Security Analysis: Part 1- Economic Assessment

Security analysis begins with assessing the economy. These are the factors that affect the performance and profitability of the firms that issue stocks. As companies wax and wane with economic conditions so do the prices of their stocks. Security analysis ferrets out the extent to which individual stocks are affected by the various economic conditions. Some sectors of the economy will be more or less affected by specific economic events. Careful security analysis will highlight those stocks that are likely to suffer and those that will remain relatively unaffected.

Security analysis of specific sectors or specific stocks involves the study of targeted sectors of the economy. Economic analysis illuminates the basis for valuation of a targeted stock. Not all stocks are created equal and while some stocks plummet with economic uncertainty others will be relatively unaffected. Broadly speaking those companies that produce elective goods will be the first to suffer in a slowdown. The automobile industry is particularly vulnerable to economic downturns but companies who produce non-elective merchandise, particularly staple food items will be less volatile.

Keeping a running score of what is happening in the economy becomes the first activity of security analysis and is conducted both formally and informally. The economic measures most indicative of economic stability or change are:

� Gross Domestic Product often referred to simply as the GDP this measurement reflects performance of the economics within the country as a whole. GDP is an assessment of the total monetary value of all the goods and services provided within this country. The GDP numbers are issued by the Commerce Department every three months. Keeping tabs on the GDP gives the security analyst a picture of the annual rate of growth or slump in real time dollar figures. When the GDP grows the potential affect is the beneficial for the securities market and conversely when the GDP plummets the securities market sags as well.

� Industrial Output figures are published every month by the Federal Reserve Board. The industry figures show actual changes in production of U.S. mines, factories, and utilities. This is an index that goes up when the economy is healthy, and down when the economy is ailing. Because the Industrial production figures are published monthly they provide an inside look at business health between the GDP reports. The industrial output survey gives detailed figures for sectors and so gives the securities analyst a good look at how specific industries are performing.

âÂ?¢ The Index of Leading Indicators is one number that is derived from around a dozen statistical indicators that affect the GDP. The changes in factors such as the numbers of employee layoffs, the price of raw materials, the number of new orders placed by industry, and the money supply actually precede (and so are said to “lead”) the GDP. Again these figures are released by the Commerce Department.

� Individual Gross Income is an indication of personal spending potential and reflects before tax income. This monthly report can be misleading due to cash transactions that may not be reported, however the intent of the report is to explain changes in consumer purchasing activity during economic swings. These reports come out monthly from the Commerce Department.

� Sales at Retail Level are also estimated monthly by the good old Commerce Department and covers everything from tomato juice to trucks. An investor doing a careful security analysis will recognize that the clues to consumer spending can be a predictor of short and long term future conditions in the economy. Sulky sales for several weeks will lead to decreased orders and decreased production resulting in decreased value of the company stock.

âÂ?¢ Money Supply is reported every week by the Federal Reserve and is actually a three part measurement. Understanding the money supply and the interactive economic affects are critical to any security analysis. The three parts of the measurement look at 1.) Currency, demand deposits, and NOW accounts. 2.) All the factors in the first part plus savings deposits, money market deposit accounts, and money market mutual funds. 3.) The third part includes the first two parts and large Certificates of Deposit. The factor that analysts pay the closest attention to is the second part. When the growth that is measured by currency, demand deposits, NOW accounts, savings deposits, money market deposit accounts and money market mutual funds is steady and “reasonable” the economy is thought to be expanding at a healthy pace. When these factors show a sharp spurt of growth it is considered inflationary and “The Fed” will take steps to slow the economic growth. On the other side of the coin is the evidence that a recession is looming when the growth of these factors slams on the brakes.

� Consumer Prices can be another tool in security analysis but may not be an accurate picture of what they are purported to measure. Using consumer price indexes, which are published monthly by the Labor Department, can be a tool if used cautiously in conjunction with other tools but should be viewed as peripheral indicators of economic conditions.

� Employment is widely quoted as an indicator of economic well being. Careful security analysis will look at both the percentage of workers who are involuntarily out of work, and the number of payroll jobs reported by business. Simply looking at unemployment numbers can give a false evaluation as they may not actually be accurate. Payroll jobs numbers will indicate when companies are either cutting production or ramping up production to meet demands.

Now just to keep you mumbling to yourself I would like to point out that changes in stock prices nearly always occur before the changes discussed above become apparent in the economic picture. Actually stock prices are part of the formula for predicting the direction of the economy. Effective security analysis takes this conundrum into consideration and hones a whisper sharp sensitivity to underlying economic changes. To fine tune your sensitivity study the following sites carefully with your morning coffee each day.

� Http://www.whitehouse.gov/fsbr/esbr.html for easy access to Federal economic indicators. You will find links to the most timely information produced by government agencies and all the information from the Economic Statistics Briefing Room.

� www.conference-board.org/ Provides information on consumer confidence, leading economic indicators and the Consumer Confidence Index.

� www.economist.com Authoritative weekly newspaper focusing on international politics and business news and opinion.

âÂ?¢ www.dismal.com For beginners there is a section in the “Today’s Economy” sidebar titled Especially for Students

Perfecting security analysis is a full time job that embodies art and science, discipline and passion, quick thinking and studied reasoning. The beginning of expertise is a full understanding of the closely embraced dance of the market and the economy.

References:
Fundamentals of Investing, Gitman and Joehnk, 2003, Pearson-Addison Wesley

Morningstor Complete Investor, Benz and Dorsey, 2006, Wiley