBOR is a measure of a bunch of banks in London and how much it costs for them to borrow money from each other. Normally, LIBOR is lower than the Federal Funds Rate because banks are willing to lend to each other at very low rates, knowing that they’ll get their money back. Unlike the Federal Funds Rate, no government has a say in what LIBOR is, so it’s a good measure of how much banks trust each other. You see LIBOR on a number of private student loans as well as mortgages and home equity loans.

There’s a measure called the TED spread, which is the difference between the 3 month Treasury bill rate and LIBOR. You’ll hear the TED spread mentioned a lot in financial outlets like CNBC and Bloomberg. Normally, the 3 month Treasury bill rate and LIBOR are very close, indicating that banks are staying competitive in borrowing money from each other and in fact would prefer to borrow from each other than from the government. When LIBOR starts to exceed the 3 month Treasury bill rate by significant amounts, it indicates a trust problem – banks don’t trust each other and would rather borrow from the government instead.

The last measure that I think is important is called the VIX, or volatility index. This is a measure created by the Chicago Board Options Exchange, and it’s based on the S&P 500 plus what investors are betting the S&P 500 will be like in 30 days. It’s, in other words, an attempt to predict the future, and the VIX is a measure of how fearful investors are. The VIX is a powerful and very obscure measure that tells a lot about what investors think the future holds. The VIX is a number, and the lower it is, the less volatile the market is, meaning that investors are calm and feeling good about investing in the next 30 days. When the VIX is high, it means investors are unsure, uncertain, and may behave irrationally, pulling money out of the markets or doing things that in normal times wouldn’t make a lot of sense.

To monitor these different measures, you have to go to a few places. Google Finance and Yahoo Finance both have great measures for the Dow, S&P 500, and NASDAQ. The CBOE VIX is only listed on Yahoo Finance for some odd reason. You’ll find LIBOR and the Federal Funds rates on Bloomberg, along with the TED spread.

One word of caution – when you start digging into this stuff, don’t fixate on any one number or stare too much at them. These measures of the market are best viewed as trends – what happened in the last week or month – rather than as discrete data points – zOMG the Dow fell 400 points! – and you’ll feel a little less panicked during rougher times if you watch trends rather than the daily numbers per se.

All of this stuff, by the way, is foundational stuff if you want to get involved in investing. As you save money for college or life after college, you really need to grab a book or two and read up on this for it to come together and be helpful to you. It will take a little time and reading, but it’s well worth it, since you’ll find that you’ll understand better what’s happening to your money.

More important, you’ll know when you see news headlines that there’s more behind the headlines and you can look at the real numbers to decide just how good or bad the news is for yourself.

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