In this module, we focus on US economic indicators. However, the same (or similar) indicators are released in foreign countries. While each indicator alone cannot provide a full consensus about the state of the economy. These indicators can be evaluated together to make conclusions about the economy. Key Economic Indicators The Bloomberg site provides a monthly Economic Calendar identifying when each of the reports are released. This calendar in the market data section of the site, allows the viewer to click on different reports and see how the different indicators can affect the economy. The consensus forecast is given for each indicator. An analysis of the data appears in a report below. Each report has an analysis below to assist with interpretation. Key economic indicators (also called market movers) are highlighted. http://www.bloomberg.com/markets/economic-calendar/ Key Economic Indicators Key economic indicators are measurements of different aspects of the US economy that signify strengths and weaknesses. Economic indicators can strongly influence movements in financial markets. However, studying economic indicators can be challenging because: 1. There is a large volume of economic data that is released on a daily basis. Key Economic Indicators 2. In a global market, it is important to study not only US economic indicators, but also indicators of other countries, especially industrialized nations such as the United Kingdom, Japan and major Euro-zone countries (i.e. Germany and France). This compounds the number of economic indicators that must be followed. Key Economic Indicators 3. Some economic indicators are much more influential than others. As a student of the financial markets, it is important to identify these. 4. The relative importance of these economic indicators can change over time. In particular, the markets will place more emphasis on economic indicators they believe that the Federal Reserve is following in their assessment of the strength of the US economy. Key Economic Indicators 5. The economic indicators and the lag time differ within a period covered. Lag time is the time between the period the announcement covers and its release date. Cover different time periods. Some indicators have different lag times…the period between the period covered and its release. 6. What drives financial market movements is not the “actual data” that is released but, rather, how this “actual data” compares with “the consensus forecast” – what major economists are predicting. Remember, financial markets are “efficient” meaning all available market information, including the consensus forecast, is built into security prices. Indicators 1. Employment • Employment Situation: Released monthly the first Friday of the following month and breaks down the employment situation demographically by industry, sector, and geographic region. The Employment Situation covers more than 500 industries and a few hundred metropolitan areas. The most watched data of the report is the new non-farm payroll which shows how many jobs were created in the previous month outside of the agriculture sector. Indicators Employment Indicators New Jobless Claims: The jobless claims report is released every Thursday and it shows the number of individuals who filed for unemployment benefits for the first time. If the number of first-time files decreases, it indicates a positive trend; but if the number of first-time files increases, it indicates a negative Because jobless claims are released weekly, data may be volatile. Indicators Employment Indicators 2. Inflation Consumer Price Index (CPI): The CPI is a measure of inflation at the retail level and is released monthly. It shows the price change for a fixed basket of goods bought by an average working class family. This index is important because it is used to adjust many different contracts that affect living standards (wages, rent, social security benefits). Indicators • Producer Price Index (PPI): The PPI is a measure of inflation at the wholesale level. The index calculates the price change of the raw materials that go into the basket of finished goods. Indicators 2. Inflation- continued Indicators • Core CPI and PPI: The Core CPI and Core PPI removes food and energy from the price change calculation. Food and energy are considered the most volatile elements of the indexes. They are removed from the core calculation in order to obtain a more accurate picture of actual price changes occurring in the economy. Indicators 3. Gross Domestic Product (GDP) • The GDP is a sum of all of a country’s production within a quarter. The US GDP is released quarterly. GDP is the most comprehensive economic indicator. A higher GDP points to a stronger economy. GDP also can be divided by the population (GDP per capita) to show a country’s standard of living. Indicators 3. Gross Domestic Product (GDP) Continued GDP = C + I + G + NX C = Consumption I = Investments G = Government Spending NX = Net Exports = Exports-Imports Indicators 3. Gross Domestic Product- Continued Gross Domestic Product