Transcript Day 5 - 0121

Active Equity Portfolio Management:
Economic and Industry Analysis
01/21/09
Economic Analysis
• What are the basic fundamental
analysis strategies for constructing a
portfolio?
• Where does macroeconomic analysis fit
in?
• What are the characteristics and
phases of a business cycle?
2
Economic Analysis
• How can we use economic data
releases to assess where we are in the
business cycle?
• What represents a good indicator?
• What should we look for in the releases?
3
Industry Analysis
• Why do industry analysis?
• Revisiting the business cycle: What
industries do well at different phases of the
business cycle?
4
Fundamental Analysis Strategies
• Top-down approach:
• Identify which broad asset classes may do well in
the near future. This is referred to as asset class
rotation or tactical asset allocation.
• Identify sectors within these asset classes that
are expected to outperform. This is referred to as
a sector rotation strategy.
• Select securities within these asset classes.
• Bottom-up approach:
• Identify undervalued securities.
5
Economic Analysis
• There is a clear relationship between
actual and expected returns for assets
and economic activity.
• The stock market tends to turn before
the economy.
• For the purpose of developing CMEs,
economic analyses allow us to fine-tune
our asset class return expectations
6
Business cycles
• The business cycle can be defined in terms
of five phases: recession, initial recovery,
early upswing, late upswing, and slowdown.
• We may not see every phase in each cycle.
• The business cycle represents fluctuations
in GDP in relation to long-term trend
growth.
7
Business cycles
• Recession
• A recession is defined as two consecutive
quarterly declines in GDP.
• During this phase, there is a large decline
in inventories and business investment.
• Duration: few months to a year
• Confidence: Weak
• Short term interest rates drop during this
phase.
8
Business cycles
• Recession
• Capital market effects:
• With a fall in interest rates, bond yields drop
as well.
• Stock markets bottom out and then tend to
rise towards the end of the recession and often
indicates an economic recovery.
• Inflation: Peaks during this phase.
9
Business cycles
• Initial recovery
• This is the phase during which the
economy picks up from a slowdown or
recession.
• Duration: Few months
• Confidence: Increasing for business, still
low for consumers (high unemployment)
• There may be interest rate decreases
during this period as the government
seeks to stimulate the economy
10
Business cycles
• Initial recovery
• Capital market effects:
• Decline in government bond yields anticipating
decline in inflation
• Stock markets rise strongly
• Riskier assets (small stocks, emerging market
equities) tend to perform the best
• Inflation: declining
11
Business cycles
• Early Upswing
• This phase is characterized by strong
economic growth without inflationary
pressures.
• Duration: a year to several years
• Confidence: Increasing and strong for
business, increasing for consumers (falling
unemployment)
• Short term interest rates slowly start to
increase.
12
Business cycles
• Early Upswing
• Capital market effects:
• Stabilization of longer term bond yields.
• Stock markets still trending up.
• Inflation: Remains low
13
Business cycles
• Late Upswing
• During this phase the economy is in
danger of over-heating. Inflation starts to
pick up.
• Duration: a year to several years
• Confidence: high among consumers and
businesses.
• Short term interest rates increase as the
government tries to reduce inflationary
pressures.
14
Business cycles
• Late Upswing
• The government tries to manage a “soft
landing” to ensure that economic growth
is slowed without a recession.
• Capital market effects:
• Bond yields tend to rise.
• Stock markets still moving up but tend to be
more volatile.
• Inflation: gradually picks up
15
Business cycles
• Slowdown
• During this phase, rising interest rates
slow the economy. Companies correct
inventory levels.
• Duration: few months to a year
• Confidence: Starts to decline for
consumers and businesses.
• Short term interest rates tend to peak
during this period.
16
Business cycles
• Slowdown
• Government continues to manage for a a
“soft landing”.
• Capital market effects:
• Yield curve often inverts
• Stock markets may fall with interest-sensitive
stocks performing the best (utilities and
financial services).
• Inflation: rising
17
Economic data
• There are at least 4 economic indicators
released each week.
• Attributes of a good indicator:
• Accuracy – is the survey sample large and
representative?
• Timeliness
• Predictive ability
18
Economic data: Employment
• Employment Situation (monthly)
• Based on household and establishment surveys.
• Unemployment rate is mainly useful at indicating
economic downturns
• What to look for:
• Changes in household employment
• Change in nonfarm employment (net of government)
• Hours worked (41.5 hours or better is a good sign)
19
Economic data: Employment
• Weekly Claims for Unemployment Insurance
(weekly)
• Tracks new filings for unemployment insurance
benefits.
• This measure can be erratic.
• What to look for:
• 4-week average of Initial claims (should be
below 400,000 to signal economic recovery)
20
Economic data: Consumer Spending and
Confidence
• Personal Income and Spending (monthly)
• Personal consumption expenditure represents
about 70% of GDP.
• What to look for:
• Changes in Disposable income chained dollars
• Changes in expenditures on durable goods
21
Economic data: Consumer Spending and
Confidence
• Retail sales (monthly)
•
•
•
•
•
First report of the month on consumer spending
Represents about 1/3 of consumer spending
Based on surveys of retailers
Tends to be volatile and often revised
Does not include service businesses
• What to look for:
• 3-month averages of changes in retail sales,
total adjusted for inflation
22
Economic data: Consumer Spending and
Confidence
• Survey of consumer sentiment (semimonthly)
• Near-time assessment of consumer attitudes on
business climate, personal finance and shopping.
