1

NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-7

Session-14

Economic Analysis – II

Outline • Economic Indicators • Economic Forecasting • Cyclical Indicator Approach • Diffusion Indices • Monetary Variables and Securities Prices

This session is a continuation of previous session on Economic Analysis. In the previous session, we have discussed the importance of economic analysis as part of fundamental analysis. We also discussed the demand and supply shocks that affect the economy, thus affecting the stocks of companies. The other tools and techniques involved in economic analysis are discussed in this session.

Economic Indicators

Economic environment goes through different stages or phases. These sequential stages together are known as business cycle. The business cycle can be explained as a pattern of changing economic output and growth: an initial period of rapid growth followed by a period of slow growth or even stagnation after which the economy contracts (Mayo, 2006). Figure 14.1 shows a typical business cycle. The peak is the end of expansion and trough occurs at the bottom of recession.

Figure 14.1: Business Cycle

2

Different industries show varied performance as the economy moves from one stage to another stage. Cyclical industries like producers of capital goods takes the hit when economy goes through slow down but outperform other industries during expansion. Defensive industries like food producers and pharmaceutical firms are less sensitive to business cycle and do better compared to other industries during recession.

Cyclical Indicators: Because of cyclical nature of the business cycle, the different phases of business cycle can be predicted. The Conference Board provides a set of cyclical indicators that helps forecast, measure and interpret short-term fluctuations in economic activity. The Conference Board is a worldwide, not-for-profit and nonpartisan business membership organization that provides timely research on management practices and economic trends. The cyclical indicators are classified as below:

• Leading Indicators: Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity.

• Coincidence Indicators: Economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle.

• Lagging Indicators: Economic series that experience their peaks and troughs after those of the aggregate economy.

Different list of indicators for the above three types are given in the Table 14.1

Table 14.1: List of Cyclical Indicators

Leading Indicators Coincidence Indicators Average weekly hours, manufacturing Employees on nonagricultural payrolls Average weekly initial claims for unemployment insurance

Personal income less transfer payments

Manufacturers’ new orders, consumer goods and materials

Index of industrial production

Vendor performance, slower deliveries diffusion index Manufacturing and trade sales Manufacturers’ new orders, nondefense capital goods Lagging Indicators Building permits, new private housing units Average duration of unemployment Stock prices, 500 common stocks Inventories to sales ratio, manufacturing and trade Money supply, M2 Change in labor cost per unit of output, manufacturing

(%) Interest rate spread, 10-year Treasury bonds less Federal funds (%)

Average prime rate charged by banks (%)

Index of consumer expectations Commercial and industrial loans outstanding Consumer installment credit outstanding to personal

income ratio Change in consumer price index for services (%)

Source: Business Cycle Indicators Handbook, The Conference Board (www.conference-board.org/data/bci.cfm accessed on 07 December, 2012)

Trend in few Leading Indicators with reference to Indian Market: Select charts of cyclical indicators in Indian context are given below.

3

Figure 14.2: Leading Indicators

Figure 14.3: Coincidence Indicator

Figure 14.3: Lagging Indicator

4

Analysts are expected to look at trends in individual indicators in a particular category [leading, lagging or coincidence] and a composite time series that combines the indicators in terms of an index for a particular category. This would indicate the overall trend in economic condition.

Analyzing the Indicators: One simple way of analyzing the economic indicators is to find out the rate of change over previous period. While a positive rate of change indicates a growth, one has to look for the trend in such rate of change i.e. increasing or decreasing. The rate of change reaches peaks before the just before the peak in the series itself. Another important tool is to find out the diffusion index. It is a measure of how widespread a phenomenon and is based on the trends, direction of change, rate of change and comparison of previous business cycles. One can set of a diffusion index of leading indicators by counting the number of indicators that rise during a particular period and expressing it as a percentage of total. This can indicate the probable length of a particular phenomenon in the economy. The movements of individual series during the current business cycle can be compared with that in the previous cycles.

Monetary variables, Inflation and Securities Market: Rsearchers have found close relationship between security prices and monetary variables that are dictated by monetary policy of a country. The monetary policy instruments affect money supply, interest rates, inflation etc. among other things. The central banks engage in open market operations like buying and selling government securities and control liquidity in market. This can lead to change in interest rates thus affecting the prices of debt instruments like bonds and in turn stock prices. Hence it is imperative to forecast the growth in money supply as an important task while forecasting the stock prices. There is also a strong relationship between inflation and interest rates. An anticipated increase in inflation rate can lead to rise in expected rate of return for investors. This in turn leads to decrease in bond prices. But the relationship between inflation and stock prices is not direct. It all depends upon how the cash flows of the companies are affected by inflation.

Financial Conditions Index: Goldman Sachs has created a composite financial condsiotns series (the Goldman Sachs Financial Conditions Index – GSFCI) that can show the overall trend in financial market. This index consists of four variables with respective weights as below: Real three-month LIBOR (0.35) Real A-rated corporate bond yield (0.55) Real Goldman Sachs Trade-Weighted Dollar Index (0.05) The equity market capitalization / GDP ratio (0.05)

An increase in GSFCI reflects a tightening of the monetary environment. Goldman Sachs has also designed a Financial Conditions Index for India (GS India FCI) with following variables and respective weights: interest rates (0.55) money supply (0.29) exchange rate (0.125) stock market (0.035).

5

References:

Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi Mayo, Herbert B. (2009), An Introduction to Investments, 1/e, Cengage Learing Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage) Learning, New Delhi Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New Delhi

Source of Data: Database on Indian Economy: RBI's Data Warehouse, Reserve Bank of India (http://dbie.rbi.org.in/ )

6

Questions and Answers

Q.1: What is diffusion index?

Ans.: It is a measure of how widespread a phenomenon. It is based on the trends, direction of change, rate of change and comparison of previous business cycles. One can set of a diffusion index of leading indicators by counting the number of indicators that rise during a particular period and expressing it as a percentage of total.

Q.2: State the different types of interrelationship among inflation, interest rates and security prices.

Ans.:

• Inflation and interest rates generally move together. • Interest rates and bond prices are inversely related. • There is no direct and consistent relationship between interest rates and stock prices. It varies

over period of time.

Q.3: What is a yield curve? What can one infer about the economy by looking at the yield curve?

Ans.: Yield curve shows relationship between market yields and time to maturity, holding all other characteristics, like credit risk, constant. Upward sloping and steepening curve implies accelerating economic activity whereas flat structure implies a slowing economy. Inverted curve may imply a recession.

Q.4: What is financial conditions index (FCI). Given an example of FCI and its components. Ans.: A financial conditions index (FCI) summarizes the information about the future state of the economy contained in these current financial variables. Ideally, an FCI should measure financial shocks – exogenous shifts in financial conditions that influence or otherwise predict future economic activity. One of the example of FCI is: Financial Conditions Index for India (Goldman Sachs: (GS India FCI). The components and the respective weights of the same are:

• interest rates (0.55) • money supply (0.29) • exchange rate (0.125) • stock market (0.035).

Q.5: State the macroeconomic variables that can be considered as determinants of stock prices. Ans.: Some of the macroeconomic variables as determinants of stock prices are:

• Potential output of economy o Productivity, resources, investment opportunities

• Corporate tax rate • Government spending • Nominal money supply