Chapter 12 – Macroeconomic and Industry Analysis
CHAPTER TWELVE
MACROECONOMIC AND INDUSTRY ANALYSIS
CHAPTER OVERVIEW
This is the first of three chapters that cover fundamental security valuation. This chapter
introduces a top-down approach to fundamental security analysis. It covers the first two
components: macroeconomic and industry analysis. The text begins with a global analysis,
particularly with respect to how the performance of domestic firms is influenced by international
economic performance. The chapter’s main focus however is on aspects of the U. S. economy
that affect security returns, including fiscal and monetary policy. Factors such as leading,
coincident, and lagging indicators are discussed and illustrated. In addition, a brief presentation
of the determinants of interest rates is covered. The chapter concludes with a discussion of
industry analysis, including North American Industry Classification System (NAICS)
classifications of industries, information sources, the industrial life cycle and a Porter framework
that can be used to analyze industry competition.
CHAPTER OUTLINE
The top-down approach to fundamental analysis begins with analyzing the economy. Expected
economic performance will influence the choice of industry and the specific firm chosen as an
investment.
1. The Global Economy
PPT 12-2 through PPT 12-4
A top-down analysis of a company begins with an examination of global economic prospects.
Factors that may have relevance include political risk and exchange-rate risk. Exchange-rate risk
has several elements that are important to global economic analysis. Unfavorable movements in
exchange rates will affect a firm’s sales and profits and can change relative competitive positions
of firms. When investing in foreign markets, analysts must consider the effect that changes in
exchange rates will have on returns The extent to which exchange rates and other variables will
impact a firm depend upon its particular product market, the extent of hedging the firm engages
in, the expected response by competitors and the elasticity of demand of the firm’s product.
Stock-market returns, while mostly good everywhere in 2016 show a large range of performance
in both local currency terms and in U.S. dollar terms.
Chapter 12 – Macroeconomic and Industry Analysis
In Figure 12.1 you may wish to emphasize several points. First, when the results in U.S. dollars
are more negative than the results in the local currency, this indicates that the local currency
weakened against the dollar in nominal terms in 2016. Second, notice also the widespread
global effects of the financial crisis. When recession affects the majority of countries at the same
time, the depth of the recession can be expected to be more severe and the recovery can be
expected to be slower than normal. As of this writing many economists expect an L shaped
recovery rather than the more typical V shaped recoveries we have had from the previous mild
recessions of the 90s and the early 2000s. Third, notice that stock market returns were terrible
even though the countries had positive GDP growth. In some cases, countries with higher
growth rates had poorer stock returns. As always what matters is the deviation from expected
growth rather than the absolute growth rate.
2. The Domestic Macroeconomy
PPT 12-5 through PPT 12-7
This section will present some of the key economic statistics used to describe the state of the
macroeconomy. Key economic variables used in assessing the economy include gross domestic
product, unemployment rates, interest rates, inflation, budget deficits, and consumer sentiment.
The relationship between earnings and the price level of the S&P 500 is presented in the PPT.
Stock prices tend to rise and fall with earnings. The graph data implies a P/E ratio of between 12
and 25 which may be used as a ‘normal’ (non-bubble, non-depressed) range for the P/E ratio. In
doing so we would be relying on historical data. GDP data is published quarterly, and is often
revised. Forecasts of GDP abound and can be found at the Philadelphia Federal Reserve website
or in the Economist Magazine or at the IMF website.
The unemployment rate as of this writing was over 3.9%. Consumer confidence hit all time lows
during the crisis in 2008 but is currently quite strong. An increase in consumer confidence
bodes well for the economy since about 75% to 80% of growth in GDP has been driven by
growth in consumer spending in recent years.
The Federal Reserve (Fed) reduced short-term interest rates to nearly zero in an attempt to
stimulate aggregate demand during the crisis. However with the credit markets frozen and a
large debt overhang on too many households, consumption and investment have not grown
enough to prevent additional unemployment. The budget deficit ballooned to record levels with
the economic stimulus package. In general terms, budget deficits can crowd out private
investment (government borrowing is between 20% and 25% of total credit market debt, but
expect this percent to rise), leading to higher interest rates and slower growth. Recently, the Fed
has gradually increased rates until they sit around 1.9% in 2018.
Chapter 12 – Macroeconomic and Industry Analysis
Actually we have not observed crowding out because the foreign sector has supplied sufficient
funds to satisfy both public- and private-credit demands in the U.S. To do so however, the U.S.
has been absorbing about 80% of the world’s savings. This is probably unsustainable in the long
run and higher interest rates in the future are a distinct possibility, but not while the global
economy remains weak. China should recover more quickly than the U.S. if the proper policies
are utilized to stimulate domestic spending.
