1 Chapter Five Economic Activity McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All...

11

Chapter Five

Economic Activity

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

22

Top-Down Evaluation ProcessTop-Down Evaluation Process

Macroanalysis of the economyMacroanalysis of the economy

• Industry variablesIndustry variables

Common stocks by expected risk-return Common stocks by expected risk-return characterisicscharacterisics

• Combine surviving stocks into portfolio of Combine surviving stocks into portfolio of assetsassets

Change optimal portfolio as conditions change

33

44

Valuation process beginsValuation process beginswith an economic analysiswith an economic analysisValuation process beginsValuation process beginswith an economic analysiswith an economic analysis

Accurateforecast

Examination ofeconomic

Activity

Accuratestock marketpredictions

Industries thatprosper

• Present a

nd expected

interest rates

• Monetary & Fiscal p

olicy

Government and consumer

spending patterns

• Business cycles

• Regression

A

nalysis

• Probability

T

heory

• Seat-o

f-the-pants

ju

dgment

• World

-wide

currency flu

ctuations

• Internatio

nal debt

obligations

Unemployment

Productivity

Price changes

Valuationof

potential investments

Valuationof

potential investments

55

Economic Activity and the Business CycleEconomic Activity and the Business Cycle

Federal Government Economic PolicyFederal Government Economic Policy

Fiscal PolicyFiscal Policy Monetary Policy Monetary Policy Government Policy, Real Growth, & InflationGovernment Policy, Real Growth, & Inflation

66


GOALSGOALS Stable pricesStable prices

(a low inflation rate)(a low inflation rate) Business stability at high levels of productionBusiness stability at high levels of production

(low levels of unemployment)(low levels of unemployment) Sustained real growth in gross domestic productSustained real growth in gross domestic product

(actual economic growth after deducting inflation)(actual economic growth after deducting inflation) Balance in international paymentsBalance in international payments

(balance of exports and imports as well as(balance of exports and imports as well as cash flows into and out of the United States)cash flows into and out of the United States)

Guided by the Employment Act of 1946, Federal Reserve Board of Governors, President’s Council of Economic Advisors, and other acts of the U.S. Congress

Goals often conflict because they do not all respond favorably to same stimulus

77

Employment Act of 1946Employment Act of 1946““The Congress declares that it is the continuing The Congress declares that it is the continuing

policy and responsibility of the Federal policy and responsibility of the Federal Government to use all practical means consistent Government to use all practical means consistent with its needs and obligations and other essential with its needs and obligations and other essential considerations of national policy, with the considerations of national policy, with the assistance and cooperation of industry, assistance and cooperation of industry, agriculture, labor, and State and Local agriculture, labor, and State and Local governments, to coordinate and utilize all its governments, to coordinate and utilize all its plans, functions and resources for the purpose of plans, functions and resources for the purpose of creating and maintaining, in a manner calculated creating and maintaining, in a manner calculated to foster and promote free competitive enterprise to foster and promote free competitive enterprise and the general welfare, conditions under which and the general welfare, conditions under which there will be afforded useful employment there will be afforded useful employment opportunities, including self-employment, for opportunities, including self-employment, for those willing, able, and seeking to work and to those willing, able, and seeking to work and to promote maximum employment, production, and promote maximum employment, production, and purchasing power….”purchasing power….”

88

Employment Act of 1946Employment Act of 1946

Also established:Also established: Council of Economic AdvisersCouncil of Economic Advisers

to assist the President in implementing to assist the President in implementing the Actthe Act

Joint Economic Committee of CongressJoint Economic Committee of Congressof Senators and Representativesof Senators and Representativesto review economic policy at least to review economic policy at least annually annually

Required an annual:Required an annual: Economic Report of the PresidentEconomic Report of the President to be submitted by the President to Congressto be submitted by the President to Congress

99


INSTRUMENTSINSTRUMENTS Monetary Policy (conducted by Federal Reserve)Monetary Policy (conducted by Federal Reserve)

• Control of the money supply (Open Market Control of the money supply (Open Market Operations)Operations)

• Changing reserve requirements of financial Changing reserve requirements of financial institutionsinstitutions

• Discount rate policyDiscount rate policy• Setting margin requirementsSetting margin requirements• Jawboning Jawboning

Fiscal Policy (conducted by Federal Government)Fiscal Policy (conducted by Federal Government)• Government spending and taxationGovernment spending and taxation• Import quotas and tariffs, subsidies, regulation of Import quotas and tariffs, subsidies, regulation of

industry competitionindustry competition• Possible intervention on the foreign exchange marketPossible intervention on the foreign exchange market

Incomes Policy (conducted by Federal Government)Incomes Policy (conducted by Federal Government)• Wage and price controlsWage and price controls

