Chapter 19Global Economic Activity

and Industry Analysis

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Top Down Analysis, I.

• Some money managers use a “bottoms-up” approach to select securities. This approach does not use:―perceived economic cycles ―industry specific information.

• The more common style is called “top-down” analysis.―Money managers take a “big picture” perspective of the global economy.―With the big picture in view, the manager then filters and sorts potential

investments into smaller and smaller groups.

• This process is like a funnel: ―All possible investments go in at the top. ―Based on economic, industry, and company analyses, the money manager

identifies the best potential investments.

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Top Down Analysis, II.

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Three-Step Valuation Approach1. General economic outlook

―First examine the influence of the general economy on all firms and the security markets

―Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash

2. Industry outlook―Determine which industries will prosper and which industries will suffer on a

global basis and within countries ―analyze the prospects for various global industries with the best outlooks in

this economic environment3. Company analysis

―turn to the analysis of individual firms in the preferred industries and to the common stock of these firms.

―Determine which companies in the selected industries will prosper and which stocks are undervalued

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Does the Three-Step Process Work?•Stock prices are heavily influenced by the state of the

economy and by economic events on both a global and domestic basis.―Studies indicate that most changes in an individual firm’s

earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry

―Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production

―Most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry

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Investment Strategies

• Market timing. Should you try to buy and sell in anticipation of the future direction of the market?

• Asset allocation. How should you distribute your investment funds across the different classes of assets? ―For example, it is a decision of allocating your money into stocks, fixed

income securities, and cash.

• Security selection. Within each class, which specific securities should you buy?

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Asset Allocation or Security Selection?• Is asset allocation or security selection more important to the success of a portfolio?

• Most people are inclined to think security selection is the more important element for successful investing.

• Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest:― About 90 percent of portfolio performance stems from asset allocation.― So, 10 percent of portfolio performance comes from security selection.

• How is this result possible? Well, consider the Crash of 2008. ― Bonds outperformed stocks in 2008― Even those elusive “skilled stock pickers” might underperform bonds

o Stocks tend to move togethero Even a “skilled stock picker” would have trouble beating bonds if most stock prices are

performing poorly relative to bond prices

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Why Asset AllocationHistorical Returns of Various Asset Classes

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What is Security Analysis?

• “The process of gathering information, organizing it into a logical framework, and then using it to determine the intrinsic value of a share of common stock.”

•Two different approaches―Fundamental analysis―Technical analysis

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Security Analysis• Fundamental analysis is a term for studying a company’s

accounting statements and other financial and economic information to estimate the economic value of a company’s stock.―The basic idea: to identify both “undervalued” or “cheap” stocks to buy and

“overvalued” or “rich” stocks to sell.

• Technical Analysis (“Chartists”): Many investors try to predict future stock price movements based on investor sentiment, errors in judgment, and/or historical prices.―Technical analysis differs significantly from fundamental analysis. ―Unlike fundamental analysis, technical analysis does not rely on traditional

stock valuation techniques.―Technical analysis attempts to exploit recurring and predictable patterns in

stock prices and search for bullish (positive) and bearish (negative) signals about stock prices or market direction.

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THE GLOBAL and DOMESTIC ECONOMY

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Global Macroeconomic Activity, I.• An important measure of economic health is gross domestic product, GDP.

• GDP is the market value of goods and services produced over a time period.

• GDP is an indicator, or measure, of the standard of living for people in a country.

• The next slide has a figure that illustrates this important relationship.

• This figure plots the GDP and corresponding market capitalization of the 15 leading economies in the world, as of mid-2012.

• What is the relationship between GDP and market values? ― They seem to be significantly correlated.― Countries with the highest GDP also have the highest equity market valuations. ― The correlation value is .97—almost perfectly positive.

• So, investors wanting to allocate capital across countries should consider using GDP growth in their decisions.

