Unit 12 - Economics and Analysis

Business cycle

predictable long-term pattern of alternating period of economic growth and decline through 4 stages, expansion>peak>contraction>trough

Expansion

in the business cycle characterized by

• Increased consumer demand for goods and services

• Increases in industrial production

• Rising stock prices

• Rising property values

• Increasing GDP

Peak (prosperity)

in the business cycle characterized by >

• Very low unemployment or high employment

• Slowdown of inflation

• Slowdown of GDP growth

• Steady consumer demand

Contraction

downturns in the business cycle characterized by >

• Rising numbers of bankruptcies and bond defaults

• Higher consumer debt

• Falling stock prices

• Rising inventories (a sign of less consumer demand in hard times)

• Decreasing GDP

Trough

in the business cycle characterized by

• High unemployment/low employment

• Flat GDP

• Low inflation

• Low (but not decreasing) consumer demand

Recovery

in the business cycle, the period of expansion from a low to the prior high

Recession

when the economy enters an extended period of contraction that continues for six months (two quarters) or longer, can be mild or severe

Depression

if a contraction continues for 18 months

Gross domestic product (GDP)

a nation's annual economic output, all the goods & services produced within the nation (all activity that within the borders and activity generated by a foreign company) stated as % change from one period to the next (positive=economy is growing, negative=economy is contracting) – i.e. a foreign company operating in U.S. Released quarterly in the U.S. by the U.S. Department of Commerce

Gross national product (GNP)

based on the activity of the citizens and entities of the nation, wherever it may occur and used significantly less than GDP (not including activities of foreign companies) – i.e. US company opens location abroad

Consumer price index (CPI)

measures changes in prices consumers pay for a basket of goods and services (i.e. food, housing, transportation, medical care, and entertainment), used as one of the primary measures of inflation and is calculated monthly determining real GDP (higher=high inflation and lower=lower inflation or deflation)

Real GDP

GDP adjusted for inflation using CPI

Constant dollar measurement

uses CPI to adjust economic data for inflation so values from different time periods can be compared fairly (calculating real GDP)

Leading indicators

economic indicators that tend to change direction ahead of the overall economy, change of direction can be long (months) or short (weeks) but reliable

• Money supply (M2)

• Building permits (housing starts)

• Average weekly initial claims for state unemployment compensation

• Average work week in manufacturing

• New orders for consumer goods and machine tool orders

• Changes in inventories of durable goods, sensitive materials prices, business and consumer borrowing

• Stock prices (as measured by the S&P 500 Index)

Coincident indicators

indicators that change direction with the economy, often published after the time period has passed thus are good confirmation tools of the leading indicators

• Number of hours worked (as a proxy for personal income)

• Employment levels (as measured by the rate of unemployment)

• Nonagricultural employment

• Personal income

• Industrial production

• Manufacturing and trade sales

• GDP

Lagging indicators

indicators that change direction after the economy has begun a new trend serving as confirmation of the new trend, help analysts differentiate long-term trends from short-term reversals

• Corporate profits

• Average duration of unemployment

• Labor cost per unit of output (manufacturing)

• Ratio of inventories to sales

• Commercial and industrial loans outstanding

• Ratio of consumer installment credit to personal income

Inflation

general increases in price, mild can encourage economic growth as gradually increasing prices stimulate business investments but high reduce a dollar’s buying power hurting the economy

Deflation

general decline in prices, occurs during severe recessions when unemployment is on the rise

Stagnation

prolonged periods of slow or little economic growth with low inflation accompanied by high unemployment

Hyperinflation

pace of inflation is extremely high and accelerating, severely erodes purchasing power of a currency (very rare) – investors move cash away from the nation

Stagflation

unusual combination of inflation and high employment, occurs when economy isn’t growing and there is a lack of consumer demand and business activity but prices are still rising (inflation doesn’t need to be high just present with high unemployment)

Cyclical industries

highly sensitive to business cycles and inflation trends often producing durable/capital goods (heavy machinery, cars, washers/dryers, etc.) and raw materials (steel, concrete, and other industrial metals) – during recessions the demand declines, do well in expansions and poorly in contractions

Noncyclical (defensive) industries

least affected by normal business cycles as they general produce consumer goods/consumables (foods, utilities, clothing, pharmaceuticals, tobacco/liquor), company that makes a product that is used once and consumer in the process – during recessions stocks decline less than other industries but during expansions/bull markets stocks advance less, investments into them involve less risk and low returns

Countercyclical industries

perform better when the economy turns down as they produce products that are bought when people are scared and looking for safety (gold mining or any precious metals) – deliver best returns during a recession

