Taking a more hands-on approach to managing your investments often means improving your understanding of three key areas in the financial world: the economy, the markets, and how they may affect your investments.
An economy is the collective grouping of all resources (people, money, debt, goods, services, etc.) that a country has in play at any given moment. Throughout the course of a year, an economy can be either strong or weak, depending on unemployment rates, consumer spending levels, and whether rising prices are a concern. When studying the economy and its affect on the market, keep in mind that Wall Street analysts are constantly tracking and interpreting a continuous stream of economic data.
Economic data, the statistical by-product of every economy, is more manageable when broken down into the four most popular categories:
- Unemployment Status - A monthly report that lists how many people in the United States are working and how many are unemployed. Typically, the unemployment status is an indication of whether jobs are readily available (often referred to as a tight labor market). When the unemployment rate is low, say around 4%, then the economy is perceived to be strong by most workers because employers are willing to pay higher wages to their employees.
- Gross Domestic Product (GDP) - A monthly number, adjusted for inflation, which illustrates the value of all goods a nd services produced within the United States. The GDP is developed and released by the Department of Commerce and is a broad measure of a country’s economic health.
- Consumer Price Index (CPI) - A monthly index from the Bureau of Labor Statistics that monitors the current prices of country’s goods and services. The CPI is used to identify whether prices are rising (inflation) or falling (deflation) and t he purchasing power of the U.S. dollar.
- Consumer Confidence Index - A monthly index from the Conference Board that measures the U.S. population’s confidence in the overall economy. The Board uses a survey to question people about their perception of job security and their willingness to spend money.
Understanding Markets and Exchanges
When most people think of stock markets, images of Wall Street brokers crowded onto the floor of the New York Stock Exchange usually come to mind. Navigating the complex arena of the NYSE, NASDAQ, and Amex is easier once you understand the basics of what markets are and how they work.
There are two major categories of stock markets: the more traditional “exchanges” and the newer “electronic markets”.
- New York Stock Exchange (NYSE) - Established in 1789 and home to more than 3,000 publicly-held companies, the NYSE (commonly called “the Big Board”), has a bricks-and-mortar physical location at the heart of Wall Street. The NYSE has the most stringent rules regarding the minimum requirements regarding market value, earnings, and assets that a company must meet in order to be traded on the NYSE.
- American Stock Exchange (AMEX) - Second only to the NYSE in size, the Amex is also a physical building in the heart of New York. Like the NYSE, AMEX uses “floor brokers” to buy-and-sell stocks at the best price. Floor brokers can either handle the stock transaction themselves, on the exchange floor, or they can turn the sale over to a trading specialist, who will then find a way to conduct the transaction on the broker’s behalf.
- National Association of Securities Dealers Automated Quotation System (NASDAQ) - Established in 1971, the NASDAQ is an electronic market, unlike the NYSE and the Amex. NASDAQ brokers are called “market makers” and they buy and sell stocks over an electronic system rather than an exchange floor. The NASDAQ is home to more than 5,000 companies and is generally the market for technology stocks and smaller, less established companies.
- Over the Counter (OTC) - This is where most U.S. publicly held companies are traded, as most companies are too small or too new to meet the requirements set forth by the NYSE, Amex, or NASDAQ. OTC trading is conducted over an electronic network and posted on the OTC Bulletin Board.
- Electronic Communication Networks (ECNs) - The newest type of market, ECNs are the “Generation X” to the traditional markets. ECNs eliminate the middleman in stock trading, resulting in lower trading fees for the traders. In addition, ECNs are open past normal trading hours, making the markets available to more non-traditional traders.
How the Economy and the Markets Affect Your Investments
If you aren’t overwhelmed by the alphabet soup of CPI, GDP, NYSE, NASDAQ, and ECN, then take a deep breath and get ready for the easy part: understanding how the economy and the market work together.
Over time, a strong U.S. economy helps create higher salaries for workers, which in turn leads to an increase in sales and profits for businesses, which drives up stock prices, which then drives up the value of investment portfolios.
Conversely, when prices rise too high (inflation), consumer spending slows, profit margins begin to slide, stock prices fall, companies initiate layoffs in order to shore up profits, and the economy slows.