Guided by the Employment Act of 1946, Federal Reserve Board of Governors, President’s Council of Economic Advisors, and other acts of the U.S. Congress

1010


1950s-early 1960s 1961-1969 Early 1970s Late 1970s Early 1980s Mid/Late1980s 1990s 2000s

Focu

s on

em

ploy

men

t

and

econ

omic

gro

wth

Rap

id g

row

th,

low

une

mpl

oym

ent,

Acc

eler

atin

g in

flatio

n

Hig

h in

tere

st ra

tes

at e

nd,

Imba

lanc

e in

Int’l

pay

men

ts

Dev

alua

tions

of d

olla

r (tw

ice)

,

aban

don

gold

sta

ndar

d,

inco

mes

pol

icie

s (w

age/

pric

e co

ntro

ls)

Red

uce

unem

ploy

men

t

Con

trol i

nfla

tion,

Mod

erat

e ec

onom

ic g

row

th

Thre

e-ye

ar ta

x cu

t

Red

uced

infla

tion,

gre

w G

DP,

Led

to re

cord

gov

ernm

ent d

efic

its

Rec

ord

empl

oym

ent,

Red

uced

une

mpl

oym

ent %

,

Ste

ady

real

gro

wth

,

Gov

ernm

ent s

urpl

uses

Low inflation

Moderate grow

th

Recession, tax cuts

for the rich. 9/11 attacks,

Iraqi war

Early recession, recovery,

tax increase,

Vietnam w

ar,

Large government deficits

Full employm

ent

Large increases in money supply

Imbalance in international paym

ents,

Interest rates at record levels,

Oil em

bargo 4x increase in

gasoline prices; stagflation

Tight monetary policy

increased

interest rates depressed stock

prices as required rate of return

rose to record levels

“Supply-side economics”,

Increased focus on international issues,

Negotiated reductions in govt spending,

Major bull m

arket started in 1982Low

ered interest rates and inflation,

Bull market follow

ed by 1987 crash

Red

uce

unem

ploy

men

t,

Eco

nom

ic g

row

th, …

1111

PLEASE NOTEPLEASE NOTEThe Next Two SlidesThe Next Two Slides

Show the same Show the same information in a “table” information in a “table” format as the one shown in format as the one shown in the previous “fish-bone” the previous “fish-bone” diagramdiagram

1212

Federal Government Economic PolicyFederal Government Economic PolicyPeriod Goals Economy & Policy

1950s -early 1960s

Focus on employment and economic • Low inflation• Moderate growth

1961-1969

Rapid growth, low unemployment Accelerating inflation High interest rates at end Imbalance in Int’l payments

Vietnam war Large government deficits Full employment Large increases in money supply

Early 1970s

Devaluations of dollar (twice) Abandon gold standard Incomes policies (wage/price controls)

Imbalance in international payments Interest rates at record high levels Oil embargo 4x increase in gasoline prices Stagflation

Late 1970s

•Reduce unemployment•Control inflation,•Moderate economic growth

Tight monetary policy Increased interest rates Depressed stock prices as required rate of return rose to record levels

1313

Federal Government Economic PolicyFederal Government Economic PolicyPeriod Goals Economy & Policy

Early 1980s

Three-year tax cut•Reduced inflation, grew GDP•Led to record government deficits

• Supply-side economics• Increased focus on international issues• Negotiated reductions in govt spending• Major bull market started in 1982

Mid 1980s –Late 1980s

•Record employment•Reduced unemployment %

•Lowered interest rates and inflation•Bull market followed by 1987 crash

1990s

•Steady real growth •Government surpluses

•Early recession•Recovery•Tax increase

2000s

• Reduce unemployment, • Economic growth, …

Recession tax cuts for the rich9/11 attacksIraqi war

1414

Fiscal PolicyFiscal PolicyGreat impact on direction of economic activityGreat impact on direction of economic activity

Deficit spendingDeficit spending Government spends more than it receivesGovernment spends more than it receives Must be financed by the U.S. TreasuryMust be financed by the U.S. Treasury

• If Treasury sells securities to the Federal Reserve,If Treasury sells securities to the Federal Reserve,can be very expansionary: stimulating spending in can be very expansionary: stimulating spending in economyeconomy

• If Treasury sells securities to banks and individuals,If Treasury sells securities to banks and individuals,can be less expansionary, less increase in the money can be less expansionary, less increase in the money supply, supply, short-term interest rates will rise, some short-term interest rates will rise, some “crowding out” of private investment unless the Federal “crowding out” of private investment unless the Federal Reserve intervenesReserve intervenes

Creating surplusesCreating surpluses Government revenues exceed spendingGovernment revenues exceed spending