Growth industries

disconnected from business cycle as it constantly performs well regardless of the economy (could refer to an individual company, may be long-term (i.e. auto industry) or short-term(dot-com companies) but eventually business will become more established and move in line with the economy

Special situation industries

normally applied to a specific company, but it could apply to an industry as a whole, when a company shows unusual profit potential or downside risk resulting from nonrecurring circumstances (i.e. hostile takeover or cultural shift) – not always positive

Financial statement

provide fundamental analysts with data on the financial strength and weaknesses of a company allowing ratios to be calculated to make comparisons with competitors, released on a quarterly and annual basis

Balance sheet

provides a snapshot of a company's financial position at a specific time, identifying value of the company's assets and liabilities but can’t tell if business is improving or deteriorating

Assets

what a company owns, divided into three categories >current, fixed, and other

Current assets

cash and assets that may be easily converted to cash (i.e. securities, accounts receivable, company’s inventory)

Fixed assets

assets that are difficult to liquidate (i.e. real estate, furniture, and equipment) and may take longer than 12 months to sell

Other assets

assets that are difficult to value (i.e. trademarks, copyrights, reputation, and intellectual property), called intangibles or goodwill

Liabilities

what a company owes, divided into two categories > current and long-term

Current liabilities

liabilities that are due now or in the near future, within 12 months (i.e. wages, accrued taxes, accounts payable, or interest payments)

Long-term liabilities

debts that will not be paid off in the near future (i.e. notes, bonds, and principal)

Net worth

difference between assets and liabilities, shareholder equity (preferred stock, common stock and retained earnings)

Preferred stock net worth

any funds received from the sale of preferred stock

Common stock net worth

the par value of the common stock

Capital in excess of par

monies received from the sale of common stock in excess of the par value

Retained earnings

earnings the company has made that have not been paid out as dividends

Short-term liquidity

three of the balance sheet ratios that include working capital, current ratio, and acid-test ratio

Working capital

amount of money that a company can spend (or lose) and remain operational = current assets – current liabilities (expressed as a dollar amount)

Current ratio

a better figure to use when comparing the liquidity of companies, the higher the ratio the more liquidity = current assets / current liabilities (expressed as ratio)

Acid-test ratio (quick ratio)

test of a company's liquidity if everything really goes bad, expressed as ratio = (current assets – inventory) / current liabilities

Debt ratio (debt-to-equity ratio)

a measure how much of a corporation's net worth is derived from long-term debt, the higher the ratio the less long-term liquidity a company has = long-term debt / (long-term debt + net worth)

Income statement (profit and loss statement or P&L)

summarizes a corporation's revenues and expenses for a fiscal period comparing revenue with costs and expenses during the period, reflecting business activity over a specific time period, and used to judge efficiency of a company’s operation and profitability

Fiscal period

usually one quarter of the year, year to date, or the full year

Operating income

sometimes referred to earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortization (EBITDA)

Earnings per share (EPS)

calculated by dividing earnings available to the common shareholders (earnings) by number of outstanding shares

Price-to-earnings ratio (P/E)

measure of the amount of earnings a company makes compared with its current market value (CMV) or the stock's price, expressed by a number = CMV/EPS

Exchange rate

value of one currency measured against another, the value of the U.S. dollar measured against foreign currencies affects the balance of trade

Dollar weakens against foreign currency

price of U.S products decrease in terms of foreign currency (i.e. cost more $s to get yen), exports will increase and imports will decrease (increasing inflation rate)

Dollar strengthens against foreign currency

price of U.S products increases in terms of foreign currency, exports will decrease (price in foreign market increases) and imports will increase (ex. cost more yen to get a $1) – U.S companies will keep prices down to compete as imports will be less expensive (keeps inflation in check)

Balance of payments

flow of money between U.S and other countries, may be a surplus or a deficit

Deficit

more money flows into U.S than out, occurring when interest rates in another country are high because money flows to where it earns the highest return (causing dollar to weaken)

Surplus

more money flows out of U.S than in, causing the dollar to strengthen

Balance of trade

the export and import of U.S. merchandise

U.S. credit side (money flowing in)

sales of American products to foreign countries (U.S. exports)

U.S. debit side (money flowing out)

American purchases of foreign goods (U.S. imports)

Fiscal policy

government's use of taxes and government spending to influence the economy by Congress or the President, can increase or decrease spending and taxes to encourage economic growth, reduce unemployment, or control inflation (take time to implement)

