Use the following case in answering Problems 26 – 28:
Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department
of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.
In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.
The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy that they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.
Stock prices are useful as a leading indicator. To explain this phenomenon, which of the following is most accurate?
Stock prices:
a. Predict future interest rates and reflect the trends in other indicators.
b. Do not predict future interest rates, nor are they correlated with other leading indicators; the usefulness of stock prices as a leading indicator is a mystery.
c. Reflect the trends in other leading indicators only and do not have predictive power of their own.
