ECONOMIC ANALYSIS

Fundamental Analysis• Fundamental analysts look for companies whose financial

health is good and getting better, and which are undervalued by the market

• They scour financial reports, calculate ratios, compare to other similar companies, etc

• Fundamental analysts believe that “earnings drive stock prices” at least in the long run

• Fundamentalists tend to be buy and hold investors, as opposed to technicians who tend to be shorter-term traders

• Approach to Fundamental Analysis: Domestic and global economic analysis, Industry analysis, Company analysis

3-step process…• Monetary and fiscal policies (taxes, money supply,

inflation) influence the aggregate economies of countries– Resulting economic conditions influence all industries and

companies• Alternative industries react to economic changes at

different points in business cycles– Demographic changes, foreign operations

• Identify best companies in promising industries

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

• 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 involuntarily 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.

Economic Growth• GDP (Gross Domestic

Product) components– Consumption

spending– Investment

spending– Government

expenditures– Export and import

activity

Producer PI Consumer PIDeflater

-Inf.

Merchandise Trade Balance

+ X

Public Construction+Govrn. Sp.

Housing Starts Building permitsDurable goods ordersNew home salesConstruction spendingFactory ordersBusiness Inventory

+Invest.

Car Sales Retail SalesPersonal Income and expenditure

Consumption

Purchasing Manager ’s Index EmploymentIndustrial Production Capacity

Real GDP

Producer PI Consumer PIDeflater

-Inf.

Merchandise Trade Balance

+ X

Public Construction+Govrn. Sp.

Housing Starts Building permitsDurable goods ordersNew home salesConstruction spendingFactory ordersBusiness Inventory

+Invest.

Car Sales Retail SalesPersonal Income and expenditure

Consumption

Purchasing Manager ’s Index EmploymentIndustrial Production Capacity

Real GDP

• Demand shock - an event that affects demand for goods and services in the economy.– Tax rate cut– Increases in government spending

• Supply shock - an event that influences production capacity or production costs.– Commodity price changes– Educational level of economic participants

• Fiscal Policy - government spending and taxing actions.– Direct policy– Slowly implemented

• Monetary Policy - manipulation of the money supply to influence economic activity. Policies of the Fed to control the money supply and thereby affect the overall economy

Open market operations Discount rate changes Reserve requirement changes

Shocks and Federal Government Policy

Macro Economic Analysis

• There is a strong linkage between growth in the overall economy and growth in company earnings.

• Changes in nominal GDP explain about 37% of the changes in corporate profits on average.

• Then, to know where earnings (and thus stock prices) are going, we need to know where GDP is going.

• A GDP forecast

Corporate Earnings vs. Nominal GDP

y = 3.9195x - 0.0501

R2 = 0.3712

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

-3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

% Nominal GDP

%

Cor

pora

te E

arni

ngs

The U.S. Economic ForecastUpdated: January 3, 2007

2006 2007 2006 2007 2008III Q* IV Q I Q II Q III Q IV Q Annual Annual Annual

Real GDP 2.20 2.70 2.90 2.70 2.40 2.40 3.40 2.60 2.60CPI Inflation 2.90 -2.50 3.20 3.00 3.00 3.30 3.20 2.10 3.30Real Consumer Spending 2.90 3.60 3.50 3.50 2.80 3.00 3.20 3.30 2.80Unemployment Rate (%) 4.70 4.50 4.50 4.70 4.60 4.70 4.60 4.60 4.9090 Day T-Bills (%) 4.91 4.94 5.19 5.54 5.79 6.29 4.73 5.70 6.2910 Yr Treas Bonds (%) 4.90 4.60 4.80 5.00 5.00 5.25 4.78 5.01 5.23

* ActualSource: The Conference Board (http://www.conference-board.org/economics/stalk.cfm)

http://online.wsj.com/public/resources/documents/info-flash08.html?project=EFORECAST07'

Forecasting• Any macro economic forecast should AT LEAST include

estimates of all of the important economic numbers, including:– Real GDP growth– Inflation rates– Interest rates– Unemployment– Budget deficit– Consumer sentiment

• There are two types of forecasts:– Quantitative – based on econometric models.– Qualitative – based on educated guesses.

