1. ECONOMIC ANALYSIS

3. Economic Analysis and Efficient Markets If markets are efficient, should we bother with analysis? If markets are efficient, should we bother with analysis? Yes! In fact, in an efficient market, likely the only way to outperform market averages is to forecast the future better than the consensus. Yes! In fact, in an efficient market, likely the only way to outperform market averages is to forecast the future better than the consensus. Two basic approaches to security analysis: Two basic approaches to security analysis: Emphasize history, looking for trends Emphasize history, looking for trends Focusing on the future Focusing on the future Still look at some historical information, but focus on looking forward to future trends Still look at some historical information, but focus on looking forward to future trends Top-down approach Top-down approach Bottom-up approach Bottom-up approach

4. General Approaches to Security Analysis Top-Down Approach (Our focus) Top-Down Approach (Our focus) 1. Review the macro-economy 2. Analyze different industries and sectors 3. Determine buy/sell candidates Bottom-up Approach Bottom-up Approach Focus primarily on the firm-specific factors that will lead to success, regardless of industry or macroeconomic factors Focus primarily on the firm-specific factors that will lead to success, regardless of industry or macroeconomic factors

5. A Three-Step Process Within the three-step process of the top-down approach, all steps are crucial Within the three-step process of the top-down approach, all steps are crucial General economic influences General economic influences Government policies strongly influence the economic environment, leading to profound effects on industries Government policies strongly influence the economic environment, leading to profound effects on industries Step 1: Market analysis Step 1: Market analysis We can see the influence of changes in the overall economy on various classes of investments We can see the influence of changes in the overall economy on various classes of investments Some investments do better than others before, during, and after recessions, for instance Some investments do better than others before, during, and after recessions, for instance Step 2: Industry Influences Step 2: Industry Influences We seek to determine which industries will likely do better than others in the expected economic environment We seek to determine which industries will likely do better than others in the expected economic environment Also, changing demographic factors have different effects across industries Also, changing demographic factors have different effects across industries Step 3: Company Analysis Step 3: Company Analysis Individual investments will either make or break portfolio performance Individual investments will either make or break portfolio performance Once well-positioned industries are determined, find well-positioned firms within those industries Once well-positioned industries are determined, find well-positioned firms within those industries

6. Academic support? There is academic support for this top-down approach There is academic support for this top-down approach Most changes in individual earnings related to changes in aggregate earnings and changes in a firm’s industry Most changes in individual earnings related to changes in aggregate earnings and changes in a firm’s industry There is a relationship between stock and bond prices and macroeconomic variables There is a relationship between stock and bond prices and macroeconomic variables Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry Value line puzzle Value line puzzle

7. Review of Economic Concepts Domestic Economic Activity Forecasting trends in major economic variables such as GDP, inflation, interest rates Forecasting trends in major economic variables such as GDP, inflation, interest rates GDP (Gross Domestic Product) components GDP (Gross Domestic Product) components Consumption spending Consumption spending Investment spending Investment spending Government expenditures Government expenditures Export and import activity Export and import activity Monetary policy: Policies of the Fed to control the money supply and thereby affect the overall economy Monetary policy: Policies of the Fed to control the money supply and thereby affect the overall economy  Open market operations  Discount rate changes  Reserve requirement changes Fiscal policy: Government taxing and spending policies to influence the economy and pursue other public interests Fiscal policy: Government taxing and spending policies to influence the economy and pursue other public interests

8. Real GDP  Consumption+Invest.+Govrn. Sp. + X-Inf. Purchasing Manager ’s Index Employment Industrial Production Capacity Car Sales Retail Sales Personal Income and expenditure Housing Starts Building permits Durable goods orders New home sales Construction spending Factory orders Business Inventory Public ConstructionMerchandise Trade Balance Producer PI Consumer PI

