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Economic and Industry Analysis


Title: Economic and Industry Analysis Author: Timothy R. Mayes, Ph.D Last modified by: Timothy R. Mayes, Ph.D. Created Date: 10/23/2001 3:41:35 AM – PowerPoint PPT presentation

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Title: Economic and Industry Analysis

Economic and Industry Analysis
  • Timothy R. Mayes, Ph.D.
  • FIN 3600 Chapter 11

Fundamental Analysis
  • Fundamental analysts look for companies whose
    financial health is good and getting better, and
    which are undervalued by the market
  • They scour financial reports, calculate ratios,
    compare to other similar companies, etc
  • Fundamental analysts believe that earnings drive
    stock prices at least in the long run
  • Fundamentalists tend to be buy and hold
    investors, as opposed to technicians who tend to
    be shorter-term traders

Top Down Analysis
  • Traditionally, fundamental analysts perform a
    top down analysis to determine which stocks to
    buy or sell.
  • The top down method consists of
  • A macro economic analysis
  • An industry analysis
  • A company analysis
  • In this chapter we will cover the first two.

Macro Economic Analysis
  • There is a strong linkage between growth in the
    overall economy and growth in company earnings
    (which drive stock prices, at least in the long
  • The following graph shows that changes in nominal
    GDP explain about 37 of the changes in corporate
    profits on average.
  • Obviously, then, to know where earnings (and thus
    stock prices) are going, we need to know where
    GDP is going.
  • A GDP forecast is our starting point. This
    forecast can be had from a number of sources
    including brokerage firm analysts, bank
    economists, and the WSJs semi-annual survey.

Earnings GDP
Data Source http// Data are
from Q1 1946 to Q2 2001
Example of Economic Forecast
  • This forecast, from The Conference Board as of
    January 3, 2007 is an example of the freely
    available forecasts that can be obtained.

Example of Economic Forecast (cont.)
What Your Forecast Should Include
  • Any macro economic forecast should include
    estimates of all of the important economic
    numbers, including
  • Real GDP growth
  • Inflation rates
  • Interest rates
  • Unemployment
  • And probably others, depending on your needs.

Types of Forecasts
  • There are two types of forecasts
  • Quantitative based on econometric models.
  • Qualitative based on educated guesses.
  • Qualitative forecasting is less difficult, and
    probably as good as quantitative forecasting.
  • Furthermore, we can blend the two methods.
  • There is another technique known as a
    barometric forecast which is an average of the
    forecasts by many others.

Forecasting for the Layperson
  • The most important thing to do is to watch for
    releases of various economic statistics by the
    government and private sources. These are widely
    reported by the financial media (WSJ, CNBC, etc).
  • Especially, keep an eye out for the Index of
    Leading Economic Indicators, The Consumer
    Confidence Index, the Feds Beige Book, comments
    by the chairman of the Board of Governors of the
    Federal Reserve, unemployment rates, monthly
    inflation indices, etc.

Defining Recession and Depression
  • An old saw is that a recession is when your
    neighbor loses his job, and a depression is when
    you lose yours.
  • A better definition (but not exactly correct) is
    that a recession occurs when real GDP declines
    for two consecutive quarters.
  • The NBER Business Cycling Dating Committee is the
    official arbiter of the timing of recessions.
    Its definition (from http//
    ml) is
  • The NBER does not define a recession in terms of
    two consecutive quarters of decline in real GNP.
    Rather, a recession is a period of significant
    decline in total output, income, employment, and
    trade, usually lasting from six months to a year,
    and marked by widespread contractions in many
    sectors of the economy.
  • A growth recession is a recurring period of slow
    growth in total output, income, employment, and
    trade, usually lasting a year or more. A growth
    recession may encompass a recession, in which
    case the slowdown usually begins before the
    recession starts, but ends at about the same
    time. Slowdowns also may occur without recession,
    in which case the economy continues to grow, but
    at a pace significantly below its long-run
  • A depression is a recession that is major in both
    scale and duration.

Post WWII Recessions
  • There have been 11 recessions in the U.S. economy
    since 1945. The latest began in March 2001
    (though many indicators began peaking long before
    that, especially in Q4 2000), and ended in
    November 2001.

