Chapter 6 - Economic/Industry Analysis of Equity Securities

Question 1

What do the terms ‘strategic trading’ and ‘tactical trading’ refer to?

Answer 1

Strategic trading involves establishing and maintaining a portfolio’s strategic asset allocation. This type of trading tends to be infrequent since the strategic asset allocation is the long-term asset mix.
Tactical trading involves shifting positions or portfolio allocations in reaction to or in anticipation of day-to-day releases of economic information.

Question 2

What types of tools do economists use to filter out the ‘noise’ in economic releases of information?

Answer 2

Tools include seasonal adjustments, moving averages, trend analysis.

Question 3

What do economists do to analyze indicators independent of seasonal movements (such as the over or underperformance of certain sectors during certain seasons)?

Answer 3

Economists adjust the data by first isolating the time periods that have the most influence on changes in the variable. Then they adjust the time series of the variable so the effect of seasonality is either eliminated or minimized. The data can then be compared to other months in which seasonal influences are less severe.

Question 4

What are moving averages?

Answer 4

A moving average is a smoothing technique used to average the values of the indicator over specific periods. This is helpful for indicators that display excessive volatility that cannot be explained by seasonality. More variability is removed from the time series with more time periods used.

Question 5

What is traditional trend analysis used for and how is it done?

Answer 5

Used to forecast future values for an indicator that are independent of other variables. A sufficiently large number of periods must be used in a moving average adjustment to identify a longer-term trend for an indicator. Trends in economic indicators occur over years/decades.

Question 6

What are the terms for indicators that move in tandem with the economic cycle and ones that move in the opposite direction of the cycle?

Answer 6

In tandem - procyclical
Opposite - countercyclical

Question 7

What are secular trends?

Answer 7

These are trends indicators that unfold over many years or even decades, compared to a traditional economic cycle.

Question 8

How long is a traditional economic cycle?

Answer 8

3 - 5 years.

Question 9

What is an economic forecast?

Answer 9

Economist’s prediction for the outcome of a particular economic indicator or event, including the release of economic data, the contents of an important policymaker’s speech, or the results of a planned central bank decision on interest rates.

Question 10

How do those outside the investment industry use economic forecasts?

Answer 10

Companies will develop hiring plans or capital expenditure plans based on an economic forecast. Governments will alter spending and taxation according to economic outlook.

Question 11

What is an ‘add-up’ model when referring to economic forecasts?

Answer 11

Also called a bottom-up model. Economic components are estimated/projected based on available information and the expected relationship between the information and the variable. The components are then aggregated/’added up’ to produce a sector or macro forecast.
An example of an add-up/bottom-up model is GDP.

Question 12

How do you calculate GDP?

Answer 12

GDP = consumption + private investment + government spending + exports minus imports

Question 13

What is econometrics?

Answer 13

Real-world observations, mathematics and statistical analysis are combined to test a theory and them mathematically represent it in order to predict the future value of an economic variable. It can be used to determine if certain relationships exist between different variables (such as automobile sales declining when interest rates rise).

Question 14

What are endogenous and exogenous variables?

Answer 14

Endogenous variables are one that depend on variables also generated from a forecast as they themselves are forecasts based on available data.
Exogenous variables are not determined from within a model, such as the level of government spending.

Question 15

What is a consensus forecast? What is this used for?

Answer 15

The average forecast of several economists. Used to provide an average view of major economic variables used in making investment and business decisions. Aids in positioning markets ahead of key economic releases.

Question 16

What is one of the most closely watched economic indicators?

Answer 16

Monthly US payrolls report.

Question 17

What is the effect on the markets/economy if the US payrolls report shows an increase in payrolls in a given month larger than the consensus forecast?

Answer 17

Equity markets tend to rally while bond markets tend to sell off. The US dollar tends to strengthen and commodity prices may increase on the perception that stronger employment growth suggests stronger overall demands for commodities.

Question 18

What indicators do the markets tend to focus on when growth in the economy has been evident for several months?

Answer 18

The focus shifts away from GDP to inflation indicators. As growth continues, central banks are expected to tighten monetary policy to dampen inflation.

Question 19

What is a ‘whisper estimate’?

Answer 19

Interim information arrives after the consensus forecast is calculated. The market often formulates a ‘whisper estimate’ as people discuss expectations in the lead-up to the report. Rather than comparing the outcome to the printed consensus forecast, they react to deviations from the whisper estimate instead.

Question 20

What happens if an economy grows at below its potential growth rate? What does this prompt the central bank to do?

Answer 20

Excess capacity and ultimately disinflation are created. Prompts the central bank to lower interest rates.

Question 21

What does the Bank of Canada predict Canada’s potential growth rate to be?

Answer 21

2.5%

Question 22

What is the potential rate of growth?

Answer 22

The rate at whoch an economy should grow when all resources (labour and capital) are fully utilized.

Question 23

What happens if economic growth exceeds the potential growth rate?

Answer 23

This implies that there’s excess demand, which results in higher inflation. The central bank will be prompted to tighten monetary policy by raising interest rates.

Question 24

Which Canadian economic indicators are released quarterly?

Answer 24

GDP (National Income & Expenditure Accounts) and the Industrial Capacity Utilization Rate

Question 25

Which Canadian economic indicators are released monthly?

Answer 25

• Real GDP by industry
• Labour force survey
• Canadian International merchandise trade balance
• Monthly survey of manufacturing
• Retail trade survey
• Housing starts
• CPI
• Industrial product price index

Question 26

How often are GDP reports released in the US?

Answer 26

GDP is estimated quarterly, but revised monthly.

Question 27

What is the Federal Reserve Beige Book?