9. Short and Long Term Influences Influences on Long-term Expectations Influences on Long-term Expectations Technology Technology Population Population Labor force participation Labor force participation Productivity Productivity Resource availability Resource availability Incentives to expand Incentives to expand Influences on Short-term Expectations Influences on Short-term Expectations Influences caused by fluctuations in demand Influences caused by fluctuations in demand Liquidity and bank lending Liquidity and bank lending Monetary policy Monetary policy Inflation Inflation Interest rates Interest rates International influences International influences Consumer sentiment Consumer sentiment Tax and other fiscal policy Tax and other fiscal policy Economic “shocks” Economic “shocks”

10. Key Economic Measures GDP--Total value of the economy; published each quarter by the Commerce Department 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. 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 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. 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 Retail Sales--All sales at the retail level. Monthly issue by the Commerce Department. Gives an idea of consumer attitudes; a long slow down in sales can lead to cuts in production

11. Money Supply--Amount of money in circulation. Weekly report by the FED. Moderate growth of MS has a positive impact on the economy’s growth. A rapid growth or a sharp slowdown are synonymous to future inflation and future recession, respectively. 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. 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. Producer Prices--Changes in price of different goods at different stages of production (from raw materials to finished goods). Issued monthly by the Labor Department. Better measure of Inflation. Employment--% of workforce that is unvoluntarily out of work. Issued Monthly by the Labor Department. Employment--% of workforce that is unvoluntarily out of work. Issued Monthly by the Labor Department. Housing Starts--Includes the number of new building permits issued accross the country. Issued monthly by the Labor Department. A pickup in the pace of housing starts usually follows an easing of credit conditions, which is an indication of economic health. Early indicator of future economic health. Housing Starts--Includes the number of new building permits issued accross the country. Issued monthly by the Labor Department. A pickup in the pace of housing starts usually follows an easing of credit conditions, which is an indication of economic health. Early indicator of future economic health.

12. Economic Variables and the Stock Market Real growth in GDP-- positive impact Real growth in GDP-- positive impact Industrial Production-- Continued increase is a sign of strength for GDP, and therefore the market. 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 Inflation--Bad to stock: higher inflation leads to higher rates which leads to higher P/E which make stocks less attractive Corporate Profits--Strong profits are good (duhh!!!) Corporate Profits--Strong profits are good (duhh!!!) Unemployment--Bad guy: business activity is slowing down Unemployment--Bad guy: business activity is slowing down Federal Deficit--mixed: positive in a depressed economy; can lead to inflation in a stronger economy. 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 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. Interest rates--Bad; rising rates negative effect on stock markets as bond markets become more competitive. Money Supply-- Moderate growth of MS has a positive impact on the economy’s growth. A rapid growth or a sharp slowdown are synonimous to future inflation and future recession, respectively. Money Supply-- Moderate growth of MS has a positive impact on the economy’s growth. A rapid growth or a sharp slowdown are synonimous to future inflation and future recession, respectively.

13. Factors Affecting Interest Rates Change in Money supply--as it increase, rates go down; A rapid growth or a sharp slowdown are synonimous to future inflation and future recession, respectively. Change in Money supply--as it increase, rates go down; A rapid growth or a sharp slowdown are synonimous to future inflation and future recession, respectively. The size of the federal deficit--as it increases, demand for funds increases, interest rates increase. 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. 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. The FED--usually an increase in interest rates is used to fight inflation.

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

15. Cyclical Indicator 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. 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.Cyclical IndicatorCyclical Indicator Leading Indicators series lead changes in GDP (includes layoffs, new orders by factories, change in money supply, price of raw materials,…). 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. 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 Lagging Indicator Series includes series that experience their peaks and troughs after those of the aggregate economy

16. Leading Indicator Series PeaksTroughTurns 1.Average weekly hours of production workers (manufacturing) –2–3 2.Average weekly initial claims for unemployment insurance –5–1–3 3.Manufacturers’ new orders dollars, consumer goods, and materials –2 4.Contracts and orders for plant and equipment–5+1–2½ 5.Index of raw private housing units authorized by local building permits –9–6–7 6.Index of stock prices, 500 common stocks–4 7.Money supply–5–4–5 8.Vendor performance (percentage firms receiving slower deliveries) –3–4–3 9.Changes in sensitive materials, prices smoothed–4–8–5½ 10.Changes in business and consumer credit outstanding –4–6–5 11.Changes in manufacturing and trade inventories on hand and on order. –3–4–3

