ECONOMIC ANALYSIS

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• ECONOMIC ANALYSIS

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(No Transcript)
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Economic Analysis and Efficient Markets

• If markets are efficient, should we bother with
  analysis?
• Yes! In fact, in an efficient market, likely the
  only way to outperform market averages is to
  forecast the future better than the consensus.
• Two basic approaches to security analysis
• Emphasize history, looking for trends
• Focusing on the future
• Still look at some historical information, but
  focus on looking forward to future trends
• Top-down approach
• Bottom-up approach

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General Approaches to Security Analysis

• Top-Down Approach (Our focus)
• Review the macro-economy
• Analyze different industries and sectors
• Determine buy/sell candidates
• Bottom-up Approach
• Focus primarily on the firm-specific factors that
  will lead to success, regardless of industry or
  macroeconomic factors

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A Three-Step Process

• Within the three-step process of the top-down
  approach, all steps are crucial
• General economic influences
• Government policies strongly influence the
  economic environment, leading to profound effects
  on industries
• Step 1 Market analysis
• We can see the influence of changes in the
  overall economy on various classes of investments
• Some investments do better than others before,
  during, and after recessions, for instance
• Step 2 Industry Influences
• We seek to determine which industries will likely
  do better than others in the expected economic
  environment
• Also, changing demographic factors have different
  effects across industries
• Step 3 Company Analysis
• Individual investments will either make or break
  portfolio performance
• Once well-positioned industries are determined,
  find well-positioned firms within those
  industries

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Academic support?

• There is academic support for this top-down
  approach
• Most changes in individual earnings related to
  changes in aggregate earnings and changes in a
  firms industry
• There is a relationship between stock and bond
  prices and macroeconomic variables
• Rates of return for individual stocks can be
  explained by the aggregate stock market and the
  firms industry
• Value line puzzle

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Review of Economic Concepts

• Domestic Economic Activity
• Forecasting trends in major economic variables
  such as GDP, inflation, interest rates
• GDP (Gross Domestic Product) components
• Consumption spending
• Investment spending
• Government expenditures
• Export and import activity
• Monetary policy Policies of the Fed to control
  the money supply and thereby affect the overall
  economy
• Open market operations
• Discount rate changes
• Reserve requirement changes
• Fiscal policy Government taxing and spending
  policies to influence the economy and pursue
  other public interests

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Real GDP ? Consumption Invest. Govrn. Sp. X -Inf.
Purchasing Manager s Index Employment Industrial Production Capacity Car Sales Retail Sales Personal Income and expenditure Housing Starts Building permits Durable goods orders New home sales Construction spending Factory orders Business Inventory Public Construction Merchandise Trade Balance Producer PI Consumer PI
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Short and Long Term Influences

• Influences on Long-term Expectations
• Technology
• Population
• Labor force participation
• Productivity
• Resource availability
• Incentives to expand
• Influences on Short-term Expectations
• Influences caused by fluctuations in demand
• Liquidity and bank lending
• Monetary policy
• Inflation
• Interest rates
• International influences
• Consumer sentiment
• Tax and other fiscal policy
• Economic shocks

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Key Economic Measures

• GDP--Total value of the economy published each
  quarter by the Commerce Department
• Industrial Production--Change in physical output
  of US factories, mines, and utilities. Published
  monthly by the FED.
• Leading Indicators--One summary number that leads
  changes in GDP(includes layoffs, new orders by
  factories, change in money supply, price of raw
  materials). Monthly index published by the
  Commerce Department. If the index moves in the
  same direction for several months, it is a sign
  that GDP will move the same way in the near
  future
• Personal Income--Before-tax wages and salaries,
  interests, dividends, rents, payments,
  compensations, and pensions. Issued monthly by
  the Commerce department. As it increases, buying
  increases.
• Retail Sales--All sales at the retail level.
  Monthly issue by the Commerce Department. Gives
  an idea of consumer attitudes a long slow down
  in sales can lead to cuts in production

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• Money Supply--Amount of money in circulation.
  Weekly report by the FED. Moderate growth of MS
  has a positive impact on the economys growth. A
  rapid growth or a sharp slowdown are synonymous
  to future inflation and future recession,
  respectively.
• Consumer prices--Changes in prices for a fixed
  basket of goods and services. Issued monthly by
  the Labor Department. Measures inflation.
• Producer Prices--Changes in price of different
  goods at different stages of production (from raw
  materials to finished goods). Issued monthly by
  the Labor Department. Better measure of
  Inflation.
• Employment-- of workforce that is unvoluntarily
  out of work. Issued Monthly by the Labor
  Department.
• Housing Starts--Includes the number of new
  building permits issued accross the country.
  Issued monthly by the Labor Department. A pickup
  in the pace of housing starts usually follows an
  easing of credit conditions, which is an
  indication of economic health. Early indicator of
  future economic health.

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• Economic Variables and the Stock Market
• Real growth in GDP-- positive impact
• Industrial Production-- Continued increase is a
  sign of strength for GDP, and therefore the
  market.
• Inflation--Bad to stock higher inflation leads
  to higher rates which leads to higher P/E which
  make stocks less attractive
• Corporate Profits--Strong profits are good
  (duhh!!!)
• Unemployment--Bad guy business activity is
  slowing down
• Federal Deficit--mixed positive in a depressed
  economy can lead to inflation in a stronger
  economy.
• Weak Dollar--Mixed. It makes our equity markets
  less attractive to foreign investors. US products
  are more attractive which in turn is good for the
  economy
• Interest rates--Bad rising rates negative effect
  on stock markets as bond markets become more
  competitive.
• Money Supply-- Moderate growth of MS has a
  positive impact on the economys growth. A rapid
  growth or a sharp slowdown are synonimous to
  future inflation and future recession,
  respectively.

