CHAPTER 6 THE BIG PICTURE

GNP Defined  Measures the value of everything our society consumes  Released quarterly  Highly accessible and easily understood  GNP tends to be revised

GNP Defined  GNP’s components  Stable Consumer spending (necessities) Government spending  Volatile Housing investment Business capital spending and inventory investment Net exports Consumer spending (big-ticket)

GNP Rose  What happened  Initial report 1.7 percent annual growth  Revised report 1.3 percent annual growth  What you need to know  Seasonally adjusted  Annualized  Real  What you need to do  Build comparisons

Real Final Sales Were Down  What happened  Real final sales down 1.5 percent  What you need to know  Trends in final sales – good indicator of future GNP  What you need to do  Look for a divergent trend in final sales

Consumer Spending Expanded  What happened  Consumer spending expanded 2 percent  What you need to know  Makes up 2/3 of GNP  Three segments Services, Nondurable goods, Durable goods  What you need to do  For nondurable and services, look for softening or strengthening in the rate of growth to signal economic chage  For durables, look for sharp turns

Government Spending Fell  What happened  Real government spending dropped  What you need to know  Includes federal, state, and local expenditures  Generally stable and expected to rise  What you need to do  Look for any significant deviations from a steady growth rate

Business Inventory Liquidations Slowed  What happened  Business liquidated real inventories more slowly  What you need to know  Business inventories are GNP’s most volatile component  Revisions can be massive  What you need to do  Be alert to swings

Housing Demand Improved  What happened  Demand for housing rose 12 percent  Mortgage rates fell from 17.4 percent  What you need to know  Includes new structures, repairs, and alterations  Also influenced by price and tax factors  What you need to do  Look for surge in demand when mortgage rate decline as an economic recovery begins

Capital Spending Caved In  What happened  Capital Spending dropped 12.3 percent  What you need to know  Measures major capital expenditures of businesses  Are businesses optimistic or pessimistic  How is this affecting a company’s willingness to make major expenditures  What you need to do  Look for a sharp downturn or upturn

Be Flexible in Developing Your Outlook  Conclusions should be reached using a mosaic theory  Be flexible enough to change your big picture outlook with new information

CHAPTER 7 INFLATION’S ACTION-PACKED TRENDS

Basic Tools of Inflation  Inflation is the most important ‘yardstick’ for evaluating economic change  Developing a sense of inflation’s impact on the overall economy  Ability to analyze the relationship of inflation with economic trends over periods of time

How inflation behaves in economic phases  Acceleration and Maturation  Inflation speeds up  Ease-Off and Plunge  Inflation peeks, and turns into disinflation  Revival  Disinflation is carried over, and then speeds up again

Investment guidelines when dealing with Inflation  When inflation heats up the return on real assets jumps ahead of financial assets  When inflation cools down the situation reverses and investors should invest more heavily in financial assets

Investment guidelines when dealing with Inflation  Changes in inflation have a more immediate impact on bonds and gold than stocks  Interest rates must move as much or more than inflation for stock prices to change  Not all sectors react the same  Stock in energy producing or gold mining corporations will initially increase with inflation

Price Measures to Rely On  Producer Price Index (PPI)  Consumer Price Index (CPI)  Various commodity price indexes  Oil prices

Questions about the Price Indexes  What type of prices are being measured?  When and how often is the index released?  Does the index have a visible impact on the financial markets?

Questions about the Price Indexes  How is the index compiled and calculated?  How often is the index revised and how extensively?  How is the index divided into its components?

Producer Price Index  Four basic advantages: 1. Tracks a wide range of goods, raw materials, intermediate goods, and finished products 2. Is the most market sensitive index 3. Goes through only minor revisions 4. Is composed of useful subindexes

Producer Price Index  Drawbacks:  Variable weight index that focuses on commodity prices and ignores the service industry  Calculation of the index is a very labor intensive operation  The markets follow this index intensely

Consumer Price Index  “The index of choice for taking the inflationary bias out of other economic indicators”  Represents basic items such as food, clothing, housing, bills, etc.  Fixed weight index without many revisions

Consumer Price Index  Main advantage is that it comprises of domestic and foreign commodities, and the service industry  Financial market reactions to CPI are more subdued than to the PPI

Consumer Price Index  Disadvantages  Contains fewer items than the PPI  Reported two weeks after the PPI  The computation of the components is problematic  Can sometimes be very out of sync with the public’s perception of inflation

Commodity Indexes  More sensitive to changing inflation expectations than most products and services  Two types of indexes, spot price indexes and futures indexes  Dow Jones and Commodity Research Bureau publish both indexes

Commodity Indexes  Commodity prices have a closer relationship to trends in long term bond yields than any other comparable factor

Oil- A Special Commodity  Comprises 8-10% of the average cost of producing any product  Mid-east violence and natural disasters can cause major variations in the price of oil  Bonds and stocks may react differently to sudden increases in oil prices  Other economic developments may override oil prices

The Inflation Fail-Safe  Inflation is a concept you come home to when the economic indicators are sending you mixed signals  Inflation’s momentum is strongly linked to the economic life cycle  Inflation’s trends are often more telling than any other economic factor for investment strategies

CHAPTER 8 ON INFLATION’S TRAIL

Chapter Objectives  Important fact: Inflation’s trends, rather than single monthly reports, determine what implications there might be for investing  Learn how to track price trends over longer time frames  Producer Price Index (PPI)  Consumer Price Index (CPI)  Trends matter-not whether inflation is high or low