3. Interest Rates
PPT 12-8 through PPT 12-9
Forecasting interest rates is one of the most difficult areas of applied macroeconomics and yet is
perhaps the most important to consider in analyzing investments. A very simple supply-and-
demand framework is presented along with a graphic display of supply and demand. While the
graph is straightforward, the factors that go into forecasting rates are very difficult to predict.
Fiscal and monetary policy can affect economic growth and interest rates. Fiscal policy is
government spending designed to stimulate the economy. Monetary policy is manipulating the
money supply to stimulate the economy or reduce inflationary pressures.
4. Demand and Supply Shocks
PPT 12-10
Analysis of the economy will often distinguish between demand and supply shocks. A demand
shock is an event that affects demand for goods and services. A tax cut is a policy action
designed to influence the demand from economic participants. A supply shock influences
production capacity or production costs. Higher levels of education for the work force should
have the effect of increasing productivity or reducing production costs. A change in the price
and/or availability of oil is another example of a supply shock.
Chapter 12 – Macroeconomic and Industry Analysis
The economic growth rate in the 1990s was very high because of technological growth, low
commodity prices, low interest rates and low taxes. This was a favorable combination of
positive supply and demand ‘shocks.’ Negative supply shocks tend to result in demand greater
than supply, which is inflationary. Negative supply shocks also may result in reduced output,
leading to slower economic growth. Note: monetary policy is not very effective at correcting
supply shocks, except perhaps in the very short run. If a negative supply shock is serious enough,
stagflation (a stagnant economy with inflation) can occur.
5. Federal Government Policy
PPT 12-11
Fiscal policy involves government spending and taxing actions. Fiscal policy is an attempt to
influence the economy in a direct fashion. Monetary policy involves manipulation of the money
supply to influence economic activity. Market participants pay substantial attention to monetary
policy. Tools that are used by the Federal Reserve to influence the money supply and interest
rates include open market operations, the discount rate and reserve requirements. Supply-side
policies focus on incentives and marginal tax rates.
Fiscal policy is comprised of government spending and taxing actions to stabilize or spur growth
in the economy. This is the most direct policy method in terms of its effect on the economy
(Keynesian policy). However it is often implemented too slowly due to the political process
required. Fiscal spending has often been compared to a leaky bucket. Government spending is
very inefficient and it can be likened to carrying a leaky bucket to fill up the trough. The process
is highly politicized and government does not have a profit motive; hence, it is rarely an efficient
operation and much money is poorly spent, resulting in little growth.
Chapter 12 – Macroeconomic and Industry Analysis
If growth does not occur, then future taxpayers will face higher taxes to repay the debt used to
finance the spending. This is the problem with the Keynesian policy mentioned in the related
text box. However, evidence indicates that fiscal stimulus probably was called for during the
crisis of 2008. Evidence shows that severe recessions result in governments having to borrow
more than the amount needed for a temporary fiscal stimulus. Whether the actual stimulus bill
Congress passed was a good bill or not is another question. Many students will not understand
this issue and it is worth explaining. Fiscal policy is generally a poor means to fine tune an
economy, and, if misused, it can be inflationary. Fiscal policy probably was needed in the crisis
due to the inability of monetary policy to stimulate demand.
Note that changes in the discount rate are used as a signal of what direction the Fed wants
interest rates to move rather than as a direct policy tool. Changing reserve requirements change
the money multiplier and are not generally used to change the money supply. The most direct
tool is open market operations in which the Fed buys government securities from government
securities dealers. To pay for the purchase the Fed ‘hits a computer button’ and creates more
deposits on reserve at the Fed for the seller. This is the main way that the money supply is
expanded, rather than ‘printing money’ as people often euphemistically say.
Chapter 12 – Macroeconomic and Industry Analysis
Supply-siders focus on investment incentives invest, wealth generation and marginal tax rates.
Lowering tax rates tends to encourage more investment and improve incentives to work.
Together these should generate faster economic growth and “lift all boats,” so to speak.
However, we probably cannot rely solely on supply-side policies in a severe recession such as
the Financial Crisis of 2008. With the debt overhang (high levels of indebtedness) these policies
are unlikely to be sufficiently effective on their own. Income inequality may also rise as a result
of supply side policies. Those with better ideas, education, opportunities, work ethic, providence,
etc. will do better, others may not. If the majority is better off, but some much more so than
others, does this indicate that we should not use supply-side policies? If I give you the following
choice which would you prefer? Alternative 1: I give you $20 and your friend $100 or
Alternative 2: I give both of you $10 each. Studies show that many people will prefer
Alternative 2, even though both parties are better off in Alternative 1. Supply-side policies,
capitalism and global trade all can lead to higher wealth, but greater inequalities.