Peak Trough
February 1945 (Q1) October 1945 (Q4)
November 1948 (Q4) October 1949 (Q4)
July 1953 (Q2) May 1954 (Q2)
August 1957 (Q3) April 1958 (Q2)
April 1960 (Q2) February 1961 (Q1)
December 1969 (Q4) November 1970 (Q4)
November 1973 (Q4) March 1975 (Q1)
January 1980 (Q1) July 1980 (Q3)
July 1981 (Q3) November 1982 (Q4)
July 1990 (Q3) March 1991 (Q1)
March 2001 (Q1) November 2001 (Q4)
Index of Leading Economic Indicators
  • The LEI has 10 components, each with a specific

Leading Indicators and the Economy
Index of Coincident Indicators
  • The Coincident Indicators Index has 4 components,
    each with a specific weighting

Coincident Indicators and the Economy
Index of Lagging Indicators
  • The Index of Lagging Indicators has 7 components,
    each with a specific weighting

Lagging Index and the Economy
Consumer Confidence
  • The Consumer Confidence index is released
  • It is a mail survey of 5,000 individuals with an
    average of 3,500 responses.
  • In the survey, respondents are asked 5 questions
  • Respondents appraisal of current business
  • Respondents expectations regarding business
    conditions six months hence.
  • Respondents appraisal of the current employment
  • Respondents expectations regarding employment
    conditions six months hence.
  • Respondents expectations regarding their total
    family income six months hence.
  • There are three possible responses Positive,
    Neutral, Negative.

Consumer Confidence (cont.)
  • The index has two components
  • Expectations (most important)
  • Present Situation
  • The overall index is calculated as the average of
    the relative positive/negative responses to all 5
  • The expectations component is an average of the
    responses to questions 2, 4, 5.
  • The present situation component is an average of
    the responses to questions 1 and 3.
  • Before averaging, all responses are adjusted
    relative to their 1985 values.
  • The responses to each question are also
    seasonally adjusted.
  • Source http//
  • There is also a consumer sentiment index
    published by the University of Michigan.

Inflation Indicators
  • There are many indicators of inflation in the
    economy. (Inflation is defined as a general
    increase in the level of prices.)
  • The four most-watched indicators are
  • The Consumer Price Index (CPI)
  • The Producer Price Index (PPI)
  • The GDP Deflator
  • The Employment Cost Index (ECI)

Consumer Price Index
  • The CPI is published monthly by the Bureau of
    Labor Statistics (http//
  • There are many versions (even one for
    Denver-Boulder-Greeley area which is published
    semiannually), but the most watched is the
    Consumer Price Index for All Urban Workers
  • The CPI measures the change in price of a market
    basket of goods typically purchased by
    consumers. The items in this basket are
    determined by periodic surveys of about 30,000
    consumers around the country.
  • It is broken into two components
  • The total CPI (often called the Headline
  • The Core CPI (ex food and energy which are quite
  • Watch both numbers, but the core CPI is the best

Consumer Price Index (cont.)
  • The expenditure items are from 200 categories
    arranged into 8 major groups
  • FOOD AND BEVERAGES (breakfast cereal, milk,
    coffee, chicken, wine, full service meals and
  • HOUSING (rent of primary residence, owners'
    equivalent rent, fuel oil, bedroom furniture)
  • APPAREL (men's shirts and sweaters, women's
    dresses, jewelry)
  • TRANSPORTATION (new vehicles, airline fares,
    gasoline, motor vehicle insurance)
  • MEDICAL CARE (prescription drugs and medical
    supplies, physicians' services, eyeglasses and
    eye care, hospital services)
  • RECREATION (televisions, cable television, pets
    and pet products, sports equipment, admissions)
    postage, telephone services, computer software
    and accessories)
  • OTHER GOODS AND SERVICES (tobacco and smoking
    products, haircuts and other personal services,
    funeral expenses).