Stimulates the economy

increasing spending or lowering taxes

Slows the economy

decreasing spending or raising taxes

Monetary policy

Federal Reserve Board’s actions that determine the size and rate of the money supply’s growth affecting interest rates, moves made quickly

Keynesian theory (demand-side economics)

theory that active government intervention could promote prosperity by managing the demand for products to ensure economic growth and stability

Keynesian theory to increase demand

reduce taxes (increasing income, spending, and demand), increase government spending (funding larger projects and increases employment), or both

Keynesian theory to decrease demand/inflation

increase taxes (decreasing income spending, and demand), decrease government spending (fewer projects and lowering employment), or both

Supply-side theory

belief that lower taxes and reduced gov. regulation encourages business to invest, expand, and produce more goods and services stimulating economic growth, gov. should allow market forces to determine the prices of all goods

Federal Reserve Board (FRB)

central bank of the U.S (aka the Fed), primary role is to provide the country with a safer, more flexible, and more stable monetary and financial system by managing the money supply and interest rates in order to promote economic growth, control inflation, and maintain stable employment

Federal Reserve System

directed by the FRDB consisting of 12 regional Federal Reserve Banks and hundreds of national and state banks

Monetary policy

involves FRB taking actions to control how much money is availably for businesses and consumers to spend, managed by the monetarist theory

Monetarist theory

economic theory that the money supply is the major determinant of price levels and thus a well-controlled money supply will have the most beneficial impact on the economy

Money supply

the amount of cash available within the U.S. economy

Diagnostic tools for FRB

track a broad spectrum of indicators of economic activity (CPI, GDP, and employment figures), FRB uses them to understand current state of the economy and predict future trends

Direct tools for FRB

help FRB directly control the money supply and impact the economy through open market operations, discount rates, reserve requirements

Discount rate

interest rate charged to banks for loans by the Federal Reserve, lowering makes borrowing cheaper (stimulates economic activity) and raising slows borrowing (cooling economy)

Reserve requirements

rules about the minimum amount of reserves that banks must hold against deposits, lowering allows banks to lend more money and raising reduces bank lending capacity

M1

measure of the most readily available money to spend > cash and money in demand deposit accounts (DDAs) like checking accounts, money that is closest to being spent and turned into economic activity

M2

consists of M1 plus consumer savings deposits > assets that are easily moved to a DDA and spent > also includes savings accounts, retail CDs, and short-term time deposit

M3

consists of M2 plus large time deposits > assets that are a bit harder to move into a DDA and spend (i.e. negotiable (jumbo) CDs and multiday repos) by extension M1 is also included

Federal open market operations

FRDB operates by buying securities (T-bills, notes and bonds) which adds cash to the economy (boosting spending but possible increased inflation) or selling securities which removes cash (reducing inflation but possible economic contraction)

Regulation T deposit requirement

the Fed sets the minimum amount an investor must deposit when using margin to buy a security, current initial deposit is 50% of the purchase price

• Lowering > allows more borrowing but extra cash would raise stock prices, expanding economy

• Raising > limit credit, slowing economy

Reserve requirement

amount a bank must maintain on deposit with the Federal Reserve, reserves dropping below the requirement indicate the bank may not have the cash needed to meet depositors' demands

• Lowering > frees up cash at the banks to fund loan activity, expanding economy

• Raising > decreased amount available for loans

Discount rate

interest rate the Fed charges the bank for short-term loans (raising or lowering interest rates), the base rate for the nation - raising lift interest rates and lowering drops rate overall

Repo

when banks that need additional capital to meet their reserve requirement borrow money from the Federal Reserve System, Fed holds some of the bank's assets (usually loans the bank holds) as collateral for a short-term loan (usually overnight) increasing the bank’s cash reserve

Interest rate

cost of money determined by supply and demand of money, if money available exceeds demand rate falls and when demand for money exceeds supple rate rises – four major rates include federal funds, prime, broker call loan, and discount

Federal funds rate

rate that the commercial money center banks charge each other for overnight loans of $1 million or more, a barometer of the direction of short-term interest rate – the most volatile rate in the economy

Prime rate

interest rate that large U.S. money center commercial banks charge their most creditworthy corporate borrowers for unsecured loans, set by each bank with larger banks setting a rate others will follow (lowered when FRDB eases money supply and raised when money supply contracts)

Broker call loan rate

interest rate that banks charge BDs on money they borrow to lend to margin account customers (aka loan rate or call money rate), callable on a 24-hour notice - a percentage point or so above other short-term rates

Discount rate

indicates the direction of FRB monetary policy, decreasing indicates an easing of FRB policy and increasing indicates a tightening of FRB policy