6. Business Cycles
PPT 12-12 through PPT 12-20
A defensive firm is one whose performance is not as sensitive to the performance of the
economy. Cyclicals include durable goods and finished goods the purchase of which is likely to
be delayed during a recession. These might include discretionary goods like jewelry, expensive
vacations, RVs, machine tools, steel, autos, and transportation. Defensive companies would
include food producers and food processors, pharmaceutical firms, medical services and public
utilities, tobacco, movies, and alcoholic beverages. The Conference Board publishes a set of
cyclical indicators to help forecast, measure, and interpret short-term fluctuations in economic
activity. Leading indicators tend to lead economic performance. Coincident indicators tend to
change directly with the economy. Lagging indicators tend to lag performance. Information on
economic variables is regularly reported in business publications such as the Wall Street Journal
and on line at Yahoo’s website. Examples are provided in the PPT.
7. Industry Analysis
Chapter 12 – Macroeconomic and Industry Analysis
PPT 12-21 through PPT 12-34
Industry analysis is used to identify industries that are expected to perform well in the future.
The variability of return on equity, and industry stock-price performance are displayed in the
PPT. Note that performance can vary widely among industries. It can be difficult to find a high-
performing stock in a poorly-performing industry. Also, understanding the industry helps the
analyst forecast future profitability and understand the level of competition faced by a firm in
that industry. One may be able to find a good value stock in a poorly-performing industry. In
fact this is Warren Buffet’s and Peter Lynch’s preferred strategy.
Defining an industry can be difficult. Where does one draw the line between one industry and
another? Many industries are closely related. The North American Industry Classification
System or NAICS has developed a useful way to define industry groups.
Sector rotation is a strategy that can be used to select companies that should perform well in for
various stages of the business cycle. This strategy is referred to as sector rotation and some
example investment types are provided for the phases of the business cycle. It is difficult to
achieve above average returns this way however, as often we don’t know which phase of the
cycle we are in until later and the duration of each phase is also unknown.
The common stages of industry life cycles and the accompanying pattern of sales growth are
presented in the PPT. Start up industries experience rapid growth in sales. Maturing industries
experience slowing growth in sales. Industries in relative decline commonly experience
declining sales. Stages:
Start-up example: Cell phones in the 1990s. Sales and earnings grow rapidly, no or small
dividends. Note that it is difficult to pick the eventual winners in this stage. Some firms
won’t make it and investing in these type firms can be risky.
Chapter 12 – Macroeconomic and Industry Analysis
Consolidation example: Emergence of industry leaders (Verizon), survivors of the start-up
phase become more stable, industry still growing faster than the economy overall.
Maturity stage example: Product has reached saturation level (think McDonald’s or perhaps
basic cell phones today), generally more competition and less diversification, so price
competition emerges which further limits profitability.
Relative Decline example: Growth is lower than the overall economy, may be facing product
obsolescence (VCRs)
Biotech is closer to the start up phase and is enjoying high rates of investment, high rates of
return on investment and low dividends. High growth rates beget competition however and
eventually growth must slow. Utilities are in the mature phase and have lower rates of
investment and lower rates of return on investment and higher dividends.
The last section of the chapter looks at Michael Porter’s five determinants of competition: threat
of entry from new competitors, rivalry between existing competitors, price pressure from
substitute products, the bargaining power of buyers, and the bargaining power of suppliers. The
Michael Porter framework provides an excellent method of analyzing an industry and I have seen
an investment analyst presentation centered around a Porter analysis. It is worth spending a bit of
time on this topic.
Determinants of Industry Competition and Profitability
1. Threat of Entry
• New entrants reduce profitability
• Barriers to entry preserve profitability, examples of barriers include
a. Large scale required to be profitable (autos)
b. Secure distribution channels
c. Brand loyalty, unique differentiated product
2. Rivalry between existing competitors
a. Equal competitors reduce profitability
b. Slow industry growth,
c. High fixed costs,
d. Scale economies,
Components b, c, and d put pressure on industry participants to cut prices to compete. This may
limit industry profitability.
3. Pressure from substitute products
• Substitutes limit profitability (propane, natural gas)
Chapter 12 – Macroeconomic and Industry Analysis
4. Bargaining power of buyers
• A buyer that purchases a large percent of an industry’s output can limit the selling
industry’s profitability (auto parts suppliers)