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GDP versus Market Capitalization

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Global Economic Performance, 2006

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Key Economic Factors that Affect the Business Cycle

• Gross Domestic Product (GDP): Generally, as GDP goes the economy goes

• Industrial Production: Generally, as production goes the economy goes• Government Fiscal Policy

― Taxes― Government spending

• Monetary Policy― Money supply― Interest rates

• Other Factors― Inflation― Consumer spending― Business investments― Foreign trade― Currency exchange rates

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Key Economic Factors :Economic Variables and the Stock Market

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Key Economic Factors:The S&P 500, GDP, and Corporate Profits

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Key Economic Factors :Consumer Expectations,

by University of Michigan Surveys

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Key Economic Factors:Demand Shocks

•Demand―An event that affects the demand for goods and services in the

economyo Reduction in tax rateso Increases in the money supply o Increases in government spendingo Increases in foreign export demand

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Key Economic Factors:Supply Shocks

•Supply―An event that influences production capacity and production

costso Changes in the price of imported oilo Commodity price changes o Floods, Droughtso Changes in the wage rateso Educational level of economic participants

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Economic Indicators, I.• Astute investors must be able to identify the economic indicators

that help them make accurate forecasts of future economic conditions.

• Most economists rely on a group of leading economic indicators for this information.

• There are two other groups of indicators used to gauge economic activity: lagging indicators and coincident (i.e., simultaneous) indicators.

• The next slide contains a list of the major economic indicators within each of these three groups.

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Leading, Coincident, and LaggingEconomic Indicators

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Economic Indicators, II.

• Leading Indicators - tend to rise and fall in advance of the economy

•Examples―Avg. weekly hours of production workers―Stock Prices ―Initial claims for unemployment―Manufacturer’s new orders―Stock market indexes

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Economic Indicators, III.

• Stock Market as a Leading Indicatoro Stock prices reflect expectations of earnings, dividends, and interest rateso Stock market reacts to various leading indicator serieso Stock prices consistently turn before the economy doeso Stock prices usually change before the actual forecasted changes become apparent in the

economyo Stock price trends are another leading indicator often used to help predict the direction

of the economy itself

• You might be surprised by item seven in the list of leading economic indicators: stock prices, 500 common stocks. ― Investors attempt to use economic information to help decide when and where to invest.― One of the most accurate indicators, however, is the stock market itself. ― This accuracy is consistent with the general thought that the stock market does not

reflect current conditions. ― Rather, the stock market is typically looking about six months ahead.

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Leading Indicator:S&P 500 Index

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Economic Indicators, IV.

•Coincident Indicators - indicators that tend to change directly with the economy

•Examples―Industrial production―Manufacturing and trade sales

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Economic Indicators, V.

• Lagging Indicators - indicators that tend to follow the lag economic performance

•Examples―Ratio of trade inventories to sales―Ratio of consumer installment credit outstanding to personal

income

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Indexes of Leading, Coincident, and Lagging Indicators

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Other Useful Economic Indicators

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Economic Calendar

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Key Economic Factors:The Effects of Exchange Rates on Global Investments, I.

• Suppose we have $10,000 to buy shares of a company listed on the Deutsche Borse, the German stock exchange. We need Euros to make this investment.

―At the beginning of the year the exchange rate is $1.39/€. ―The shares increase in value by 10 percent during the year. ―At the end of the year, we sell the shares and convert the euros into dollars

at a rate of $1.28/€.

• What is our net dollar return?―The asset itself had a positive return.―But, what about the impact of the exchange rate?

• As with any asset, we want to invest in currencies that are appreciating.

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The Effects of Exchange Rates on Global Investments, II.

• We held euros: Did they appreciate or depreciate relative to $US? ―At the beginning of the year, one euro could be converted into $1.39. ―At the end of the year, one euro could be converted into only $1.28. ―Thus, one euro is worth less in terms of U.S. dollars at the end of the year. ―This fact means that the euro has depreciated relative to the U.S. dollar.

• The euro depreciation means that the net return to the U.S. investor will not be ten percent.

• The asset return is reduced by the depreciation of the euro.

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Key Economic Factors:Labor Market Indicators

• Economists divide the nonmilitary working-age population into three groups: 1. Employed2. Unemployed (but seeking employment)3. Unemployed and not seeking employment.

• The labor force is defined as all nonmilitary working-age people who are employed or unemployed (but seeking employment).

• The unemployment rate is the percentage of the labor force that is unemployed but seeking employment.