• Tend to reduce economic growth as government slows Tend to reduce economic growth as government slows its demand for goods and services relative to its incomeits demand for goods and services relative to its income

Government’s taxing and spending policies

1515

Fiscal Policy Cont’dFiscal Policy Cont’d

• Levying taxes or tariffs and quotas on foreign Levying taxes or tariffs and quotas on foreign goods and servicesgoods and services

Gains some trade advantages, protects Gains some trade advantages, protects some industries and jobs,some industries and jobs,

World Trade Organization (WTO) has been World Trade Organization (WTO) has been instrumental in breaking down trade barriersinstrumental in breaking down trade barriers

Lowering or eliminating tariffsLowering or eliminating tariffs

• expands world tradeexpands world trade• stimulates economic growthstimulates economic growth• at the expense of sectors with a at the expense of sectors with a

competitive disadvantagecompetitive disadvantage


but provokes retaliation, diminishes and distorts world trade

and quotas as well as preferential taxes and subsidies

*

*See the work of Michael Porter on “Competitive Advantage”

1616


Long recognition, legislative and Long recognition, legislative and implementation lags make it difficult to implementation lags make it difficult to use fiscal policy effectively.use fiscal policy effectively.

Fiscal policy initiatives are often Fiscal policy initiatives are often motivated by political considerations motivated by political considerations rather than economic concernsrather than economic concerns


1717

Figure 5-3 Panel A: Federal Budget Figure 5-3 Panel A: Federal Budget Seasonally Adjusted Annual RatesSeasonally Adjusted Annual Rates

0

500

1000

1500

2000

2500

1965 1970 1975 1980 1985 1990 1995 2000

1818

Monetary PolicyMonetary PolicyMonetary Policy Monetary Policy (conducted by Federal Reserve)(conducted by Federal Reserve)

attempts to control inflation while promoting attempts to control inflation while promoting economic and employment growth by controlling economic and employment growth by controlling the supply of money and the level of interest rates the supply of money and the level of interest rates in the economyin the economy

Open Market Operations (to control the money Open Market Operations (to control the money supply):supply):

Instrument most often used by the Federal Instrument most often used by the Federal ReserveReserve

Policy determined by the Federal Reserve’s Policy determined by the Federal Reserve’s Open Market CommitteeOpen Market Committee

Open market sales of government securities Open market sales of government securities by the Federal Reserveby the Federal Reserve

Open market purchases of government Open market purchases of government securities by the Federal Reservesecurities by the Federal Reserve

1919

Fiscal PolicyFiscal PolicyGreat impact on direction of economic activityGreat impact on direction of economic activity

Deficit spendingDeficit spending Government spends more than it receivesGovernment spends more than it receives Must be financed by the U.S. TreasuryMust be financed by the U.S. Treasury

• If Treasury sells securities to the Federal Reserve,If Treasury sells securities to the Federal Reserve,can be very expansionary: stimulating spending in can be very expansionary: stimulating spending in economyeconomy

• If Treasury sells securities to banks and individuals,If Treasury sells securities to banks and individuals,can be less expansionary, less increase in the money can be less expansionary, less increase in the money supply, supply, short-term interest rates will rise, some short-term interest rates will rise, some “crowding out” of private investment unless the Federal “crowding out” of private investment unless the Federal Reserve intervenesReserve intervenes

Creating surplusesCreating surpluses Government revenues exceed spendingGovernment revenues exceed spending

• Tend to reduce economic growth as government slows Tend to reduce economic growth as government slows its demand for goods and services relative to its incomeits demand for goods and services relative to its income


2020


• Levying taxes or tariffs and quotas on foreign Levying taxes or tariffs and quotas on foreign goods and servicesgoods and services

Gains some trade advantages, protects Gains some trade advantages, protects some industries and jobs,some industries and jobs,

World Trade Organization (WTO) has been World Trade Organization (WTO) has been instrumental in breaking down trade barriersinstrumental in breaking down trade barriers

Lowering or eliminating tariffsLowering or eliminating tariffs

• expands world tradeexpands world trade• stimulates economic growthstimulates economic growth• at the expense of sectors with a at the expense of sectors with a

competitive disadvantagecompetitive disadvantage


but provokes retaliation, diminishes and distorts world trade

and quotas as well as preferential taxes and subsidies

*

*See the work of Michael Porter on “Competitive Advantage”

2121

Monetary PolicyMonetary PolicyMonetary Policy Monetary Policy (conducted by Federal Reserve)(conducted by Federal Reserve)

attempts to control inflation while promoting attempts to control inflation while promoting economic and employment growth by controlling economic and employment growth by controlling the supply of money and the level of interest rates the supply of money and the level of interest rates in the economyin the economy