Price Index Trends: Inflation  Accelerating inflation:  Early warning sign: 12 month PPI and CPI averages tranquil 3 month averages begin to rise and commodity price averages rising Beginning of acceleration phase Investment implications: Intermediate/Long term bonds: negative Stocks: neutral/positive Gold/commodities: positive Higher return on money market instruments  Middle of strong inflationary trend: 3 and 12 month PPI, CPI, and commodity price indexes are rising Maturation phase Investment implications: Stocks and bonds: negative (except for stocks related to commodities) Gold/commodities: positive Stay with money market funds if unwilling to speculate in gold

Price Index Trends: Disinflation  Decelerating Inflation (Disinflation)  Early warning sign: Commodity prices decline 3 month PPI and CPI averages stabilize 12 month averages continue to accelerate Transition to Ease-off Investment implications: Stocks and bonds: negative When stocks and bonds turn up, be ready to switch out of money market funds and gold  Beginning of Disinflation: Commodity prices/3 month averages falling sharply 12 month rates stabilize/begin to decline Entering Plunge Investment implications : Stocks and bonds: initially neutral then extremely positive Gold/commodities: negative Money market funds perform poorly

Price Index Trends: Disinflation  Middle of Disinflation: Sharp and continuing decline in PPI/CPI and commodity indexes 3 month averages falling faster than 12 month averages Revival phase Investment Implications: Stocks and bonds: positive Gold/commodities: negative Money market funds continue to perform poorly

Cycle to Cycle Trends  If inflation in one cycle bottoms out at a higher level than the previous cycle :  Suggests the next peak will be higher as well  1970’s  First quarter 1976: CPI at cyclical low (3.9%)  Higher than previous low- 3 rd quarter 1971 (2.9%)  First quarter 1980: Inflation at record highs (16.5%)

How we react to inflation  Consumer resistance (Plunge, Revival, Acceleration)  When prices are high, we buy less of a product Question price increases Seek substitutes Big purchases put off  Big increases in inflation:  Resist  Give in  Buying spree in fear of even greater increases (advance buying)  Result: Overheating occurs (late in expansion’s maturation phase)  Disinflation:  Determined resistance  Put off purchases entirely in hopes of even lower prices (delay)  Can occur as economy comes out of recession and moves through revival phase

Road to Rising Inflation  Increased confidence about the future  Both spouses employed leaving little time to search for ways to avoid price increases  Cooperation with price increases on everyday purchases leads to cooperation on big purchases  Result: advance buying

Implications of advance buying  Buy to avoid even higher future prices  Overheating of economy  Federal reserve:  Increase money supply  Keep things in check  Can decrease money supply if things get out of hand in order to bring inflationary cycle back to resistance

Road to Disinflation  Lack of confidence about the future  One spouse unemployed or both work reduced amount of time (incentive to avoid purchases until prices are lowest)  Putting off purchases awarded with lower prices  Result: delay

Implications of Delay  Wait for sales or specials  : Auto companies

President’s wage war on inflation  Nixon and Carter  Major point:  Artificial attempts to control inflation should be viewed with skepticism  Such controls only delay or worsen prices

Nixon’s experiment  State of economy (1971):  Weak economy  Rising interest rates  High inflation  Nixon’s plan:  Wage and price controls (NEP)  Goal: stimulate economy and reduce inflation  Ultimately failed

Carter’s Controls  Credit controls introduced (March 1980)  Stock and bond prices fell  Unemployment soared  Federal reserve stepped in  Stimulated economy leading to stock and bond rally  Controls removed in June  Inflation and interest rates shot up ending rally

What would happen next time?  Would business and labor adhere to governmental guidelines or controls if adopted again?  No because business and labor were losers under such controls

5 reasons why market restraints are undesirable  Businesses would try to escape price controls by redesigning/repackaging existing products rather than focus on improving or creating new products  Entrepreneurial sectors discouraged  Weakened productivity  Large trade deficit leading to depreciation of the dollar and higher prices for imported goods and services (decreases in: corporate profits, spending on plant and equipment)  Overstimulation of the economy by the federal government due to misleading belief in success of controls

2 Types of economies  Overheating (high inflation)  Declining (disinflation)

Overheating economy  Occurs when:  Very strong growth in an expansions Maturation phase  Characteristics:  Many sectors (housing, government spending, etc.) simultaneously boom and push economy beyond limits of noninflationary growth  Interest rates rise rapidly  Bearish: bonds  Bullish: gold/precious metals  Stocks may be pushed higher  Time for aggressive/high roller investors

Overheating example: late 1970’s  Economic indicators of overheating:  Brisk consumer spending  Robust housing starts  Widespread employment gains  Booming business sector  Increases in commodity prices  Weakened productivity  Highly stimulative government spending  Implications:  Near term recession unlikely  In time, federal government will have to counteract the economic over exuberance  Next economic downturn with be comparatively severe

Declining economy (disinflation)  Occurs during:  Recessions or periods of sluggish or renewed growth  Characteristics:  Rate of increase in prices slows  Prices may fall  Excess capacity, weak demand  Bullish: stocks and bonds  Forces that disrupt disinflation:  Price declines/actions of consumers bring inflation back

Disinflation example: early 1980’s  Most prolonged period of postwar disinflation  Economic indicators of disinflation:  Severe falloff in economic activity (2 recessions)  Sharp rise in the dollar (hurt American producers)  Collapse in key commodity prices (OPEC)  Financial investments:  Stock prices doubled  Bond yields cut in half  Price of gold lost about half of its value from its prior peak

What should investors do during disinflation?  Early on:  Bonds perform well  Highly conservative investor: intermediate and long term bond funds  Cautious, aggressive, and high rollers: weight more heavily toward long term bonds  As disinflation further unfolds:  Investors can move into stocks  Gold and precious metals-avoided like the plague

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