• The labor force participation rate equals the labor force divided by the nonmilitary working-age population. ― For example, in early 2012 in the U.S., the labor force was about 154 million people. ― This number represents a labor force participation rate of 63.6 percent, because the working-age

population was about 242 million people. ― Of the labor force, about 8.6 percent were unemployed. ― The other 242 – 154 = 88 million people were not seeking employment.

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Key Economic Factors:The Consumer Price Index, I.

• The Consumer Price Index (CPI) is widely used to measure inflation.

• The CPI uses the average price of a fixed basket of goods and services.

• Inflation is the percentage change in the CPI from one period to the next. ― For example, suppose the CPI increases from 104.3 to 105.2 during the year― The inflation rate is 0.9 percent for that year [=(105.2 / 104.3)/104.3].

• Major parts of the CPI basket include housing, transportation, food, and beverages.

• Smaller parts include medical care, recreation, education, and apparel.

• Some economists focus on Core CPI, which excludes food and energy prices.

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The Consumer Price Index, II.

• On the next slide, you can see that there is a pronounced inverse relationship between inflation and Real GDP.

• This negative correlation means high inflation hurts real economic growth.

• This relation might be driven by the fact that high inflation leads to higher interest rates. ― Lenders will demand a higher interest rate to compensate for their loss in purchasing power. ― High interest rates tend to reduce the demand for loans—which, in turn, reduces economic

growth.

• A common rule of thumb on Wall Street is that the inflation rate plus the market price-to-earnings (P/E) ratio should be about 20.

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U.S. Real GDP Growth and CPI

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Key Economic Factors:Monetary Policy

• The money supply is important for the economy because it represents the “gas” for the economic “engine.”― Giving the economy more gas (i.e., more money) makes it go faster― Giving it too much money, however, can result in overheating (i.e., high inflation).

• The goal of responsible policy makers should be to keep the money supply growing at the pace to keep the economy moving forward at the desired rate.

• On the next slide, you can see the importance of money supply for investors.

• There is a positive relationship between money supply growth and stock prices .

• Note: There are various ways to measure the amount of money, or money supply, in an economy. ― The most basic measure of money supply is called M1, which includes currency and checking deposits. ― A broader money supply measure, M2, is M1 plus time deposits, savings accounts, and money markets.

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U.S. M2 and S&P 500 Index

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The Federal Reserve: The Central Bank of the United States

• A central bank is a “banker’s bank”—provides loans and holds deposits (for banks).

• The Fed regulates many U.S. banks and also monitors and changes the money supply.

• The Federal Reserve is theoretically an independent federal governmental agency.

• Goals of the Fed: keep inflation in check, generate full employment, moderate the business cycle, and help achieve long-term economic growth.

• To achieve its goals, the Fed has primarily relied on its ability to change interest rates.― The Fed has control over the discount rate, the interest rate the Fed charges its member banks on loans. ― The federal funds rate, which is the short-term rate at which banks lend to each other, generally changes with the

discount rate.

• Changes in the federal funds rate can even impact longer-term rates, like mortgage rates.

• All else equal, reducing the discount rate should stimulate demand for loans, which, in turn, spurs economic growth.

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Money Creation, I.

• The Fed has the ability to “pump” money directly into the financial system.

• To impact the money supply through the financial markets, the Fed conducts open market operations.

• To spur economic growth, the Fed buys Treasury bonds in the open market. ― Buying bonds puts money into the financial system― The Fed pays dollars to the bond sellers.

• To put the brakes on the economy, the Fed sells Treasury bonds in the open market.― Selling bonds takes money out of the financial system.― The Fed received dollars from the bond buyers.

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The Tools of Monetary Policy

• The reserve requirement:―changing commercial banks' reserves

• The discount rate:―changing the rate the Fed charges banks to borrow reserve

• The federal funds rate:―the rate banks charge each other for borrowing reserves―The Fed sets a target federal funds rate.

• Open market operations:―Fed buying and selling federal government securities by order of Federal Open

Market Committee (FOMC).―By far the most important tool of monetary policy

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The Tools of Monetary Policy

•Monetary Expansion―To expand the money supply, the Fed buys government securities.―The purchases reduce interest rates.―Paying for the securities puts reserves into the banking system.

