1. Active Equity Portfolio Management: Economic and Industry Analysis 01/21/09

2. 2 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?

3. 3 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?

4. 4 Industry Analysis Why do industry analysis? Revisiting the business cycle: What industries do well at different phases of the business cycle?

5. 5 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.

6. 6 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

7. 7 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.

8. 8 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.

9. 9 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.

10. 10 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

11. 11 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

12. 12 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.

13. 13 Business cycles Early Upswing Capital market effects: Stabilization of longer term bond yields. Stock markets still trending up. Inflation: Remains low

14. 14 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.

15. 15 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

16. 16 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.

17. 17 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

18. 18 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

19. 19 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)

20. 20 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)

21. 21 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

22. 22 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

23. 23 Economic data: Consumer Spending and Confidence Survey of consumer sentiment (semi- monthly) 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

24. 24 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

25. 25 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

26. 26 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

27. 27 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.

28. 28 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.

29. 29 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.

30. 30 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.

31. 31 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.

32. 32 Economic Analysis: Monetary policy The Taylor Rule provides one method of predicting interest rate changes. The following is an approximation of this rule:

33. 33 Economic Analysis Evaluating factors that affect business cycle Monetary Policy Inputs to the Taylor rule: R optimal = short-term interest rate target R neutral = equilibrium interest rate (approximated at 4-5% for the U.S.) GDPg forecast = current forecast real GDP growth rate GDPg trend = observed GDP real growth rate = function of increase in productivity and labor force participation (around 2-3% for the U.S.) I forecast = forecast inflation rate I target = target inflation rate (2% for the U.S.)

34. 34 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.

35. 35 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.

36. 36 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

37. 37 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

38. 38 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

39. 39 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

40. 40 The Stock Market and the Business Cycle Financial Stocks Excel trough peak Consumer Durables Excel Capital Goods, Technology and Cyclicals Excel Basic Industries Excel Consumer Staples, Utilities and healthcare Excel

41. 41 Readings RM 2 (section 4.1, 4.5.2) RB 12 (pgs. 404 – 410) RB 13 (pgs. 460-66)