ECONOMIC ANALYSISECONOMIC ANALYSIS

Overview of the Investment Process

Economic Analysis and Efficient Economic Analysis and Efficient MarketsMarkets

If markets are efficient, should we bother with If markets are efficient, should we bother with analysis?analysis?

Yes! In fact, in an efficient market, likely the only Yes! In fact, in an efficient market, likely the only way to outperform market averages is to forecast way to outperform market averages is to forecast the future better than the consensus.the future better than the consensus.

Two basic approaches to security analysis:Two basic approaches to security analysis: Emphasize history, looking for trendsEmphasize history, looking for trends Focusing on the futureFocusing on the future

Still look at some historical information, but focus on looking Still look at some historical information, but focus on looking forward to future trendsforward to future trends

Top-down approachTop-down approach Bottom-up approachBottom-up approach

General Approaches to Security General Approaches to Security AnalysisAnalysis

Top-Down Approach (Our focus)Top-Down Approach (Our focus)1.1. Review the macro-economyReview the macro-economy2.2. Analyze different industries and sectorsAnalyze different industries and sectors3.3. Determine buy/sell candidatesDetermine buy/sell candidates

Bottom-up ApproachBottom-up Approach Focus primarily on the firm-specific Focus primarily on the firm-specific

factors that will lead to success, factors that will lead to success, regardless of industry or macroeconomic regardless of industry or macroeconomic factorsfactors

A Three-Step ProcessA Three-Step Process Within the three-step process of the top-down approach, Within the three-step process of the top-down approach,

all steps are crucialall steps are crucial General economic influencesGeneral economic influences

Government policies strongly influence the economic Government policies strongly influence the economic environment, leading to profound effects on industriesenvironment, leading to profound effects on industries

Step 1: Market analysisStep 1: Market analysis We can see the influence of changes in the overall economy on We can see the influence of changes in the overall economy on

various classes of investmentsvarious classes of investments Some investments do better than others before, during, and after Some investments do better than others before, during, and after

recessions, for instancerecessions, for instance Step 2: Industry InfluencesStep 2: Industry Influences

We seek to determine which industries will likely do better than We seek to determine which industries will likely do better than others in the expected economic environmentothers in the expected economic environment

Also, changing demographic factors have different effects across Also, changing demographic factors have different effects across industriesindustries

Step 3: Company AnalysisStep 3: Company Analysis Individual investments will either make or break portfolio Individual investments will either make or break portfolio

performanceperformance Once well-positioned industries are determined, find well-Once well-positioned industries are determined, find well-

positioned firms within those industriespositioned firms within those industries

Academic support?Academic support?

There is academic support for this top-There is academic support for this top-down approachdown approach Most changes in individual earnings related to Most changes in individual earnings related to

changes in aggregate earnings and changes in changes in aggregate earnings and changes in a firm’s industrya firm’s industry

There is a relationship between stock and bond There is a relationship between stock and bond prices and macroeconomic variablesprices and macroeconomic variables

Rates of return for individual stocks can be Rates of return for individual stocks can be explained by the aggregate stock market and explained by the aggregate stock market and the firm’s industrythe firm’s industry

Value line puzzleValue line puzzle

Review of Economic ConceptsReview of Economic ConceptsDomestic Economic ActivityDomestic Economic Activity Forecasting trends in major economic variables such as Forecasting trends in major economic variables such as

GDP, inflation, interest ratesGDP, inflation, interest rates GDP (Gross Domestic Product) componentsGDP (Gross Domestic Product) components

Consumption spendingConsumption spending Investment spendingInvestment spending Government expendituresGovernment expenditures Export and import activityExport and import activity

Monetary policy: Monetary policy: Policies of the Fed to control the money Policies of the Fed to control the money supply and thereby affect the overall economysupply and thereby affect the overall economy

Open market operationsOpen market operations Discount rate changesDiscount rate changes Reserve requirement changesReserve requirement changes

Fiscal policy: Fiscal policy: Government taxing and spending policies to Government taxing and spending policies to influence the economy and pursue other public interestsinfluence the economy and pursue other public interests