17. Coincident Indicator Series PeaksTroughsAll Turns 1.Employees on nonagricultural payrolls–200 2.Personal income less transfer payments0–1–½ 3.Index of industrial production–30–½ 4.Manufacturing and trade sales–30–½

18. Lagging Indicators PeakTrough Turns 1.Average duration of unemployment in weeks (inverted) +1+8+3½ 2.Ratio of manufacturing and trade inventories to sales +2+3 3.Average prime rate charged by banks+4+14+5 4.Commercial and industrial loans outstanding +2+5+4 5.Ratio of consumer installment credit outstanding to personal income +6+7 6Labor costs per unit of output in manufacturing, actual data as percentage of trend +4+14+5

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

20. Some analysts have used a ratio of these composite series, contending that the ratio of the composite coincident series divided by the composite lagging series acts like a leading series. Some analysts have used a ratio of these composite series, contending that the ratio of the composite coincident series divided by the composite lagging series acts like a leading series. The rationale for expecting this leading relationship is that the coincident series should turn before the lagging series, and the ratio between the two series will be quite sensitive to such changes. As a result, this ratio is expected to lead both of the individual component series, especially at turning points. The rationale for expecting this leading relationship is that the coincident series should turn before the lagging series, and the ratio between the two series will be quite sensitive to such changes. As a result, this ratio is expected to lead both of the individual component series, especially at turning points.

21. Example: Forecasting Tools Searching for leading indicators that will provide signals of future economic directions Searching for leading indicators that will provide signals of future economic directions Inflation Indicators Inflation Indicators Inflation at times is related to turning points in the business cycle Inflation at times is related to turning points in the business cycle Inflation destroys the purchasing power of wealth Inflation destroys the purchasing power of wealth Federal Reserve actions indicate likely trends in inflation Federal Reserve actions indicate likely trends in inflation Money supply and money growth rates relative to measures of economic growth Money supply and money growth rates relative to measures of economic growth Commodity prices Commodity prices

22. Example: Forecasting Tools Monetary Indicators Monetary Indicators Impact both inflation and liquidity Impact both inflation and liquidity Federal Reserve policy Federal Reserve policy Differences in Interest Rates Differences in Interest Rates The Treasury yield curve can sometimes give indications about future economic growth The Treasury yield curve can sometimes give indications about future economic growth Cyclical Economic Indicators Cyclical Economic Indicators Tracking “official” leading economic indicators Tracking “official” leading economic indicators

23. Risks in Economic Forecasting Dominated by “group think” Dominated by “group think” Always using consensus numbers ensures no better than average forecasts Always using consensus numbers ensures no better than average forecasts Forecasts must be different (often) and yet still correct (usually) to create value Forecasts must be different (often) and yet still correct (usually) to create value Many analysts are short-sighted Many analysts are short-sighted Lots of data can overwhelm us Lots of data can overwhelm us Try to support a position Try to support a position Over-reliance on expected “normal” changes without regard to the possibility of “shocks” Over-reliance on expected “normal” changes without regard to the possibility of “shocks”

24. The internet http://www.morganstanley.com http://www.globalinsight.com http://www.yardeni.com http://www.whitehouse.gov/fsbr/esbr.html http://www.federalreserve.gov http://www.worldbankorg http://www.phil.frb.org/econ/forecast/index.html http://www.spglobal.com/index.html http://www.bis.org/cbanks.htm http://www.bankamerica.com/ http://www.nabe.org http://www.conference-board.org http://www.bea.doc.gov/bea/pubs.htm http://www.stats.bls.gov http://www.cbo.gov http://www.whitehouse.gov/cea/ http://www.gpoaccess.gov/indicators/browse.html http://www.census.gov/csd/qfr http://www.federalreserve.gov/pubs/bulletin http://www.yahoo.com

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