Deadly Flaws in Major Market Indicators

Economists and other market watchers look to major market indicators such as gross domestic product (GDP), gross national product (GNP), the Consumer Price Index (CPI) and the Producer Price Index (PPI) for guidance on the state of the economy and the future direction of the stock market. When the experts interpret the data, however, their market projections often overlook potential flaws in the story the indicators are telling. (See also: An Overview of Economic Indicators.)

Of course, every story can have several sides. When reviewing market projections based on economic indicators, investors need to understand all sides of the story to make a fair assessment regarding a particular indicator's validity. In some cases, the story told by major economic indicators might not be the best representation of what they are actually supposed to measure.

Gross domestic product (GDP), defined as the monetary value of all the finished goods and services produced within a country's borders, is commonly used as an indicator of a country's economic health as well as a gauge of the country's standard of living. Of course, this measure is not without its critics, who correctly point out that GDP does not take into account the so-called underground economy. All transactions that, for whatever reason, are not reported to the government are simply left out of the GDP calculation. For example, household production (the value of a stay-at-home spouse's labor) counts for nothing while the services of a maid add to GDP. Other examples of underground production include the time you spend working in your garden or fixing your car.

It is also important to understand that GDP counts production, not destruction, so rebuilding a city after a hurricane provides a boost to GDP but overlooks the billions of dollars in losses from the storm. GDP also provides an imperfect picture when comparing nations, as currency differences and specialized goods production can be difficult to equalize for computational purposes. Similarly, GDP comparisons between a nation rebuilding in the wake of destruction and a stable and healthy country could provide the impression that the former is healthier than the later. (See also: What is GDP and Why Is It So Important?)

Some critics even argue that GDP is not intended to gauge a country's health, but merely serves as a measure of a nation's productivity. By this perspective, GDP has nothing to do with a country's standard of living. Economic production provides no insight into the literacy rate, life expectancy, access to health care, leisure time or general level of happiness among a given populace. Although there is a correlation between the factors, correlation does not necessarily imply causation. In fact, the Human Development Index used by the United Nations Development Program and the Gross National Happiness Index used by the tiny nation of Bhutan would do a far better job of differentiating between an oppressed nation of illiterate peasants toiling in sweatshops and a healthy, happy nation earning fair wages in a safe work environment than would GDP.

Further confusion occurs when the subject of inflation arises. Real GDP factors in the effects of inflation, including all changes in prices that take place in a given year. Nominal GDP, on the other hand, evaluates GDP over a period of multiple years using a specific year as the base year without proper adjustments for regular price increases. So the quantity of goods and services in each year under evaluation is multiplied by the prices of those goods during the base year to provide an even comparison. The use of both nominal and real GDP can be confusing to those not familiar with the terms and their meanings. (See also: High GDP Means Economic Prosperity, or Does It?)

Gross national product (GNP) is a measure of a country's economic performance, or what its citizens produce (i.e., goods and services) and whether they produce these items within its borders. It includes GDP, plus any income earned by residents from oversees investments, minus income earned within the domestic economy by overseas residents.

Critics of GNP cite the same criticism for this measure as for GDP, in that it does not value certain activity and does not account for social wellbeing (poverty, etc.). Another strong criticism of GNP is that the metric might be almost irrelevant. Firstly, an individual can be a citizen of two different countries. Double counting her productivity would not be an accurate measure of total global production. Secondly, a nation has very little to gain from one of its citizens producing goods in another country. He might be taxed by his country of citizenship depending on the tax structure of the two nations, but the overall gains to productivity are absent.

Like GDP, GNP is calculated in both nominal and real terms. Using the wrong one in a comparison will skew results for unwary investors. (See also: How to Use Gross National Product as an Indicator.)

The Consumer Price Index (CPI) is a series of measures that reflect the weighted average of prices of a basket of consumer goods and services. The goods are weighted in the index according to their share of total consumer expenditures. Changes in the CPI are used to assess inflation. While tracking inflation is a laudable goal that can help consumers and investors understand changes associated with the cost of living, understanding CPI is not a simple matter.

The government distributes several variants of CPI each month, including the:

• CPI for Urban Wager Earners and Clerical Workers (CPI-W): This measure does not include professional, managerial or technical workers, self-employed workers, retirees or the unemployed. This metric only factors in the inflation that a certain working sect of the population is exposed to. Clearly, this is not a particularly broad or inclusive index.
• CPI for All Urban Consumers (CPI-U): This measure includes only members of urban households in certain tracked areas that have at least 2,500 inhabitants. Rural and military jobs are excluded. CPI-U is the broadest CPI measure in terms of capturing the majority of the nation, but it is still not applicable to the rural population.
• Core CPI: This measure excludes food and energy due to their volatility. Of course, food and energy costs have a significant impact on one's spending budget and generally have a hard-to-avoid impact on consumers. Any measure that does not capture them is unlikely to reflect the experiences of the majority of the population.

The CPI measures are fraught with criticism. For one, the basket of goods is fairly static, changes infrequently and may not always reflect items that provide an accurate accounting of the consumer experience. For another, some critics argue that CPI overestimates inflation, while others argue the reverse.

CPI, perhaps more than the other economic indicators, highlights how confusing it can be for investors to interpret economic data. These indicators may be useful to economists, but they are quite confusing for the average person. (See also: The Consumer Price Index: A Friend to Investors.)

The Producer Price Index (PPI) measures the average change in selling prices received by domestic producers of goods and services over time. In contrast to the COI, the PPI measures price changes from the seller's perspective.

Fortunately, PPI attracts relatively little criticism from modern economists and investors, although this was not always the case. PPI has two practical purposes in the business world. From the perspective of the consumer, it allows economists to gauge the future direction of CPI. When PPI is high, the costs will eventually be passed on to the buyers who will thus face inflationary pressures on goods bought. Additionally, from the perspective of the company, PPI allows cost of goods sold to be standardized and compared on historical levels.

Interpreting economic indicators is not always a simple process. Like picking stocks, it requires knowledge, skill, a detailed understanding of the subject matter and perhaps even a bit of luck. Economists and investors are always seeking better information, and it is not out of the question for indicators to change with the times, evolving to keep pace with world around them and the data investors and experts are seeking. (See also: Using Coincident and Lagging Indicators.)