• Considered to be a better real-time measure than
the consumer confidence index published by the
Conference Board.
• Based on surveys of 500 individuals by the
University of Michigan
• Tends to be predictive of consumer spending
especially on big-ticket items
23
Economic data: National Output and
Inventories
• GDP (quarterly)
• What to look for:
• % change in real GDP
• Normal growth tends to be in the 3-3.5% range
• Addenda: Final sales of domestic product (compared to
GDP growth)
• In the appendix: final sales of computers and motor
vehicle output
24
Economic data: National Output and
Inventories
• Advanced Report on Durable Goods Orders (monthly)
• A key indicator of future manufacturing activity
• Based on data provided by 3500 manufacturers
• Tends to foreshadow significant changes in economic activity
much sooner than other statistics.
• Revisions in this measure can be substantial.
• What to look for:
• Changes in new orders, total
• Changes in unfilled orders, total
25
Economic data: National Output and
Inventories
• Institute for Supply Management (ISM)
Manufacturing Survey (monthly)
• First monthly report on the economy with a focus on
manufacturing.
• Based on surveys of 400 member purchasing managers
• The PMI is calculated as an index value with 50 indicative of
normal economic growth (of about 2.5%)
• Every point in the index translates to about 0.3% points of
GDP growth.
• Probably one of the most valuable economic indicators.
• Overall PMI is broken down into categories including new
orders, employment and backlog of orders
26
Economic data: Housing and Construction
• Housing starts and building permits (monthly)
• Tends to be very good at foreseeing the future
direction of the economy.
• This is mainly due to its sensitivity to interest
rates.
• Based on a survey of builders.
• What to look for:
• Total housing units started should be between 1.5 to 2
million in a healthy economy.
• Building permits which tends to lead housing stars by
about 1-3 months.
27
Economic data: Prices and Productivity
• Consumer Price Index (monthly)
• This measure tends to be more relevant
than the PPI because it includes services.
• Determined by surveys of retail outlets and
other businesses.
• Tends to be a lagging indicator.
28
Economic data: Prices and Productivity
• Yield curve
• Represents the difference in yields between
long-term and short-term treasuries.
• The single best indicator of the future
course of the economy.
• An inverted yield curve has preceded each
of the recessions since 1960.
29
Economic data
• Index of leading economic indicators (monthly)
• The Conference Board calculates an index based on 10
leading indicators.
• It tends to be fairly good at indicating economic troughs.
• What to look for:
• The general rule is that three to four consecutive months of
increases (or decreases) signal an upturn (or downturn) in the
economy within three to nine months.
• The rule is more effective when more of the indicators move in
the same direction.
30
Economic Analysis: Monetary policy
• The government uses monetary policy as a
mechanism for intervention in the business
cycle.
• In general, interest rates are adjusted so
that inflation is controlled without inhibiting
economic growth.
31
Economic Analysis: Monetary policy
• The Taylor Rule provides one method of
predicting interest rate changes. The
following is an approximation of this rule:
Roptimal  Rneutral  [0.5 * (GDPg forecast  GDPgtrend )  0.5 * ( I forecast  I t arg et )]
32
Economic Analysis
• Evaluating factors that affect business cycle
• Monetary Policy
• Inputs to the Taylor rule:
• Roptimal = short-term interest rate target
• Rneutral = equilibrium interest rate (approximated at 4-5%
for the U.S.)
• GDPgforecast = current forecast real GDP growth rate
• GDPgtrend = observed GDP real growth rate = function of
increase in productivity and labor force participation
(around 2-3% for the U.S.)
• Iforecast = forecast inflation rate
• Itarget = target inflation rate (2% for the U.S.)
33
Why Do Industry Analysis?
• Cross-sectional industry performance
• There is a wide dispersion in rates of
return in different industries.
• Industry performance varies from year to
year.
34
Industry Selection Strategies
• We can determine which industries to
over/under-weight by recognizing
economic cycle phases and
understanding which industries
perform well in each phase.
35
The Business Cycle and Industry
Sectors
• Cyclical or Structural Changes
• Cyclical changes in the economy arise from the
ups and downs of the business cycle
• Structural changes occur when the economy
undergoes a major change in organization or how
it functions
• Rotation strategy is when one switches (or
over-/under-weights) from one industry
group to another over the course of a
business cycle
36
The Business Cycle and Industry
Sectors
• Defensive industries
• Future earnings are likely to withstand an
economic downturn
• Include Consumer staples (such as food
and beverages), Healthcare and Utilities
• Cyclical industries
• Sales rise and fall with general economic
activity
• Includes Consumer discretionary
37
Economic variables and different
sectors
• Inflation
• Tends to hurt the stock market in general
• Firms with high leverage (operating and financial)
might benefit from high inflation
• Natural resource industries might benefit from
inflation
38
Economic variables and different
sectors
• Interest rates
• Financial institutions are adversely impacted by
higher rates as are the housing and construction
industries.
• Consumer sentiment
• Consumer cyclical industries are affected by
changes in consumer sentiment and their ability
and willingness to borrow and spend
39
The Stock Market and
the Business Cycle
Basic
Industries
Excel
Consumer
Durables
Excel
Financial
Stocks Excel
trough
peak
Capital
Goods,
Technology
and Cyclicals
Excel
Consumer
Staples,
Utilities and
healthcare
Excel
40
Readings
• RM 2 (section 4.1, 4.5.2)
• RB 12 (pgs. 404 – 410)
• RB 13 (pgs. 460-66)
41