Producer Price Index
  • Like the CPI, the PPI is published monthly by the
    Bureau of Labor Statistics (http//
  • The PPI measures changes in wholesale prices.
  • There are over 10,000 versions of the PPI
    published every month for individual products and
  • Investors watch the PPI, but mostly focus on the

GDP Deflator
  • The GDP Deflator is published quarterly by the
    Bureau of Economic Analysis (http//www.bea.doc.go
    v/) in the GDP report.
  • The GDP Deflator measures changes in the prices
    of all domestically produced products, and is the
    broadest of all inflation indicators.
  • It includes many things (trains, planes, etc)
    that consumers do not buy as well as everything
    they do buy.
  • This measure of inflation is less-watched than
    the CPI, but it can be important and it tends to
    be less volatile.

Employment Cost Index
  • Like the CPI and PPI, the ECI is published by the
    Bureau of Labor Statistics (http//
  • The ECI measures changes in the cost of employee
    compensation (wages and benefits), and is
    published quarterly as part of the National
    Compensation Survey .
  • The ECI is reported to be one of Alan Greenspans
    favorite inflation measures.

The Beige Book
  • The Beige Book (http//
    /BeigeBook/2001/default.htm) is a summary of
    current economic conditions around the country
    published by the Federal Reserve Board.
  • The Beige Book is published 8 times per year and
    is based on anecdotal evidence gathered through
    interviews with bank directors, economists,
    business contacts, etc.
  • It contains an overall summary, plus reports from
    each of the 12 districts (Colorado is in the 10th
    district, Kansas City).

  • As part of its monthly Current Population Survey
    (http//, the Bureau of
    Labor Statistics produces the Unemployment Rate.
  • The unemployment rate is determined by a survey
    of individuals who are then placed into one of
    three categories
  • Employed
  • Unemployed and seeking work
  • Unemployed and not seeking work (discouraged
  • The unemployment rate is the ratio of unemployed
    to the total number in the workforce (discouraged
    workers are not counted).
  • Note that the labor force is actually the
    civilian labor force, it does not include those
    in the military.

Forecasting Is Hard
  • Forecasting is difficult, especially if it
    concerns the future.
  • That phrase has apparently been uttered by many
    famous people, and I cant track down the
    original. However, truer words have never been
  • Economic forecasting is especially difficult, and
    the forecasts are wrong almost by definition.
  • There are many reasons why this is the case
  • Old or bad data
  • Unexpected shocks (the Sept 11 tragedy is a
    perfect example)
  • Using historical data which gives no clues about
    major structural changes about to occur
  • Blindly following trends

Forecasting Is Hard (cont.)
  • John Casti in his 1990 book Searching for
    Certainty What Scientists Can Know About the
    Future evaluated forecasters from many fields and
    gave economists a D. Stock market forecasters
    got a very generous C and physicists got an
  • Probably the most notoriously wrong forecast of
    all time came in the early fall of 1929 when the
    great economist Irving Fisher said, "Stock prices
    have reached what looks like a permanently high
  • So, you see, forecasting is hard and your efforts
    are nearly always wrong.
  • The next slide shows an analysis of just how
    accurate a group of professional economists
    were at predicting various indicators about 6
    months ahead in 2004.

Forecasting Is Hard (cont.)
Forecasting Is Hard (cont.)
Why Forecast Economic Aggregates?
  • We dont have a choice. We are making decisions
    whose outcomes depend on the future, and we must
    make these decisions using the best available
    information that we have.
  • Otherwise, all decisions may as well be made by a
    coin toss (and even bad forecasts are usually
    better than that).
  • It is probably best not to pay too much attention
    to the point estimates of the forecast, instead
    look for trends (is GDP expected to grow slower,
    faster, or about the same?).
  • It is also important to constantly be on the
    lookout for solid reasons to revise your
    forecast, and change your decision.
  • Its no sin to be wrong, but failing to admit it
    and adjust is.

Industry Analysis
  • Once we have done a thorough economic analysis,
    we ask the question which industries will
    benefit most from the upcoming economic
  • This will lead to several industries, and our
    analysis will lead us to choose the one that we
    find to be best positioned.