Open Market Operations (to control the money Open Market Operations (to control the money supply):supply):

Instrument most often used by the Federal Instrument most often used by the Federal ReserveReserve

Policy determined by the Federal Reserve’s Policy determined by the Federal Reserve’s Open Market CommitteeOpen Market Committee

Open market sales of government securities Open market sales of government securities by the Federal Reserveby the Federal Reserve

Open market purchases of government Open market purchases of government securities by the Federal Reservesecurities by the Federal Reserve

2222

Monetary Policy Cont’dMonetary Policy Cont’d

Changing reserve requirements of financial Changing reserve requirements of financial institutionsinstitutions

Tool less frequently usedTool less frequently used Decreasing reserve requirementsDecreasing reserve requirements Increases the funds that financial institutions Increases the funds that financial institutions

can lend, thereby potentially increasing the can lend, thereby potentially increasing the supply of money and reducing interest rates supply of money and reducing interest rates

Reduces the funds that financial institutions Reduces the funds that financial institutions can lend can lend

2323


Discount rate policyDiscount rate policyChanging the interest rate that the Federal Changing the interest rate that the Federal Reserve charges commercial banks when they Reserve charges commercial banks when they borrow short-term from the Fedborrow short-term from the Fed

• Can influence an individual bank’s willingness Can influence an individual bank’s willingness to borrow money for expansionary loans to to borrow money for expansionary loans to industryindustry

• Tends to be a reactionary rather than a Tends to be a reactionary rather than a discretionary policy instrument discretionary policy instrument — —

the Federal Reserve tends to set a rate the Federal Reserve tends to set a rate reflecting competitive market conditionsreflecting competitive market conditions

• Banks do not like to borrow from the FedBanks do not like to borrow from the Fed

2424

Monetary Policy Cont’dMonetary Policy Cont’d Setting margin requirementsSetting margin requirements

• Determines the percentage amount that Determines the percentage amount that investors must put up in “cash” to buy financial investors must put up in “cash” to buy financial assetsassets

• Was very low in 1920s leading to extreme Was very low in 1920s leading to extreme leverage and wild speculation that partly led to leverage and wild speculation that partly led to the cascading stock market crash that preceded the cascading stock market crash that preceded the great depressionthe great depression

• Now 50% and infrequently adjustedNow 50% and infrequently adjusted• Investments “marked to market” daily as prices Investments “marked to market” daily as prices

change may lead to a “margin call” if the change may lead to a “margin call” if the investor’s equity falls below 30%investor’s equity falls below 30%

• Margin calls require investors to put up more Margin calls require investors to put up more cash or their broker liquidates their position to cash or their broker liquidates their position to pay off the margin loanpay off the margin loan

2525


JawboningJawboning Issuing policy pronouncements to Issuing policy pronouncements to

influence banksinfluence banks Psychological policy toolPsychological policy tool Tends to be ignored Tends to be ignored It is without “teeth” (penalties or It is without “teeth” (penalties or

incentives)incentives)

2626

Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy

Economic

Goals

Over TimeOver Time

Sustainable Growth in Real GDP

High Employment Rates

Low Unemployment RatesBalance of International Payments:

Balance of Trade

Balance of International Payments:

Cash Flows Between Countries

Maintain Stable Prices (Low Inflation Rate)

Policy Instrument TargetsPolicy Instrument Targets Raise Interest RatesRaise Interest Rates