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Factors Affecting Interest Rates

• Change in Money supply--as it increase, rates go
  down A rapid growth or a sharp slowdown are
  synonimous to future inflation and future
  recession, respectively.
• The size of the federal deficit--as it increases,
  demand for funds increases, interest rates
  increase.
• Level of economic activity-- as it increases,
  demand for funds increases, and interest rates
  tend to rise. During recession rates tend to
  fall.
• The FED--usually an increase in interest rates is
  used to fight inflation.

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this relationship is positive, yet the spread
changes over time. This indicates that investors
are not very good at predicting inflation.
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Cyclical Indicator

• The Cyclical Indicator approach to forecasting
  the economy is based on the belief that the
  aggregate economy expands and contracts in
  discernible periods (business cycle). There are
  hundreds of economic time series that relate to
  the business cycle which have grouped various
  economic series into three major cyclical
  indicator categories leading, coincident, or
  lagging indicators, since they either lead,
  coincide with, or lag the business cycle.
• Leading Indicators series lead changes in GDP
  (includes layoffs, new orders by factories,
  change in money supply, price of raw
  materials,).
• Coincident Indicator Series includes economic
  time series that have peaks and troughs that
  roughly coincide with the peaks and troughs in
  the business cycle.
• Lagging Indicator Series includes series that
  experience their peaks and troughs after those of
  the aggregate economy

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Leading Indicator Series Peaks Trough Turns
1. Average weekly hours of production workers (manufacturing) 2 3 3
2. Average weekly initial claims for unemployment insurance 5 1 3
3. Manufacturers new orders dollars, consumer goods, and materials 2 2 2
4. Contracts and orders for plant and equipment 5 1 2½
5. Index of raw private housing units authorized by local building permits 9 6 7
6. Index of stock prices, 500 common stocks 4 4 4
7. Money supply 5 4 5
8. Vendor performance (percentage firms receiving slower deliveries) 3 4 3
9. Changes in sensitive materials, prices smoothed 4 8 5½
10. Changes in business and consumer credit outstanding 4 6 5
11. Changes in manufacturing and trade inventories on hand and on order. 3 4 3
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Coincident Indicator Series
Peaks Troughs All Turns
1. Employees on nonagricultural payrolls 2 0 0
2. Personal income less transfer payments 0 1 ½
3. Index of industrial production 3 0 ½
4. Manufacturing and trade sales 3 0 ½
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Lagging Indicators
Peak Trough Turns
1. Average duration of unemployment in weeks (inverted) 1 8 3½
2. Ratio of manufacturing and trade inventories to sales 2 3 3
3. Average prime rate charged by banks 4 14 5
4. Commercial and industrial loans outstanding 2 5 4
5. Ratio of consumer installment credit outstanding to personal income 6 7 7
6 Labor costs per unit of output in manufacturing, actual data as percentage of trend 4 14 5
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Composite index

• In addition to the individual economic series in
  each category, a composite time series combines
  these leading economic series to form the
  composite leading indicator index. This composite
  leading indicator series is widely reported in
  the press each month as an indicator of the
  current and future state of the economy.

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• Some analysts have used a ratio of these
  composite series, contending that the ratio of
  the composite coincident series divided by the
  composite lagging series acts like a leading
  series.
• The rationale for expecting this leading
  relationship is that the coincident series should
  turn before the lagging series, and the ratio
  between the two series will be quite sensitive to
  such changes. As a result, this ratio is expected
  to lead both of the individual component series,
  especially at turning points.

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Example Forecasting Tools

• Searching for leading indicators that will
  provide signals of future economic directions
• Inflation Indicators
• Inflation at times is related to turning points
  in the business cycle
• Inflation destroys the purchasing power of wealth
• Federal Reserve actions indicate likely trends in
  inflation
• Money supply and money growth rates relative to
  measures of economic growth
• Commodity prices

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Example Forecasting Tools

• Monetary Indicators
• Impact both inflation and liquidity
• Federal Reserve policy
• Differences in Interest Rates
• The Treasury yield curve can sometimes give
  indications about future economic growth
• Cyclical Economic Indicators
• Tracking official leading economic indicators

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Risks in Economic Forecasting

• Dominated by group think
• Always using consensus numbers ensures no better
  than average forecasts
• Forecasts must be different (often) and yet still
  correct (usually) to create value
• Many analysts are short-sighted
• Lots of data can overwhelm us
• Try to support a position
• Over-reliance on expected normal changes
  without regard to the possibility of shocks

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The internet

• http//www.morganstanley.com
• http//www.globalinsight.com
• http//www.yardeni.com
• http//www.whitehouse.gov/fsbr/esbr.html
• http//www.federalreserve.gov
• http//www.worldbankorg
• http//www.phil.frb.org/econ/forecast/index.html
• http//www.spglobal.com/index.html
• http//www.bis.org/cbanks.htm
• http//www.bankamerica.com/
• http//www.nabe.org
• http//www.conference-board.org
• http//www.bea.doc.gov/bea/pubs.htm
• http//www.stats.bls.gov
• http//www.cbo.gov
• http//www.whitehouse.gov/cea/
• http//www.gpoaccess.gov/indicators/browse.html
• http//www.census.gov/csd/qfr
• http//www.federalreserve.gov/pubs/bulletin

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Research

• Economic Indicators vs. Cumulated returns
• Economic Indicators versus PE
• Economic Indicator classification
  http//biz.yahoo.com/c/e.html