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

Active Equity Portfolio Management: Economic and Industry Analysis

01/21/09

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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?

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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?

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Industry Analysis

• Why do industry analysis?

• Revisiting the business cycle: What industries do well at different phases of the business cycle?

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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.

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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

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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.

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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.

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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.

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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

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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

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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.

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Business cycles

• Early Upswing• Capital market effects:

• Stabilization of longer term bond yields.• Stock markets still trending up.

• Inflation: Remains low

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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.

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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

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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.

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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

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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

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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)

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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)

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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

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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

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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

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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

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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

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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

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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.

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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.

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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.

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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.

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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.

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Economic Analysis: Monetary policy

• The Taylor Rule provides one method of predicting interest rate changes. The following is an approximation of this rule:

)](*5.0)(*5.0[ argettforecasttrendforecastneutraloptimal IIGDPgGDPgRR

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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.)

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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.

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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.

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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

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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

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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

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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

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The Stock Market and the Business Cycle

Financial Stocks Excel

trough

peakConsumer Durables

Excel

Capital Goods,

Technology and Cyclicals

Excel

Basic Industries

Excel Consumer Staples,

Utilities and healthcare

Excel

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Readings

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