ECONOMIC ANALYSIS

1. ECONOMIC ANALYSIS

3. 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

4. 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

5. 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

6. 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 firm’s 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 firm’s industry • Value line puzzle

7. 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

9. 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”

10. 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

11. Money Supply--Amount of money in circulation. Weekly report by the FED. Moderate growth of MS has a positive impact on the economy’s 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.

12. 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 economy’s growth. A rapid growth or a sharp slowdown are synonimous to future inflation and future recession, respectively.

13. 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.

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

15. Cyclical Indicator • The Cyclical Indicatorapproach 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 Indicatorsseries 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

17. Coincident Indicator Series

18. Lagging Indicators

19. 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.

20. 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.

21. 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

22. 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

23. 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”

24. 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 http://www.yahoo.com

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