External drivers are factors which are outside the company's influence that can affect profitability. For example, the economy, inflation, interest rates, politics, bond market, etc. External drivers can be interpreted differently by different individuals (there is no magic formula).

To explain some of the external factors we will begin with Inflation. Inflation is the rate at which the general level of prices for goods and services are rising.

Inflation

Inflation has a direct influence on the stock market. While looking at inflation can be still subjective to the trader, a little history can explain what the effect inflation has had in the stock market's past.

Between 1970-1980 there was high inflationary trend. During this period, as inflation was rising and "not in control," the trend was for businesses and individuals to increase debt load. The rationale was to borrow today with more valuable dollars and pay off the debt in the future with less valuable dollars. While this concept is sound in a situation with up-trending inflation, the problem comes in when the inflation trend is stemmed and reversed.

As businesses and individuals continue to borrow and inflation continues to rise, the Federal Reserve (which will be discussed in further detail later) tends to step in to correct the problem. As these controls are activated, the inflationary trend changes direction. As history shows, there will always be a group of individuals and businesses that do not realize the trend has ended. As interest rates climb, they are caught with an excessive debt load which they can no longer service. By 1986 the excessive debt load was being noticed and by the early 1990s a record number of business and individual bankruptcies were declared and resulted in a high unemployment rate (1990-91). There has been a slow economic recovery since this recession and the inflation rate (consumer price index) has been trending downwards since then.

Part of the formula of a strong bull market is when inflation is perceived as being in control. During some of the best bull markets all you needed was a dart board. While the dart board is NOT recommended, these bull markets all had something in common - inflation was in control. This effect can be observed in the following super bull markets: 1920-29; 1949-66; and, in the current bull market.

Inflation also has a direct effect on interest rates. As the inflation rate climbed from the 1970s until the late 1980s, the demand for debt financing was high. Like anything, if the demand is high, so is the price, so interest rates were equally high. In 1990, the recession and the huge number of bankruptcies dramatically reduced the general debt demand. By 1993, interest rates fell about 4%. This drop in interest rates also made CDs and money markets less attractive to investors and led to a significant shift in assets to stocks and bonds (which was the beginning of the new bull market).

Interest rates

The first two types of rates are short term and long term. In general terms, if there is strong economic growth, short term rates will rise. Long term rates are related to the inflationary trend as well as rate differences between foreign countries.

There is also the discount rate and federal rate. These are the rates that are controlled by the Federal Reserve. These rates are also used to control the inflationary trend as well as the interest rate trend, and have a significant impact on investors. The discount rate is the interest rate that member banks use to borrow money from the Federal Reserve. The federal rate is one that banks use to borrow from each other. If the economy is growing too fast, the Federal Reserve will raise the federal rate to hold back the inflationary trend.

Finally, there is also the "real" interest rate. The real interest rate is the average Federal Funds rate minus the inflation rate. Most economists use the real interest rate for analysis to determine the general future direction of interest rates and the overall market.

The Federal Reserve

The Federal Reserve's primary function is to keep the economic system in balance. The Federal Reserve has three economic controls to influence imbalances like high inflation rates. The Federal Reserve can: alter the amount of reserve that member banks are required to maintain; control the discount rate; and, the Federal Funds rate.

During a recession or slow economic growth period, the Federal Reserve will lower interest rates to encourage investors to move assets into stocks and bonds (which will obviously help the stock market). When economic growth is too fast and inflationary pressures begin to build, the Federal Reserve will raise interest rates to encourage investors to move assets into money markets and CDs. This is the Federal Reserve's preferred method of economic control.

During the 1990 recession, the Federal Reserve dropped the rates to the lowest rate in two decades. In 1994, the economy began to rebound and the Federal Reserve raised the rate for the first time since 1990. This signaled the first potential of a change in the trend of the interest rate. Since then, the Federal Reserve has raised the rate 10 consecutive times (as of August 2005) which has quite conclusively made an upward trending interest rate. Even though the rate changes were quite small, it is the perception of the public that the trend has changed that put a bit of a damper on the stock market.

Note: A reasonable method for forecasting interest rates is to look at the Dow Jones Utility index. If the index in trending upwards it indicates that interest rates are trending down, if the index is trending down, it indicates that interest rates are on the rise. Utility stocks are considered sensitive to interest rates and therefore make a good leading indicator towards the interest rate trend as well as the overall market trend. (Some might argue that other indexes work just as well, however this depends on the investor's strategy.. Generally speaking the utility index works well for interest rates and for overall market trend).

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