ResultsResults

Reduces Economic Growth

Reduces Employment

Increases Unemployment

Strengthens Domestic Currency

Increases Foreign Investment Inflows

Reduces Possible Inflationary Impact

Stimulates Economic Growth

Increases Employment

Reduces unemployment

Weakens Domestic Currency

Increases Foreign Investment Outflows

Increases Possible Inflationary Impact

↑Imports + ↓Exports If Currency Stays Strong

↓ ↓ Imports + ↑↑ Exports If Currency Stays Weak

Lower Interest RatesLower Interest Rates

2727


MonetaryTools

Policy Actions

To Raise Interest Rates To Lower Interest Rates

Open Market Operations

NY Fed BankSells Securities

NY Fed BankBuys Securities

Bank Reserve Requirements

RaisesReserve

Requirements

LowersReserve

Requirements

Discount RateIncreases

Discount RateLowers

Discount Rate

JawboningSay Optimistic Things About

Economy

Say Pessimistic Things

About Economy

2828


MonetaryTools

Policy Actions





Bank Reserve Requirements

RaisesReserve

Requirements

LowersReserve

Requirements

Discount RateIncreases

Discount RateLowers

Discount Rate

JawboningSay Optimistic Things About

Economy

Say Pessimistic Things

About Economy

2929


MonetaryTools

Policy Actions





Lowers pricesof securities

Raises pricesof securities

RaisesInterest Rates

LowersInterest Rates

Takes MoneyOut of Economy

Puts MoneyInto Economy

3030


MonetaryTools

Policy Actions





Price of Bonds

Quantity of Bonds

Supply0

Demand

P0

Supply1

P1


3131


MonetaryTools

Policy Actions






Interest Rates

Loanable Funds

Supply0

Demand

I0

Supply1

I1


3232


MonetaryTools

Policy Actions






Price of Bonds

Quantity of Bonds

Supply

Demand0

P0 Demand1

P1 RaisesInterest Rates

Raises PricesOf Securities

3333


MonetaryTools

Policy Actions





LowersInterest Rates

Interest Rates

Loanable Funds

Supply0

Demand

I0

Supply1

I1

Raises Pricesof Securities



3434


Policy Instruments are formulated to Policy Instruments are formulated to achieveachieve• Policy Targets Policy Targets • Economic Goals Economic Goals

INFLUENCED BY INTERACTIONS BETWEENINFLUENCED BY INTERACTIONS BETWEEN Policy Makers: Gov’t Admin + Congress, Fed Policy Makers: Gov’t Admin + Congress, Fed

ReserveReserve Financial Institutions Financial Institutions General Public General Public

And this determines outcomes in the And this determines outcomes in the economyeconomy

Policy Instruments are formulated to Policy Instruments are formulated to achieveachieve• Policy Targets Policy Targets • Economic Goals Economic Goals

INFLUENCED BY INTERACTIONS BETWEENINFLUENCED BY INTERACTIONS BETWEEN Policy Makers: Gov’t Admin + Congress, Fed Policy Makers: Gov’t Admin + Congress, Fed

ReserveReserve Financial Institutions Financial Institutions General Public General Public

And this determines outcomes in the And this determines outcomes in the economyeconomy

3535

Government Policy, Real Growth, Government Policy, Real Growth, and Inflation: GDPand Inflation: GDP

November 1991, the United States shifted November 1991, the United States shifted its primary measure of economic activity from its primary measure of economic activity from

Gross National Product (GNP) to Gross National Product (GNP) to Gross Domestic Product (GDP)Gross Domestic Product (GDP) GDP measures only output and consumption GDP measures only output and consumption

within the United States in a given yearwithin the United States in a given year Use of GDP makes our accounts more compatible Use of GDP makes our accounts more compatible

with other nations and more consistent with with other nations and more consistent with employment, production, and capacity measuresemployment, production, and capacity measures

GDP does not include products made by GDP does not include products made by US firms in foreign countries US firms in foreign countries but GNP did include such productsbut GNP did include such products

3636

Government Policy, Real Growth, Government Policy, Real Growth, and Inflation: Real GDPand Inflation: Real GDP

Real Gross Domestic Product reflects Real Gross Domestic Product reflects the value of GDP in constant dollarsthe value of GDP in constant dollars• Eliminates the distortions of inflation Eliminates the distortions of inflation

from GDP by deflating dollar GDP by use from GDP by deflating dollar GDP by use of the “GDP Price Deflator” – a broader of the “GDP Price Deflator” – a broader measure than the Consumer Price Indexmeasure than the Consumer Price Index

• Measures output in physical termsMeasures output in physical terms Changes in Real GDP tend to be Changes in Real GDP tend to be

inversely related to the rate of inversely related to the rate of inflationinflation

3737

Government Policy, Real Growth, Government Policy, Real Growth, and Inflation: Components of GDPand Inflation: Components of GDP

To understand the influence of major To understand the influence of major sectors in the economy, GDP is sectors in the economy, GDP is often divided into four basic areas:often divided into four basic areas:

1.1. Personal consumption expendituresPersonal consumption expenditures2.2. Government purchasesGovernment purchases3.3. Gross private investment, and Gross private investment, and 4.4. Net exportsNet exports

3838

Government Policy, Real Growth, Government Policy, Real Growth, and Inflation: Consumer Spendingand Inflation: Consumer Spending

Consumer spending has grown faster Consumer spending has grown faster than other sectors over the last four than other sectors over the last four decades, is driving force behind decades, is driving force behind economic growtheconomic growth

Consumer spending in now more than 60 Consumer spending in now more than 60 percent of GDP in the United Statespercent of GDP in the United States

Economic forecasters pay close attention Economic forecasters pay close attention to the mood of the consumer as a resultto the mood of the consumer as a result

University of Michigan surveys consumer University of Michigan surveys consumer expectations monthly and reports on expectations monthly and reports on their state of optimismtheir state of optimism

3939

Government Policy, Real Growth, Government Policy, Real Growth, and Inflation: Consumer Spendingand Inflation: Consumer Spending