Answer 27

Similar to the Bank of Canada’s Monetary Policy Report, it is a summary of economic conditions in Federal Reserve districts released 8 times per year.

Question 28

How are industries classified?

Answer 28

S&P and MSCI developed a comprehensive industry and sector classification system known as the Global Industry Classification System (GICS). An industry is classified by the product or service it produces and each industry belongs to an industry group and each industry group belongs to one of 11 sectors. Each industry is broken down into sub-industries.

Question 29

What are the 11 Global Industry Classification System (GICS) sectors as defined by S&P/MSCI?

Answer 29

• Consumer staples
• Consumer discretionary
• Energy
• Materials
• Communication
• Real estate
• Financials
• Health care
• Industrials
• Utilities
• Information technology

Question 30

How do recessions feed on themselves?

Answer 30

Consumers and businesses spend less. Since sales are falling, businesses reduce their spending, lay off workers, buy less merchandise and postpone plans to expand. Business suppliers then lay off workers and reduce spending. Workers spend less as they earn less, and business income/profits continue to decline.

Question 31

How do you characterize the trough in the business cycle?

Answer 31

Characterized by high unemployment rates, a decline in annual income, overproduction and rising inventory levels. Eventually, real GDP stops declining and starts recovering.

Question 32

How do you characterize the peak of the business cycle?

Answer 32

Real GDP stops increasing and begins declining. Business expansion ends its upward climb. Employment, consumer spending, and production reach their highest level.

Question 33

What is typically the longest stage of the business cycle?

Answer 33

Recovery and expansion.

Question 34

What is one of the dangers of the “peak” stage of the business cycle?

Answer 34

Inflation.

Question 35

How do the stock market cycle and business cycle work together?

Answer 35

The stock market cycle leads the business cycle by several months since the stock market moves based on the anticipation of economic activity and tries to forecast future fundamental events.

Question 36

How does the financials sector typically react to various phases of the business cycle?

Answer 36

Financial companies are interest rate sensitive and benefit from a decline in interest rates. Financials are usually one of the first groups to advance after a bear stock market and are considered a leading indicator of the equity markets.

Question 37

How does the consumer discretionary sector tend to move through the business cycle?

Answer 37

Companies in this sector tend to lead the stock market at the bottom and move up along with the stock market at the start of a new bull cycle. Consumer discretionary stocks are interest rate sensitive and sensitive to the business cycle in general.

Question 38

How does the information technology sector react to different phases of the business cycle?

Answer 38

Technology stocks are often popular during the early to mid stages of an economic expansion. They can be quite cyclical depending on their dependence on capital spending and business/consumer demand.

Question 39

How do stocks in the industrials sector react to different phases of the business cycle?

Answer 39

As capital spending increases through an expansion, companies often expand their production capacity to meet demand. At this point, industrials stocks tend to grow.

Question 40

How do stocks in the communication services sector react to different phases of the business cycle?

Answer 40

Diversified telecommunication services companies are less sensitive to changes in the business cycle, while media and entertainment companies are more sensitive. Spending increases during an expansion and these stocks perform better.

Question 41

How do stocks in the materials sector perform during the various phases of the business cycle?

Answer 41

Stocks in this sector include chemicals, paper and forest, and steel. They have profits driven by high utilization of capacity and strong market demand for products. These stocks tend to be popular with investors late in an economic expansion.

Question 42

How do stocks in the energy sector perform during the various phases of the business cycle?

Answer 42

Political events have historically had a major impact on these industries. They are all driven by the supply and demand picture for energy worldwide. Energy stocks tend to be popular with investors late in the business cycle.

Question 43

How do stocks in the consumer staples sector perform during the various phases of the business cycle?

Answer 43

These stocks tend to experience fairly steady demand and are less sensitive to changes in the business cycle. Typically attract investment when the economic cycle has matured or is in the early stages of contraction.

Question 44

How do stocks in the health care sector perform during the various phases of the business cycle?

Answer 44

Generally, health care stocks are defensive and move similarly to consumer staples. These companies are generally unaffected by economic fluctuations.

Question 45

How do stocks in the utilities sector perform during the various phases of the business cycle?

Answer 45

Utilities companies have historically been very sensitive to interest rates due to large debt financing costs incurred to build infrastructures. These stocks perform well in an environment of declining interest rates.

Question 46

How do stocks in the real estate sector perform during the various phases of the business cycle?

Answer 46

Companies tend to be sensitive to interest rate cycles and therefore are sensitive to economic cycles. As interest rates decline, real estate market activity increases and the sector becomes a more attractive investment.

Question 47

What are examples of barriers to entry?

Answer 47

• Product differentiation (established companies have distinct advantages over newer companies)
• Absolute advantage (an example is an established company having patented proprietary technology that results in costs so low that new companies cannot produce a similar product at a similar price)
• Economies of scale (avg cost per unit for a new firm can be higher than large established firms with significant market share, specifically for industries with high start-up costs)

Question 48

Why is the relationship between a government and different industries so important?

Answer 48

Governments can protect industries they deem important, or they can enact legislation that reduces an industry’s profitability if they do not approve of an industry.
As well, governments choose which industries to open up to foreign competition (and by how much) during trade negotiations. Industries deemed less important may face increased competition that can cut into profits and lower share prices.

Question 49

Which factors (4) impact the degree to which an industry’s labour conditions affect its profitability?

Answer 49

1. Degree of automation (how important labour is)
2. Management and labour relations (negative impacts if almost every contract negotation provokes a strike)
3. Level of share ownership (companies with share ownership/profitability-based bonus schemes may have higher productivity and fewer strikes)
4. Labour productivity (with more productive workers, companies can offset higher costs related to wage increases)