• Qualitative forecasting is less difficult, and probably as good as quantitative forecasting.

• Furthermore, we can blend the two methods.• There is another technique known as a “barometric”

forecast which is an average of the forecasts by many others.

Forecasting (cont.)

• 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

• 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

Forecasting Biases• Economic forecasting is especially difficult, and the forecasts are

wrong almost by definition.• There are many reasons why this is the case:

– Old or bad data– Unexpected shocks (the Sept 11 tragedy is a perfect example)– Using historical data which gives no clues about major structural

changes about to occur– Blindly following trends

• John Casti in his 1990 book Searching for Certainty: What Scientists Can Know About the Future evaluated forecasters from many fields and gave economists a “D.” Stock market forecasters got a very generous “C+” and physicists got an “A.”

• Probably the most notoriously wrong forecast of all time came in the early fall of 1929 when the great economist Irving Fisher said, "Stock prices have reached what looks like a permanently high plateau."

• Forecasting is hard and your efforts are nearly always wrong.• The next slide shows an analysis of just how “accurate” a group

of professional economists were at predicting various indicators about 6 months ahead in 2004.

Why Forecast Economic Aggregates?

• We don’t have a choice. We are making decisions whose outcomes depend on the future, and we must make these decisions using the best available information that we have.

• Otherwise, all decisions may as well be made by a coin toss (and even bad forecasts are usually better than that).

• It is probably best not to pay too much attention to the point estimates of the forecast, instead look for trends (is GDP expected to grow slower, faster, or about the same?).

• It is also important to constantly be on the lookout for solid reasons to revise your forecast, and change your decision.

• Its no sin to be wrong, but failing to admit it and adjust is.

Forecast Timing: Short and Long Term Impacts

• 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”

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• 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 synonymous to future inflation and future recession, respectively.

Recession and Depression• Incorrect definition: A recession occurs when real

GDP declines for two consecutive quarters.• The NBER Business Cycling Dating Committee is

the official arbiter of the timing of recessions. Its definition (from http://www.nber.org/cycles.html) is:– “The NBER does not define a recession in terms of two

consecutive quarters of decline in real GNP. Rather, a recession is a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy.”

– “A growth recession is a recurring period of slow growth in total output, income, employment, and trade, usually lasting a year or more. A growth recession may encompass a recession, in which case the slowdown usually begins before the recession starts, but ends at about the same time. Slowdowns also may occur without recession, in which case the economy continues to grow, but at a pace significantly below its long-run growth.”

– A depression is a recession that is major in both scale and duration.

Post WWII Recessions• There have been 11 recessions in the U.S.

economy since 1945. Peak Trough

February 1945 (Q1) October 1945 (Q4)

November 1948 (Q4) October 1949 (Q4)

July 1953 (Q2) May 1954 (Q2)

August 1957 (Q3) April 1958 (Q2)

April 1960 (Q2) February 1961 (Q1)

December 1969 (Q4) November 1970 (Q4)

November 1973 (Q4) March 1975 (Q1)

January 1980 (Q1) July 1980 (Q3)

July 1981 (Q3) November 1982 (Q4)

July 1990 (Q3) March 1991 (Q1)

March 2001 (Q1) November 2001 (Q4)

Dcember 2007 (Q4) ????

