Stock Analysis

Economic Factors

The following terms pertaining to the economy are often considered when analyzing markets and investments. 

Business Cycle - the business cycle has four phases: expansion, peak, recession and trough. These cycles create price changes, which lead to changes in total spending in relation to the amount of goods and services being produced. 

Inflation - Inflation is a gradual rise in prices and resulting decreasing in purchasing power. It is normally associated with economic expansion and a low unemployment figure.

Deflation - Deflation is a decline in prices, where production exceeds demand. Deflation normally occurs during recessions and leads to a rise in unemployment.

Gross National Product (GNP) or Gross Domestic Product (GDP) - This statistic measures all goods and services produced in the U.S. In a full year. GNP can be expressed in the following ways:

• Money GNP, using inflated dollars
• Real GNP, measured in 1972 dollars. Real GNP is considered a more realistic measure, as it is adjusted for the effects of inflation. Recession-means 6 months of declining GNP. 

Depression - Means 6 quarters of declining GNP

Consumer Price Index (CPI) - This indicator of the change in prices of goods and services is published by the U.S. Bureau of Labor Statistics. Included in the index are food, transportation, medical care, entertainment and other items purchased by households and individuals.

Balance of Payments - This is a summary of money flowing in and out of the U.S.

If the U.S. Is spending more for imported goods and services than it receives for goods it exports, a deficit results. If the US received more money by selling goods in foreign markets than it spent on imports, the deficit would decrease. A decrease in the balance of payments raises the federal deficit;an increase in the balance of payments would reduce the deficit.

 Money Supply - This is the total amount of available money and credit in the US. The Federal Reserve Board attempts to control money and credit to create a stable, growing economy. The following are the most significant components of the money supply for the purposes of analyzing investment markets.

M-1 - includes all currency in circulation plus demand deposits. Demand deposits are those which depositors may withdraw at any time (on demand) without prior notice, such as business and personal checking accounts at commercial banks.

M-2 - includes M-1 plus overnight eurodollars (dollars trading overseas), overnight repurchase agreements, money market shares, savings deposits held by thrift institutions and time deposits in commercial banks. A time deposit is one that the depositor agrees to leave in the bank for a set period of time. (time deposits earn a specific amount of interest;if funds are withdrawn sooner than agreed, interest is forfeited).

 The Federal Reserve Board computes the M-1 measure weekly and publishes it each Thursday afternoon. The M-2 figure is published on the last Thursday of each month.

 Prime Rate - This is the rate of interest banks charge their best customers, usually well established companies, to borrow money.

Call Rate - This is the rate of interest banks charge brokerage firms to borrow money, also referred to as the broker loan rate. Brokerage firms often borrow to extend credit for margin accounts. The loans are collateralized by securities and referred to as "call loans"

Intermediation - This is the process whereby investors deposit funds in commercial banks and savings and loans. These "intermediaries" in turn to invest the funds in bonds or other securities with yields higher than the rates they are paying depositors.

Disintermediation - This is the process whereby investors withdraw funds on deposit with banks and savings and loans, and invest directly in securities with higher rates of return. 

The Federal Reserve Board and Monetary Policy

The Federal Reserve System, the nation's central bank, was established in 1908 as an independent agency of the federal government. The US is divided into 12 Federal Reserve Districts. The Federal Reserve's Board of Governors is responsible for coordinating the activities of the 12 district banks. The Board has seven members who are appointed by the President and confirmed by the Senate. In recent years, the goals of the Federal Reserve Board ("Fed") have been to reduce the federal deficit, promote economic growth and control inflation. The following are its three primary tools for implementing monetary policy.

Open Market Operations

Open market operations are the Fed's most effective short term monetary control. Using open market operations, the Fed can effect changes in the economy by increasing or decreasing the money supply. Open market operations consist of buying or selling US government securities, primarily treasury bills. The Fed may also purchase or sell treasury notes and bonds. When the Fed buys government securities, it pays for them with funds which are channeled into commercial banks. This increases the banks' deposits and adds to their funds available for loans.

 To tighten the money supply, the Fed sells government securities to banks and securities dealers, who pay for them using demand deposits held by commercial banks. The withdrawals reduce the amount of money banks are able to lend.

 The Federal Open Market Committee (FOMC) oversees the Fed's open market operations. Members of the FOMC include the seven governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York and the presidents of four other district banks represented on a rotating basis. While each member of the FOMC has one vote, the Chairman of the Board of Governors traditionally plays a decisive role in formulating policy, and acts as chief spokesman for the system.

 The FOMC meets approximately once a month to review economic conditions, goals and guidelines for open market operations. At the end of its meeting, it issues directives to the manager of the Fed's open market account in New York to buy or sell government securities.

 Discount Rate

This is the rate of interest the Fed charges commercial banks for borrowed funds. Borrowing from the Fed's "discount window" is intended to help banks in emergency situations;it is not to be used as an inexpensive means of borrowing to generate profits. If the Fed considers bank borrowing excessive, it may discourage it by raising the discount rate.

An increase in the discount rate tightens the money supply;a decrease eases the money supply. Because the discount rate affects the cost of borrowed funds throughout the banking system, it has a significant impact on short term interest rates. Changes in the discount rate are made infrequently and are usually considered a strong indication of a shift or reversal in monetary policy.