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

Short and Long Term InfluencesShort and Long Term Influences Influences on Long-term ExpectationsInfluences on Long-term Expectations

TechnologyTechnology PopulationPopulation Labor force participationLabor force participation ProductivityProductivity Resource availabilityResource availability Incentives to expandIncentives to expand

Influences on Short-term ExpectationsInfluences on Short-term Expectations Influences caused by fluctuations in demandInfluences caused by fluctuations in demand Liquidity and bank lendingLiquidity and bank lending Monetary policyMonetary policy InflationInflation Interest ratesInterest rates International influencesInternational influences Consumer sentimentConsumer sentiment Tax and other fiscal policyTax and other fiscal policy Economic “shocks”Economic “shocks”

Key Economic MeasuresKey Economic Measures

GDP--GDP--Total value of the economy; published each quarter Total value of the economy; published each quarter by the Commerce Departmentby the Commerce Department

Industrial Production--Industrial Production--Change in physical output of US Change in physical output of US factories, mines, and utilities. Published monthly by the factories, mines, and utilities. Published monthly by the FED. FED.

Leading Indicators--Leading Indicators--One summary number that leads One summary number that leads changes in GDP(includes layoffs, new orders by factories, changes in GDP(includes layoffs, new orders by factories, change in money supply, price of raw materials). Monthly change in money supply, price of raw materials). Monthly index published by the Commerce Department. If the index published by the Commerce Department. If the index moves in the same direction for several months, it is index moves in the same direction for several months, it is a sign that GDP will move the same way in the near futurea sign that GDP will move the same way in the near future

Personal Income--Personal Income--Before-tax wages and salaries, Before-tax wages and salaries, interests, dividends, rents, payments, compensations, and interests, dividends, rents, payments, compensations, and pensions. Issued monthly by the Commerce department. pensions. Issued monthly by the Commerce department. As it increases, buying increases.As it increases, buying increases.

Retail Sales--Retail Sales--All sales at the retail level. Monthly issue by All sales at the retail level. Monthly issue by the Commerce Department. Gives an idea of consumer the Commerce Department. Gives an idea of consumer attitudes; a long slow down in sales can lead to cuts in attitudes; a long slow down in sales can lead to cuts in production production

Money Supply--Money Supply--Amount of money in circulation. Amount of money in circulation. Weekly report by the FED. Moderate growth of MS has a Weekly report by the FED. Moderate growth of MS has a positive impact on the economy’s growth. A rapid positive impact on the economy’s growth. A rapid growth or a sharp slowdown are synonymous to future growth or a sharp slowdown are synonymous to future inflation and future recession, respectively.inflation and future recession, respectively.

Consumer prices--Consumer prices--Changes in prices for a fixed basket Changes in prices for a fixed basket of goods and services. Issued monthly by the Labor of goods and services. Issued monthly by the Labor Department. Measures inflation.Department. Measures inflation.

Producer Prices--Producer Prices--Changes in price of different goods Changes in price of different goods at different stages of production (from raw materials to at different stages of production (from raw materials to finished goods). Issued monthly by the Labor finished goods). Issued monthly by the Labor Department. Better measure of Inflation.Department. Better measure of Inflation.

Employment--Employment--% of workforce that is unvoluntarily out % of workforce that is unvoluntarily out of work. Issued Monthly by the Labor Department.of work. Issued Monthly by the Labor Department.

Housing Starts--Housing Starts--Includes the number of new building Includes the number of new building permits issued accross the country. Issued monthly by permits issued accross the country. Issued monthly by the Labor Department. A pickup in the pace of housing the Labor Department. A pickup in the pace of housing starts usually follows an easing of credit conditions, starts usually follows an easing of credit conditions, which is an indication of economic health. Early which is an indication of economic health. Early indicator of future economic health.indicator of future economic health.