Consumer expectations are a leading Consumer expectations are a leading indicator of economic activity:indicator of economic activity:

When consumer confidence When consumer confidence increases,increases, spending tends to spending tends to increaseincrease

When consumer confidence wanes,When consumer confidence wanes, spending tends to contractspending tends to contract

Consumer expectations tend to Consumer expectations tend to change before recessionary and change before recessionary and expansionary periodsexpansionary periods

4040

Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators

The economy expands and contracts The economy expands and contracts over the business cycleover the business cycle

GDP and other economic data is GDP and other economic data is useful for tracking the changes over useful for tracking the changes over the cyclethe cycle

The National Bureau of Economic The National Bureau of Economic Research (NBER) is the final Research (NBER) is the final authority in documenting cyclical authority in documenting cyclical turning pointsturning points

4141


The NBER defines a The NBER defines a recessionrecession as as

a significant decline in economic a significant decline in economic activityactivity

spread across the economy,spread across the economy,

lasting more than a few months,lasting more than a few months,

and normally visible in real GDP,and normally visible in real GDP,

employment, industrial production,employment, industrial production,

and wholesale-retail salesand wholesale-retail sales

4242


Economic cycles have existed and been Economic cycles have existed and been observed for more than 150 yearsobserved for more than 150 years

Troughs Troughs represent the end of a recession represent the end of a recession and the beginning of an expansionand the beginning of an expansion

PeaksPeaks represent the end of an expansion represent the end of an expansion and the beginning of a recessionand the beginning of a recession

During eight peacetime cycles from 1945 During eight peacetime cycles from 1945 and 2001, contractions lasted an average and 2001, contractions lasted an average of 10 months and expansions 52 months of 10 months and expansions 52 months for an average complete business cycle for an average complete business cycle during modern peacetime of five and one-during modern peacetime of five and one-quarter yearsquarter years

4343


Predicting business cycles is easier said Predicting business cycles is easier said than done: than done:

No two cycles are alikeNo two cycles are alike Some are related to monetary policy, Some are related to monetary policy,

others to demand, and some are others to demand, and some are inventory-inducedinventory-induced

Length and depth of cycles also varyLength and depth of cycles also vary Not all industries or segments of the Not all industries or segments of the

economy are equally affected by cycleseconomy are equally affected by cycles

4444


Forecasts of the turning points of the Forecasts of the turning points of the business cycle might enable one to business cycle might enable one to better choose investments to hold better choose investments to hold over its various phases over its various phases

Economic indicators may help to Economic indicators may help to evaluate the direction of the business evaluate the direction of the business cyclecycle

The NBER classifies indicators relative to The NBER classifies indicators relative to their performance at economic peaks their performance at economic peaks and troughsand troughs

4545


Leading indicatorsLeading indicators change direction in change direction in advance of general business conditionsadvance of general business conditions• Helps anticipate rising corporate profits and Helps anticipate rising corporate profits and

possible stock market price increasespossible stock market price increasesCoincident indicators Coincident indicators move approximately move approximately

with the overall economywith the overall economyLagging indicatorsLagging indicators usually change direction usually change direction

after business conditions have turned after business conditions have turned aroundaround

The Conference Board publishes The Conference Board publishes Business Business CycleCycle IndicatorsIndicators which also tabulates which also tabulates moving averages, turning dates, composite moving averages, turning dates, composite and diffusion indexes, and information on and diffusion indexes, and information on rates of changerates of change

4646


Composite indexes of indicators tend to Composite indexes of indicators tend to outperform the individual indicators outperform the individual indicators although this varies over time:although this varies over time:• The ten leading indicators seem to The ten leading indicators seem to

provide quite long notices before peaks provide quite long notices before peaks but very short warnings before troughsbut very short warnings before troughs

• Indicators sometimes give false signalsIndicators sometimes give false signals• And sometimes give no clear signalAnd sometimes give no clear signal

4747


Despite indicators and forecasting methods, Despite indicators and forecasting methods, investors cannot escape uncertainty in investors cannot escape uncertainty in managing their portfoliosmanaging their portfolios

The stock market itself is the most reliable The stock market itself is the most reliable and accurate of the leading indicators – and accurate of the leading indicators – creating a problem if your objective is to creating a problem if your objective is to forecast common stock prices – you are forecast common stock prices – you are constrained by the fact that the stock constrained by the fact that the stock market is anticipatory and works on a lead market is anticipatory and works on a lead time of about nine months at peaks and five time of about nine months at peaks and five months at troughsmonths at troughs

4848

Stock Prices and Economic Stock Prices and Economic VariablesVariables

Money SupplyMoney Supply Gross Domestic ProductGross Domestic Product Industry Production and Industry Production and