•Monetary Contraction―To contract the money supply, the Fed sells government securities.―The sales increase interest rates.―Receiving payment for the securities removes reserves from the banking

system.

The Federal Funds Rate

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Key Economic Factors:Fiscal Policy, I.

• The level of Federal tax rates and spending is referred to as fiscal policy.

• Potentially, fiscal policy has significant impacts on the overall economy.

• For example, if the government wanted to spur investment:― it could reduce (or even eliminate) taxes on capital gains.― Or, the federal tax code could allow for a faster depreciation of capital spending by businesses—

which would also spur investment.

• Unlike citizens, the federal government is not forced to abide by, or even set, a restrictive budget.

• A “hot button” issue in recent years has been the fact that the federal government’s expenditures exceed tax revenues—the resulting shortfall is called the budget deficit.

• Over time, these budget deficits grow and increase the national debt, because excess spending must be paid for with borrowings.

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Country Debt, 2010

Note: This recent debt level in Spain has been viewed as burdensome for economic growth.

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2009 Economic Environment

•Recession•Fiscal stimulus•Historically low interest rates•Significant decline in stock prices•Large increases in liquidity and the money

supply

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Sources for Economic Outlook

•Wall Street Journal

•Barron’s

•Fortune, Business Week, Forbes

•Government Publications

•Brokerage firm/commercial bank reports

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INDUSTRY ANALYSIS

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Industry Analysis, Overview

• Economic information is helpful to investors when they are looking for areas of potential growth (or decline).

• While much of the discussion in previous sections focused on country level issues, economic information is also useful for analyzing industries.

• For example, in an attempt to help spur the economy, the federal government passed a stimulus bill (through fiscal policy).― Much of this new spending was supposed to go to capital improvements such as roads. ― As a result, many investors thought industrial firms would be big beneficiaries of this

spending because new equipment would be required.

• To learn how to evaluate sectors and firms within an industry, we turn our focus to the general process of sector and industry analysis.

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Industry Analysis

•Evaluate the competitive position of a particular industry in relation to other industries―Looking for new opportunities & growth potential

• Identify companies within the industry that look promising―Looking for strong market positions, pricing leadership,

economies of scale, etc.

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There are Many Ways to Define a Sector

• A good starting point is the list of ten basic sectors used by Standard and Poor’s, the creator of the S&P 500 Index.

• On the next slide, you can see a list of the ten sectors, along with their mid-2012 index weights. ― Some sectors are quite small (such as telecommunications and utilities).― Other sectors (such as financials and technology) are quite large.

• While these weights are not extremely volatile, they do change when some sectors do well relative to other sectors. ― In early 2007 financials comprised over 20 percent of the index weight. ― Financials were less than 15 percent of the index following the financial crisis and related Crash of

2008.

• Understanding the reasons behind these movements could give you an advantage, and maybe it gives you a way to weight your portfolio.

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Ten Sectors of S&P, April 2012

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Basic Sectors

• Information Technology―AAPL, MU, GOOG

• Telecommunication Services―T, VZ

• Industrials ―GE, CAT

• Consumer Discretionary―GPS, GM

• Basic Materials―MON, DOW

• Energy―XOM, VLO

• Consumer Staples―KO, PG

• Health Care―PFE, LLY, MRK, JNJ

• Utilities―DUK, FE

• Financials―WFC, JPM

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S&P 500 Heat Map

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Business Cycle

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Making Cyclical and Defensive Investment Decisions: Where will the Business Cycle go?

• Industries (and companies) have different sensitivities to the business cycle.

• Analysts often refer to cyclical or defensive industries or companies.

• Cyclical Sectors― Examples: industrials and materials ― have above-average sensitivity to the business cycle.

• A “cyclical” company is one that performs relatively better in a climate of strong growth.

• Defensive sectors― Examples: health care and consumer staples― Have relatively little sensitivity to the business cycle.

• A “defensive” company is one that performs relatively better in a climate of weak growth.

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Sector Rotation• Selecting Industries in line with the stage of the business cycle

Peak – natural resource firms Contraction – defensive firms Trough – equipment, transportation and construction firms Expanding – cyclical industries

• Another Example:―Falling interest rateso Housing, home building, lumber, household durable good stocks

―Rising interest rateso Food, pharmaceutical, beverage, tobacco stocks

―Rising inflationo Basic materials, energy stocks and commodities

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Industry Cyclicality• Discretionary goods (Jewelry sales) are more cyclical over time.