Economic Variables and the Stock MarketEconomic Variables and the Stock Market

Real growth in GDP--Real growth in GDP-- positive impact positive impact Industrial Production--Industrial Production-- Continued increase is a sign of Continued increase is a sign of

strength for GDP, and therefore the market.strength for GDP, and therefore the market. Inflation--Inflation--Bad to stock: higher inflation leads to higher Bad to stock: higher inflation leads to higher

rates which leads to higher P/E which make stocks less rates which leads to higher P/E which make stocks less attractiveattractive

Corporate Profits--Corporate Profits--Strong profits are good (duhh!!!)Strong profits are good (duhh!!!) Unemployment--Unemployment--Bad guy: business activity is slowing Bad guy: business activity is slowing

downdown Federal Deficit--Federal Deficit--mixed: positive in a depressed economy; mixed: positive in a depressed economy;

can lead to inflation in a stronger economy.can lead to inflation in a stronger economy. Weak Dollar--Weak Dollar--Mixed. It makes our equity markets less Mixed. It makes our equity markets less

attractive to foreign investors. US products are more attractive to foreign investors. US products are more attractive which in turn is good for the economyattractive which in turn is good for the economy

Interest rates--Interest rates--Bad; rising rates negative effect on stock Bad; rising rates negative effect on stock markets as bond markets become more competitive.markets as bond markets become more competitive.

Money Supply--Money Supply-- Moderate growth of MS has a positive Moderate growth of MS has a positive impact on the economy’s growth. A rapid growth or a impact on the economy’s growth. A rapid growth or a sharp slowdown are synonimous to future inflation and sharp slowdown are synonimous to future inflation and future recession, respectively.future recession, respectively.

Factors Affecting Interest Rates Factors Affecting Interest Rates

Change in Money supply--Change in Money supply--as it increase, as it increase, rates go down; A rapid growth or a sharp rates go down; A rapid growth or a sharp slowdown are synonimous to future inflation slowdown are synonimous to future inflation and future recession, respectively.and future recession, respectively.

The size of the federal deficit--The size of the federal deficit--as it as it increases, demand for funds increases, increases, demand for funds increases, interest rates increase.interest rates increase.

Level of economic activity--Level of economic activity-- as it increases, as it increases, demand for funds increases, and interest rates demand for funds increases, and interest rates tend to rise. During recession rates tend to fall.tend to rise. During recession rates tend to fall.

The FED--The FED--usually an increase in interest rates usually an increase in interest rates is used to fight inflation.is used to fight inflation.

Inflation and Interest Rates

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

Cyclical IndicatorCyclical Indicator The The Cyclical IndicatorCyclical Indicator approach to forecasting the approach to forecasting the

economy is based on the belief that the aggregate economy is based on the belief that the aggregate economy expands and contracts in discernible periods economy expands and contracts in discernible periods ((business cycle)business cycle). There are hundreds of economic time . There are hundreds of economic time series that relate to the business cycle which have series that relate to the business cycle which have grouped various economic series into three major grouped various economic series into three major “cyclical indicator” categories: leading, coincident, or “cyclical indicator” categories: leading, coincident, or lagging indicators, since they either lead, coincide with, lagging indicators, since they either lead, coincide with, or lag the business cycle. or lag the business cycle.

Leading IndicatorsLeading Indicators seriesseries lead changes in GDP lead changes in GDP (includes layoffs, new orders by factories, change in (includes layoffs, new orders by factories, change in money supply, price of raw materials,…).money supply, price of raw materials,…).

Coincident Indicator SeriesCoincident Indicator Series includes economic time includes economic time series that have peaks and troughs that roughly coincide series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle.with the peaks and troughs in the business cycle.

LLagging Indicator Seriesagging Indicator Series includes series that includes series that experience their peaks and troughs after those of the experience their peaks and troughs after those of the aggregate economy aggregate economy

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

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

Lagging IndicatorsLagging IndicatorsPeak 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

Composite indexComposite index

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

Some analysts have used a ratio of these Some analysts have used a ratio of these composite series, contending that the ratio of composite series, contending that the ratio of the composite coincident series divided by the the composite coincident series divided by the composite lagging series acts like a leading composite lagging series acts like a leading series.series.

