1 chapter five economic activity mcgraw-hill/irwin © 2006 the mcgraw-hill companies, inc., all...
TRANSCRIPT
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
Federal Government Economic PolicyFederal Government Economic Policy
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
Federal Government Economic PolicyFederal Government Economic Policy
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
Federal Government Economic PolicyFederal Government Economic Policy
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
Government’s taxing and spending policies
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
Fiscal Policy Cont’dFiscal Policy Cont’d
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
Government’s taxing and spending policies
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
Government’s taxing and spending policies
2020
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
Government’s taxing and spending policies
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
Monetary Policy Cont’dMonetary Policy Cont’d
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
Monetary Policy Cont’dMonetary Policy Cont’d
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
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
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
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
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
2929
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
MonetaryTools
Policy Actions
To Raise Interest Rates To Lower Interest Rates
Open Market Operations
NY Fed BankSells Securities
NY Fed BankBuys Securities
Lowers pricesof securities
Raises pricesof securities
RaisesInterest Rates
LowersInterest Rates
Takes MoneyOut of Economy
Puts MoneyInto Economy
3030
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
MonetaryTools
Policy Actions
To Raise Interest Rates To Lower Interest Rates
Open Market Operations
NY Fed BankSells Securities
NY Fed BankBuys Securities
Price of Bonds
Quantity of Bonds
Supply0
Demand
P0
Supply1
P1
Lowers pricesof securities
3131
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
MonetaryTools
Policy Actions
To Raise Interest Rates To Lower Interest Rates
Open Market Operations
NY Fed BankSells Securities
NY Fed BankBuys Securities
Lowers pricesof securities
Interest Rates
Loanable Funds
Supply0
Demand
I0
Supply1
I1
RaisesInterest Rates
3232
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
MonetaryTools
Policy Actions
To Raise Interest Rates To Lower Interest Rates
Open Market Operations
NY Fed BankSells Securities
NY Fed BankBuys Securities
Lowers pricesof securities
Price of Bonds
Quantity of Bonds
Supply
Demand0
P0 Demand1
P1 RaisesInterest Rates
Raises PricesOf Securities
3333
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
MonetaryTools
Policy Actions
To Raise Interest Rates To Lower Interest Rates
Open Market Operations
NY Fed BankSells Securities
NY Fed BankBuys Securities
LowersInterest Rates
Interest Rates
Loanable Funds
Supply0
Demand
I0
Supply1
I1
Raises Pricesof Securities
Lowers pricesof securities
RaisesInterest Rates
3434
Economic Policy Goals and Monetary PolicyEconomic Policy Goals and Monetary Policy
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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
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Stock Prices and Economic VariablesStock Prices and Economic Variables
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
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Stock Prices and Economic VariablesStock Prices and Economic Variables
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
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Stock Prices and Economic VariablesStock Prices and Economic Variables
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
Industrial Production and Manufacturing
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Stock Prices and Economic VariablesStock Prices and Economic Variables
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
Industrial Production and Manufacturing
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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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Business Cycles and Industry Business Cycles and Industry RelationshipsRelationships
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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Business Cycles and Industry Business Cycles and Industry RelationshipsRelationships
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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Business Cycles and Industry Business Cycles and Industry RelationshipsRelationships
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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Business Cycles and Cyclical Business Cycles and Cyclical IndicatorsIndicators
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