-3%

-1%

1%

3%

5%

7%

9%

1954

1957

1960

1964

1967

1970

1973

1977

1980

1983

1986

1990

1993

1996

1999

2003

2006

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

Index of Leading Economic Indicators

The LEI has 10 components, each with a specific weighting:

Component FactorLeading Indicators 2002

1 Interest rate spread, 10-year Treasury bonds less federal funds 33.05%2 Money supply, M2 30.38%3 Average weekly hours, manufacturing 18.12%4 Manufacturers' new orders, consumer goods and materials 4.96%5 Stock prices, S&P 500 common stocks 3.08%6 Vendor performance, slower deliveries diffusion index 2.76%7 Average weekly initial claims for unemployment insurance 2.61%8 Building permits, new private housing units 1.91%9 Index of consumer expectations 1.83%

10 Manufacturers' new orders, nondefense capital goods 1.30%Total 100.00%

Index of Coincident Indicators• The Coincident Indicators Index has 4

components, each with a specific weighting:Component FactorCoincident Index 2002

1 Employees on nonagricultural payrolls 52.30%2 Personal income less transfer payments 21.76%3 Manufacturing and trade sales 11.87%4 Industrial production 14.07%

Total 100.00%

Index of Lagging Indicators• The Index of Lagging Indicators has 7

components, each with a specific weighting:Component FactorLagging Index 2002

1 Average prime rate 25.21%2 Inventories to sales ratio, manufacturing and trade 12.57%3 Consumer installment credit to personal income ratio 19.92%4 Consumer price index for services 19.29%5 Commercial and industrial loans 13.00%6 Labor cost per unit of output, manufacturing 6.24%7 Average duration of unemployment 3.78%

Total 100.01%

Forecasting GDP• Yield curve has had considerable success

in predicting recessionsLead Lag Analysis in Months

NBER Peak

NBER Trough

Length of Cycle Inversion Lead Normal Lead

Length of Inversion

Dec-69 Nov-70 11 Oct-68 14 Feb-70 9 16Nov-73 Mar-75 16 Jun-73 5 Jan-75 2 19Jan-80 Jul-80 6 Nov-78 14 May-80 2 18Jul-81 Nov-82 16 Oct-80 9 Oct-81 13 12Jul-90 Mar-91 8 May-89 14 Feb-90 13 9

Average last four 11 11 7 15

Recent RecessionMar-01 Nov-01 8 Jul-00 8 Mar-01 8 8

Business Cycle 5-Year Yield Spread

Yield curve and GDP

-3%

-1%

1%

3%

5%

7%

9%

1954

1957

1960

1964

1967

1970

1973

1977

1980

1983

1986

1990

1993

1996

1999

2003

2006

%change Real GDP

5year-3monthspread

Recession correct

Recession correct

Caution is advised…• Inverting the yield curve (even if it is a false

signal) will likely increase disagreement among market participants because most associate inversions with bad economic news

• Increased disagreement will lead to higher VIX and corporate spreads

• Increased volatility leads to higher costs of capital

• Higher costs of capital lead to less investment, employment and ultimately a moderation in economic growth

Forecasting Interest Rates

• Change in Money supply--as it increase, rates go down; A rapid growth or a sharp slowdown are synonymous 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.

Consumer Confidence• The Consumer Confidence index is released monthly.• It is a mail survey of 5,000 individuals with an average of 3,500 responses.• In the survey, respondents are asked 5 questions:

1. Respondents appraisal of current business conditions. 2. Respondents expectations regarding business conditions six months hence. 3. Respondents appraisal of the current employment conditions. 4. Respondents expectations regarding employment conditions six months hence. 5. Respondents expectations regarding their total family income six months

hence. • There are three possible responses: Positive, Neutral, Negative.• The index has two components:

– Expectations (most important)– Present Situation

• The overall index is calculated as the average of the relative positive/negative responses to all 5 questions.

• The expectations component is an average of the responses to questions 2, 4, 5.

• The present situation component is an average of the responses to questions 1 and 3.

• Before averaging, all responses are adjusted relative to their 1985 values.• The responses to each question are also seasonally adjusted.• Source:

http://www.consumerresearchcenter.org/consumer_confidence/methodology.htm• There is also a consumer sentiment index published by the University of

Michigan.