Reserve Requirements

A reserve requirement is the percentage of its deposits a bank must keep on reserve with the Fed. Demand deposits are volatile, and therefore have a higher reserve requirement than time deposits, which remain in banks for longer periods of time.

The higher the reserve requirement, the less banks can lend. An increase in reserve requirements makes money less available;a decrease in reserve requirements has the opposite effect.

In summary, if the Fed wishes to decrease the availability of money and credit, it sells government securities in the open market. When banks and dealers pay the Fed for securities they have purchased, substantial amounts of money are taken out of the banking system, resulting in tighter money and credit. If the Fed wishes to increase the availability of money and credit, the FOMC, through its trading desk, will buy government securities in the open market. When the Fed pays the banks and nonbank dealers for the securities, the result is an injection of funds into the banking system, making money and credit more available.

Any method or tool that creates additional money for the banking system is inflationary;any method or tool that shrinks the amount available in the banking system is deflationary. It should be noted that the amount of money banks can lend depends not only on the Federal Reserve's policy of ease or restraint, but also on the banks' ability to attract money from depositors. The greater a bank's deposits, the greater it's lending ability and the more profit it will make on loans;the less deposits it attracts, the less money it will have to lend.

The Federal Reserve System and Securities Markets

In addition to open market operations and changes in the discount rate and reserve requirements, the Fed has several other methods of controlling the cost and availability of funds. These include raising and lowering margin requirements for loans to purchase securities.

The Securities and Exchange Act of 1934 gave the Federal Reserve Board the power to determine the amount of credit extended by brokerage firms and banks for the purchase of securities. Regulation T of the Federal Reserve System governs margin lending by brokerage firms;Regulation U covers lending by banks. For several years, the "Reg T" margin requirements for initial stock purchases has been 50%.

Margin requirements are not as effective a tool for the Fed as the three methods described above. Margin requirements affect only the securities markets;open market operations, the discount rate and reserve requirements affect the entire banking system. 

Multiplier Effect

The multiplier effect is the magnifying effect of the Fed's monetary policy. As money is created by loans, and deposits are made with the borrowed funds, there is a multiplying effect as "money creates more money". For example, if a $10,000 loan from a bank is deposited in another bank, the second bank may lend the deposited funds less the reserve requirement.

For example, if the reserve requirement is 16%, the second bank must keep $1,600 and may lend $8,400. If this $8,400 is deposited into a third bank, the bank must keep 16% or $1,344 on reserve and may lend $7,056.

Theoretically, this process can continue through several banks, until many times the amount of the original $10,000 loan is added to available credit. If the above example were carried further, it would show that $10,000 of new money in the banking system creates approximately $62,500 in additional credit.

 A rough method of determining the amount of credit generated by a new deposit is to divide 100 by the reserve requirement as follows: 

Ex: 100/16% = 6.25, so the multiplier is 6.25 times

$10,000 new money injected into the banking system x 6.25 = $62,500 in credit.

The multiplier effect is accomplished through the commercial banking system, this is why banks are said to "manufacture money".

Fiscal Policy

Fiscal policy involves taxation and government spending. While Congress must approve fiscal policy, it is the Office of Management and Budget ("OMB") that conceives the strategy.

If the economy is at full employment, where an increase in government spending would only increase prices and lead to inflation, the government may adopt a policy of restraint. It can implement this policy by raising taxes or decreasing expenditures. If unemployment rises to a level where the nation's resources are under utilized, the government may respond with a fiscal policy to stimulate the economy. The results could be a decrease in taxation, an increase in government spending or both.

The system which requires interaction between the Federal Reserve's monetary policies and the government's fiscal policies is intended to curb inflation and deflation, thus minimizing the extremes of economic expansion and recession.

Fundamental Analysis

The focus of fundamental investment analysis is on a company's primary business and how it is managed. Industries are evaluated based on qualitative factors such as general outlook, foreign competition and the possible effects of the economy and fiscal policy. Individual companies are examined with respect to their products, profitability, financial structure, management and other internal considerations.

Industry Analysis

Industries develop through a cycle which consists of the following phases. 

Pioneering, characterized by rapid expansion; 

Maturity, where many small companies consolidate into a few large companies;and

Stabilization, where growth slows and a few companies remain.

As an industry evolves through these three phases, and growth potential is diminished, investors demand higher dividend payouts from individual companies within the industry.

Industries are classified as follows:

Defensive - A defensive industry is one that is relatively insensitive to changes in the economic environment. Demand for its products will remain fairly level regardless of the economy, interest rates or fiscal policy. Defensive industries include food, pharmaceuticals and utilities. 

Cyclical - Cyclical industries are those most affected by changes in the general economy and business cycles. Many cyclical industries are highly sensitive to interest rates. The automobile, housing and steel industries are among those considered cyclical.

Growth - A growth industry is one that is growing faster than the overall economy. Growth industries are characterized by accelerated research and development;dividend payouts, if any, are low. For most companies in growth industries, stock prices are influenced more by investor expectations of future performance than by economic factors. Current examples of growth industries include biotechnology, robotics, and telecommunications.

Fundamental analysts seek industries with positive aspects, and then examine individual companies within those industries to determine which have the best potential.