ManufacturingManufacturing

Three economic variables very helpful in forecasting stock prices are:

4949

Stock Prices and Economic VariablesStock Prices and Economic Variables

Historically popularHistorically popular Studies have found long-term relationships Studies have found long-term relationships

between economic growth and the money supplybetween economic growth and the money supply Monetarists believe that money explains much of Monetarists believe that money explains much of

economic behavior:economic behavior:• As the supply of money increases relative to demand, As the supply of money increases relative to demand,

people make adjustments in their portfolios of assetspeople make adjustments in their portfolios of assets• If people have too much money, they buy bonds and If people have too much money, they buy bonds and

short-term monetary assets, stocks, and, finally, real short-term monetary assets, stocks, and, finally, real assets. This direct effect of money on stock prices is assets. This direct effect of money on stock prices is sometimes referred to as the sometimes referred to as the liquidity effectliquidity effect

Money Supply

5050


There is a strong relationship There is a strong relationship between the level of economic between the level of economic activity measured by GDP and long-activity measured by GDP and long-run movements in the stock marketrun movements in the stock market

Gross Domestic Product

5151


Although manufacturing only accounts for Although manufacturing only accounts for about 20 percent of U.S. GDP and is about 20 percent of U.S. GDP and is declining in importance, it is still valuable declining in importance, it is still valuable and employs large numbers of peopleand employs large numbers of people

The Institute of Supply Management Index The Institute of Supply Management Index (ISM) indicates the expansion and (ISM) indicates the expansion and contraction of manufacturingcontraction of manufacturing• When the ISM index is above 50, When the ISM index is above 50,

manufacturing is expanding; manufacturing is expanding; when below 50, contractingwhen below 50, contracting

Industrial Production and Manufacturing

5252


In deciding the last recession in 2001,In deciding the last recession in 2001,the NBER gave significant weight to the the NBER gave significant weight to the continuous decline in manufacturing from continuous decline in manufacturing from late 1997 though 2001 before it reversedlate 1997 though 2001 before it reversed

Measures of output per hour and capacity Measures of output per hour and capacity utilization help analysts forecast inflation utilization help analysts forecast inflation and interest ratesand interest rates

Rising worker productivity from corporate Rising worker productivity from corporate investment in technology reduces the cost investment in technology reduces the cost of production, constrains prices of of production, constrains prices of manufactured products, and keeps the manufactured products, and keeps the U.S. competitiveU.S. competitive


5353


Capacity UtilizationCapacity Utilization When capacity utilization is low, companies When capacity utilization is low, companies

use their most efficient and productive use their most efficient and productive plant and equipmentplant and equipment

As capacity utilization grows, firms employ As capacity utilization grows, firms employ less efficient plant and equipment, reducing less efficient plant and equipment, reducing profit margins and encouraging price risesprofit margins and encouraging price rises

Thus excess capacity, price competition Thus excess capacity, price competition domestically and from abroad, and domestically and from abroad, and increased worker productivity, suggest increased worker productivity, suggest lower inflation fearslower inflation fears


5454

Business Cycles and Industry Business Cycles and Industry RelationshipsRelationships

Each industry may be affected by the Each industry may be affected by the business cycle differentlybusiness cycle differently

Industries with an underlying consumer-Industries with an underlying consumer-oriented demand will tend to be sensitive oriented demand will tend to be sensitive to short-term business cycle swingsto short-term business cycle swings

Thus industries producing durable goods Thus industries producing durable goods such as washers and dryers, refrigerators, such as washers and dryers, refrigerators, stoves, and automobiles as well as their stoves, and automobiles as well as their suppliers will feel the brunt of spending suppliers will feel the brunt of spending shiftsshifts

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Necessity-oriented companies such as Necessity-oriented companies such as food and pharmaceuticals tend to be food and pharmaceuticals tend to be consist performers since people have to consist performers since people have to eat and illness is not deeply dependent on eat and illness is not deeply dependent on the economythe economy

Industries with low-price-elastic products Industries with low-price-elastic products that are habitual in nature such as that are habitual in nature such as cigarettes and alcohol also are not very cigarettes and alcohol also are not very much affected by the business cyclemuch affected by the business cycle

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Some industries prosper during recessionsSome industries prosper during recessions The movie industry traditionally prospered The movie industry traditionally prospered

during recessions although competition during recessions although competition from convenient use of cable TV, VCRs, from convenient use of cable TV, VCRs, and DVDs may change that relationshipand DVDs may change that relationship

Housing has traditionally done well during Housing has traditionally done well during recessions as interest rates fall and more recessions as interest rates fall and more prospective home buyers can afford prospective home buyers can afford mortgagesmortgages