Staples (Grocery sales) are more stable over time.

• Factors affecting sensitivity of earnings to business cycles―Sensitivity of sales of the firm’s product to the business cycles: Foods vs.

Luxury goods―Operating leverage: Fixed vs. Variable cost―Financial leverage: Debt vs. Equity financing

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Rotational Investing, I.

• Macroeconomic trends and government actions can favor some industries more than others.

• Unsophisticated investors might believe that if the S&P 500 return is positive, then the returns for all sectors must be positive.

• It is possible for some sectors within the S&P 500 to have a negative return over a given period even if the entire index has a positive return.

• As a result, active investors will decide to enter and exit industries.

• The process of moving investment dollars from one industry to another is often referred to as rotational investing because investors “rotate” dollars out of some industries and into others.

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Rotational Investing, II.

• The next slide provides a snapshot of performance differences.

• As of April 23, 2012, look at the data for the last week (the column labeled “Net (%) 7”) ― The consumer staples sector had lost about 0.09 percent of its value― The energy sector was up about 0.85 percent.

• Other time periods provide different stories about relative performance.

• For example, look at the data over the last year (the column labeled “Net (%) 360”):― energy (-11.82%)― consumer staples (19.11%)

• So, did investors sector rotate over that past year?

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S&P 500 Sector Returns(as of 4/23/2012)

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Industry Stock Price Performance, 2006

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The Industry Life Cycle

• There are other factors that lead investors to rotate sectors.

• One particularly relevant factor the industry life cycle.

• The next slide shows that industries often follow this life cycle: ― Start-up― Consolidation― Maturity― Decline

• Each industry is different and the stages can vary in length.

• By understanding an industry life cycle, investors might be able to identify which companies are poised for higher growth and which ones are likely to fade away.

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The Industry Life Cycle

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Porter’s Five Forces Model of Competition

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Porter’s Five Forces, II.

The framework has five pieces.

1. Threat of new entrants: How easy is it for new firms to enter the market? ― High “barriers to entry” impacts how likely a firm retains market share. ― Morningstar refers to these barriers to entry as a company’s “economic moat.”

2. Bargaining power of buyers: How difficult is it for buyers to switch to another seller?― The easier it is to switch, the more pricing pressure on the seller.― This pressure affects how well a company can maintain its profit margin.

3. Bargaining power of suppliers: How easy is it for suppliers to raise prices?― The easier it is for suppliers to raise prices, the hard it is for the company to control costs.― This relative lack of control affects how well a company can maintain its profit margin.

4. Threat of substitute products: How easy is it for buyers to substitute another product?― This area is similar to new entrants, but it goes a step further. ― For example, if beef prices increase significantly, a consumer could switch to chicken. ― Thus, firms face competition from products outside their specific industry.

5. Intensity of rivalry. The above factors help rate competitive intensity within the industry. ― Investors can then identify which industries (and companies) they think are most likely to retain (or gain) market share.― Retaining (or gaining) market share is needed to grow profits (and increase the stock price).

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An Example: Airline Industry Analysis

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An Example of a Published

Industry Report

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Sources for Industry Outlook

•Trade publications

•Wall Street Journal

•Fortune, Business Week, Forbes

•Standard & Poor’s Industry Surveys

•Brokerage house reports

•Yahoo! Finance.com

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Data Sources: Industry Analysis

•Go to TxState Library Web Site•Go to Database•Under Database, find “Standard & Poor’s Net

Advantage”•Click on “Industries.”•Choose the industry you want to find S&P industry

analysis for recent quarter or year.

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Useful Internet Sites

• www.economist.com (for data on current economic conditions)• www.xe.com (exchange rates and a currency converter)• www.usdebtclock.org (for a running tab of US federal government debt)• finviz.com/map.ashx (to see the current heat map)• www.standardandpoors.com (learn about GICS under index resources)• www.morningstar.com/InvGlossary/economic_moat.aspx (check out the

economic moat rating)• jmdinvestments.blogspot.com (reference for the latest financial information)