The rationale for expecting this leading The rationale for expecting this leading relationship is that the coincident series should relationship is that the coincident series should turn before the lagging series, and the ratio turn before the lagging series, and the ratio between the two series will be quite sensitive to between the two series will be quite sensitive to such changes. As a result, this ratio is expected such changes. As a result, this ratio is expected to lead both of the individual component series, to lead both of the individual component series, especially at turning points. especially at turning points.

Composite coincident series

Composite lagging series= Composite leading series

Example: Forecasting ToolsExample: Forecasting Tools Searching for leading indicators that will Searching for leading indicators that will

provide signals of future economic provide signals of future economic directionsdirections

Inflation IndicatorsInflation Indicators Inflation at times is related to turning points in Inflation at times is related to turning points in

the business cyclethe business cycle Inflation destroys the purchasing power of Inflation destroys the purchasing power of

wealthwealth Federal Reserve actions indicate likely trends Federal Reserve actions indicate likely trends

in inflationin inflation Money supply and money growth rates relative to Money supply and money growth rates relative to

measures of economic growthmeasures of economic growth Commodity pricesCommodity prices

Example: Forecasting ToolsExample: Forecasting Tools

Monetary IndicatorsMonetary Indicators Impact both inflation and liquidityImpact both inflation and liquidity Federal Reserve policyFederal Reserve policy

Differences in Interest RatesDifferences in Interest Rates The Treasury yield curve can sometimes The Treasury yield curve can sometimes

give indications about future economic give indications about future economic growthgrowth

Cyclical Economic IndicatorsCyclical Economic Indicators Tracking “official” leading economic Tracking “official” leading economic

indicatorsindicators

Risks in Economic ForecastingRisks in Economic Forecasting

Dominated by “group think”Dominated by “group think” Always using consensus numbers ensures no Always using consensus numbers ensures no

better than average forecastsbetter than average forecasts Forecasts must be different (often) and yet still Forecasts must be different (often) and yet still

correct (usually) to create valuecorrect (usually) to create value Many analysts are short-sightedMany analysts are short-sighted Lots of data can overwhelm usLots of data can overwhelm us Try to support a positionTry to support a position Over-reliance on expected “normal” Over-reliance on expected “normal”

changes without regard to the possibility changes without regard to the possibility of “shocks”of “shocks”

The internetThe internethttp://http://www.morganstanley.comwww.morganstanley.comhttp://http://www.globalinsight.comwww.globalinsight.comhttp://http://www.yardeni.comwww.yardeni.comhttp://http://www.whitehouse.gov/fsbr/esbr.htmlwww.whitehouse.gov/fsbr/esbr.htmlhttp://http://www.federalreserve.govwww.federalreserve.govhttp://http://www.worldbankorgwww.worldbankorghttp://http://www.phil.frb.org/econ/forecast/index.htmlwww.phil.frb.org/econ/forecast/index.htmlhttp://http://www.spglobal.com/index.htmlwww.spglobal.com/index.htmlhttp://http://www.bis.org/cbanks.htmwww.bis.org/cbanks.htmhttp://http://www.bankamerica.comwww.bankamerica.com//http://http://www.nabe.orgwww.nabe.orghttp://www.conference-board.orghttp://www.conference-board.orghttp://www.bea.doc.gov/bea/pubs.htmhttp://www.bea.doc.gov/bea/pubs.htmhttp://www.stats.bls.govhttp://www.stats.bls.govhttp://www.cbo.govhttp://www.cbo.govhttp://www.whitehouse.gov/cea/http://www.whitehouse.gov/cea/http://www.gpoaccess.gov/indicators/browse.htmlhttp://www.gpoaccess.gov/indicators/browse.htmlhttp://www.census.gov/csd/qfrhttp://www.census.gov/csd/qfrhttp://www.federalreserve.gov/pubs/bulletinhttp://www.federalreserve.gov/pubs/bulletinhttp://www.yahoo.com http://www.yahoo.com

ResearchResearch

Economic Indicators vs. Cumulated Economic Indicators vs. Cumulated returnsreturns

Economic Indicators versus PEEconomic Indicators versus PE Economic Indicator classification Economic Indicator classification

http://biz.yahoo.com/c/e.htmlhttp://biz.yahoo.com/c/e.html