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Sensitivity to business cycles may also be Sensitivity to business cycles may also be seen in industries producing capital goodsseen in industries producing capital goods

Although many service-oriented industries Although many service-oriented industries are less prone to business cycle fluctuations, are less prone to business cycle fluctuations, some such as architects, civil engineers, and some such as architects, civil engineers, and auto repair shops are very cyclically sensitiveauto repair shops are very cyclically sensitive

Cyclical industries may sometimes be good Cyclical industries may sometimes be good investments because the market does not investments because the market does not look far ahead to see recoveries and their look far ahead to see recoveries and their impact on cyclical profitsimpact on cyclical profits

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Federal Government Economic Federal Government Economic PolicyPolicy

1.1. Stable prices (a low inflation rate).Stable prices (a low inflation rate).2.2. Business stability at high levels of Business stability at high levels of

production (low levels of unemployment).production (low levels of unemployment).3.3. Sustained real growth in gross domestic Sustained real growth in gross domestic

product (actual economic growth after product (actual economic growth after deduction inflation).deduction inflation).

4.4. A balance in international payments A balance in international payments (primarily a balance of exports and (primarily a balance of exports and imports but also including cash flows in imports but also including cash flows in and out of the U.S.).and out of the U.S.).

www.www.ibmibm.com.com www.att.comwww.att.com

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U.S. Business Cycle Expansions and U.S. Business Cycle Expansions and ContractionsContractions

www.nber.comwww.nber.com

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Technology CompaniesTechnology Companies

www.microsoft.comwww.microsoft.com www.intel.comwww.intel.com www.cisco.comwww.cisco.com

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WEBSITE COMMENTSwww.economy.com Provides access to economic

data—some sources are fee based.

http://finance.yahoo.com/ Provides info about companies, markets, and the economy. Permits tracking individual portfolios

www.dismal.com Contains articles on economies and tracks info from U.S. and global sources.

www.fedstats.gov Has links to economic data.

www.freelunch.com Has links to other economic sites, has listings of economic reports and news events, and provides access to economic data.

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WEBSITE COMMENTS

www.bea.doc.gov Provides links to sources of U.S. government economic data.

www.ny.frb.org Contains links to New York Federal Reserve Bank analysis and data.

www.stls.frb.org/fred Contains historic interest rate, bond and economical data– site is free

www.mworld.com Provides industry and economic data as well as data on money flows into stock funds.

www.bos.frb.org Home page of the Federal Reserve of Boston Providing economic info.

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WEBSITE COMMENTS

www.ita.doc.gov Provides access to U.S. government reports in international trade with reports being fee-based.

www.fool.com Personal finance website from the “Motley Fools”

www.smartmoney.com Has info and news about U.S. economy.

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SummarySummary

The valuation process for investment is The valuation process for investment is based on fundamental analysis of the based on fundamental analysis of the economy, industry, and companyeconomy, industry, and company

This method assumes decisions are based This method assumes decisions are based on economic concepts of value over the on economic concepts of value over the long-term trend of the stock marketlong-term trend of the stock market

The purpose of this analysis is to eliminate The purpose of this analysis is to eliminate losers and focus on sound investments for losers and focus on sound investments for your portfolioyour portfolio

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SummarySummary

First step in the valuation process is an First step in the valuation process is an analysis of the economy and long-term analysis of the economy and long-term economic trendseconomic trends

Difficulties in attaining government policy Difficulties in attaining government policy goals arise from trade-offs between goals arise from trade-offs between conflicting objectivesconflicting objectives

Monetary and fiscal policy tools attempt to Monetary and fiscal policy tools attempt to stimulate sustainable economic activity stimulate sustainable economic activity without inciting inflationary pressureswithout inciting inflationary pressures

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SummarySummary

Nominal interest rates are influenced Nominal interest rates are influenced by inflationary expectations resulting by inflationary expectations resulting in higher required rates of return for in higher required rates of return for the investorthe investor

Business cycles are short-term Business cycles are short-term swings in economic activity that swings in economic activity that affect stock prices because they affect stock prices because they change investor expectations of risk change investor expectations of risk and returnand return

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SummarySummary Leading, lagging, and coincident cyclical Leading, lagging, and coincident cyclical

indicators help to forecast economic activityindicators help to forecast economic activity One index potentially most helpful to an One index potentially most helpful to an

investor is the composite index of 10 leading investor is the composite index of 10 leading indicators.indicators.

The sensitivity of various industries to the The sensitivity of various industries to the business cycle is an important investment business cycle is an important investment concern: firms in consumer durable goods as concern: firms in consumer durable goods as well as capital goods manufacturing are well as capital goods manufacturing are perhaps the most vulnerable to the business perhaps the most vulnerable to the business cyclecycle

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