Inflation Indicators• There are many indicators of inflation in

the economy. (Inflation is defined as a general increase in the level of prices.)

• The most-watched indicators are:– The Consumer Price Index (CPI)– The Producer Price Index (PPI)– The GDP Deflator– The Employment Cost Index (ECI)

Consumer Price Index• The CPI is published monthly by the Bureau of Labor

Statistics (http://www.bls.gov/cpi/).• There are many versions (even one for Denver-Boulder-

Greeley area which is published semiannually), but the most watched is the Consumer Price Index for All Urban Workers (CPI-U).

• The CPI measures the change in price of a “market basket” of goods typically purchased by consumers. The items in this basket are determined by periodic surveys of about 30,000 consumers around the country.

• It is broken into two components:– The total CPI (often called the “Headline Number”)– The Core CPI (ex food and energy which are quite volatile)

• Watch both numbers, but the core CPI is the best indicator.

Consumer Price Index (cont.)• The expenditure items are from 200 categories arranged into 8

major groups:– FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken,

wine, full service meals and snacks); – HOUSING (rent of primary residence, owners' equivalent rent, fuel

oil, bedroom furniture); – APPAREL (men's shirts and sweaters, women's dresses, jewelry); – TRANSPORTATION (new vehicles, airline fares, gasoline, motor

vehicle insurance); – MEDICAL CARE (prescription drugs and medical supplies,

physicians' services, eyeglasses and eye care, hospital services); – RECREATION (televisions, cable television, pets and pet products,

sports equipment, admissions); – EDUCATION AND COMMUNICATION (college tuition, postage,

telephone services, computer software and accessories); – OTHER GOODS AND SERVICES (tobacco and smoking products,

haircuts and other personal services, funeral expenses).

Producer Price Index• Like the CPI, the PPI is published

monthly by the Bureau of Labor Statistics (http://www.bls.gov/ppi/).

• The PPI measures changes in wholesale prices.

• There are over 10,000 versions of the PPI published every month for individual products and services.

• Investors watch the PPI, but mostly focus on the CPI.

GDP Deflator• The GDP Deflator is published quarterly by the

Bureau of Economic Analysis (http://www.bea.doc.gov/) in the GDP report.

• The GDP Deflator measures changes in the prices of all domestically produced products, and is the broadest of all inflation indicators.

• It includes many things (trains, planes, etc) that consumers do not buy as well as everything they do buy.

• This measure of inflation is less-watched than the CPI, but it can be important and it tends to be less volatile.

Employment Cost Index• Like the CPI and PPI, the ECI is

published by the Bureau of Labor Statistics (http://www.bls.gov/ncs/ect).

• The ECI measures changes in the cost of employee compensation (wages and benefits), and is published quarterly as part of the National Compensation Survey .

• The ECI is reported to be one of Alan Greenspan’s favorite inflation measures.

The Beige Book• The Beige Book (

http://www.federalreserve.gov/FOMC/BeigeBook/2001/default.htm) is a summary of current economic conditions around the country published by the Federal Reserve Board.

• The Beige Book is published 8 times per year and is based on anecdotal evidence gathered through interviews with bank directors, economists, business contacts, etc.

• It contains an overall summary, plus reports from each of the 12 districts (Colorado is in the 10th district, Kansas City).

Unemployment• As part of its monthly Current Population Survey (

http://www.bls.gov/cps/home.htm), the Bureau of Labor Statistics produces the Unemployment Rate.

• The unemployment rate is determined by a survey of individuals who are then placed into one of three categories:– Employed– Unemployed and seeking work– Unemployed and not seeking work (“discouraged”

workers)

• The unemployment rate is the ratio of unemployed to the total number in the workforce (discouraged workers are not counted).

• Note that the “labor force” is actually the civilian labor force, it does not include those in the military.

Useful Economic Indicators