What is an Industry?
  • An industry is a group of companies which produce
    similar goods and/or services.
  • Until recently (and often still), industries were
    classified by Standardized Industrial
    Classification (SIC) codes, but this was replaced
    by the North American Industry Classification
    System (NAICS, http//
    s.html) which is much more detailed than SIC.
  • SIC codes were 4-digit, while the NAICS uses 6
    digits for a much finer, and more useful,
    breakdown of industries.
  • NAICS will also facilitate comparisons of
    companies in the US, Canada, and Mexico (it was
    developed by all three countries for this

Components of Industry Analysis
  • The purpose of industry analysis is to identify
    which industries will be good for investors in
    the upcoming environment.
  • Your textbook has an excellent discussion of 9
    issues that should be addressed
  • Competitive Structure
  • Permanence
  • Phase of Life Cycle
  • Vulnerability to External Shocks
  • Regulatory and Tax Conditions
  • Labor Conditions
  • Historical Financial Performance
  • Financial and Financing Issues
  • Industry Stock Price Valuation

Competitive Structure
  • Some of the questions to be answered are
  • What companies are in the industry?
  • What are their market shares?
  • Which are publicly traded?
  • Has the number of competitors been rising,
    fallen, or remained stable?

  • Some of the questions to be answered are
  • Is the industry likely to survive in the
  • Are there any major technological threats (such
    as laser printer was to the dot matrix printer)?
  • Are there regulatory threats?

Phase of Life Cycle
  • Some of the questions to be answered are
  • Where is the industry in its life cycle? The
    best returns and most risk tend to occur early in
    the cycle.
  • The possible phases are
  • Birth Phase
  • Growth Phase
  • Mature Growth Phase
  • Stabilization or Decline Phase

Vulnerability to External Shocks
  • Some of the questions to be answered are
  • Could major portions of the industry be
    nationalized by foreign governments?
  • Are they dependent on supplies of key commodities
    (such as oil)?
  • Are they subject to external political whims?
    (South Africas gold industry suffered when
    Apartheid became an international issue.)
  • Are they subject to fashion trends that may soon

Regulatory and Tax Conditions
  • Some of the questions to be answered are
  • What are the current regulations that the
    industry faces?
  • Are there likely to be new regulations?
  • Are the industrys products subject to special
    taxes (such as sin taxes on alcohol and tobacco
    products or the windfall profits tax on oil
    companies in the 1970s)?
  • Are there special tax breaks offered to the

Labor Conditions
  • Some of the questions to be answered are
  • What percentage of the industrys workers are
  • Are the unions generally hostile or complacent?
  • Is unionization increasing or decreasing?
  • Are qualified workers easily obtainable, or are
    they difficult to find? This has been a
    particular problem for the high-tech industries.

Historical Financial Performance
  • Some of the questions to be answered are
  • What is the historical record of industry
    revenue, earnings and dividends?
  • Are these financial variables cyclical,
  • Have they been growing slowly, rapidly, or about
  • What is the average cost structure in the
    industry? Heavy on fixed costs? Or, are
    variable costs the lions share?

Financial and Financing Issues
  • Some of the questions to be answered are
  • How much debt does the average firm have?
  • What is the mix between fixed assets and current
    assets? Is it labor intensive or capital
  • What is the average age of the fixed assets?
    Will they have to be replaced soon?

Industry Stock Price Valuation
  • Some of the questions to be answered are
  • What is the historical average P/E for the
  • How high has it been? What were the economic
    conditions when the highs were hit?
  • How low has it been? What were the economic
    conditions when the lows were hit?
  • Where is it now? Where should it be, based on
    historical economic comparisons?
  • What kinds of capital gains and dividend yields
    have historically been generated?

Sources of Industry Information
  • The primary sources of industry-wide information
    are trade groups, for example
  • Semiconductor Industry Association
  • Wards (automobiles, http//
  • Electronics Industry Association
  • Software Publishers Association
  • There are also many trade magazines that may, or
    may not, be published by the trade associations.
  • Additionally, Value Line Investment Survey
    (http// publishes an analysis
    of each of the industries that they cover.
  • Finally, research analysts at brokerage firms
    often provide reports on the industries that they