is revised in each of the two months after the initial release. For example, GDP for the first quarter is released in April and revised in May and June. These releases can vary substantially. The three GDP figures below are for the first quarter in 2013. As you can see, the actual GDP changed with each revision from the GDP released in April to the GDP released in June. Indicators Gross Domestic Product (GDP)- Continued Indicators 4. Consumer Confidence • Every month, American consumers and households are surveyed regarding their views of the economy and employment Indicators 4. Consumer ConfidenceContinued Consumer confidence in the economy can have a great affect on stocks and bond prices. For example, in a recessionary economy; where unemployment is high, consumers will be reluctant to purchase goods and services, adversely affecting economic growth. Measures of Consumer Confidence US Consumer Confidence Index: A monthly survey of 5,000 households taken by The Conference Board that provides a measure of how confident consumers are about the economy. Michigan Consumer Sentiment Index: A monthly survey conducted by the University of Michigan that conducts telephone surveys in order to gauge the overall consumer expectations about the economy. Retail Sales: A measure of how much and what goods consumers are buying from data collected by the US Census Bureau. This data is released in the middle of each month for the previous month. This indicator is important because retail sales make up about half of total consumer spending and a third of the total economic activity. Strong retail sales data can indicate a high degree of consumer confidence. Indicators 5. Housing • Housing Market Index: A monthly report; surveying members of the National Association of Home Builders, that gauges their perceptions of the overall economy and the housing market. This indicator is similar to the Consumer Confidence indictor because it identifies how willing people are to buy homes. A willingness to buy a home shows confidence but an aversion to buy a home indicates consumer uncertainty in the economy. • Other housing indicators are Housing Starts, Building Permits, New Home Sales, and Existing Home Sales. Fundamental Security Analysis A company’s financial ratios are typically compared to other companies within the same industry. For example, Walgreen's ratios are compared to the ratios of CVS and Rite Aid. This real life depiction comparing the three companies is shown at the end of this section. 1. Liquidity Ratio: Measures a company’s ability to pay off debt. Liquidity ratios are important to determining if a company is in a sound financial position and can recover if unexpected events occur in the company or the economy. Current Ratio: The ratio of current assets to current liabilities. It shows a company’s ability to pay off short term debt with its short term assets. A large ratio indicates the company is in a sound position. 2. Quick Ratio: A measure of how well a company can pay off its short term liabilities with its current assets, not including its inventory. The quick ratio excludes inventory because inventory tends to be less liquid, thus difficult to quickly turn into cash even though it is a current asset. Quick Ratio = Current Assets - Inventory Current Liabilities 3. Profitability Ratios: measure how much return a company can generate with either its assets or equity in the business. – Return on Assets: A measurement of how profitable a company is based on their assets. It shows how many dollars of net income are generated per dollar of asset. ROA = Net Income Total Assets – Return on Equity: A measurement of how profitable a company is based on the equity put into the business from the shareholders. It is the ultimate measure of profitability from the shareholders’ perspective. ROE = Net Income Shareholders’ Equity 4. Price to Earnings Ratio: A measure that shows the company’s current share price per??? the current earnings per share. A high P/E ratio means that the investors are expecting the earnings to increase in the future. A lower P/E means that investors do not expect the company’s earnings to increase significantly. 5. Solvency Ratio: A measurement or measure that shows how well a company is able to cover its long-term liabilities. It takes the company’s after tax net profit and depreciation and divides that by the total liabilities (current and long term). Example Example: Refer to the below financial Income Statement and Balance Sheets from CVS, Rite Aid & Walgreens. Calculate the companies’ current ratios, quick ratios, return on assets, return on equity, and price to earnings ratios. Make a comment on what each ratio says about the company and compare each ratio denoting which company has the strongest ratio. (*Note: These Financial Statements are simplified for the purpose of the example) CVS Caremark: Stock Price= $60.32, Earnings per Share= $3.86 Rite Aid: Stock Price= $3.41, Earnings per Share=($0.43) Walgreens: Stock Price= $50.54, Earnings per Share= $2.43 Example Rite Aid’s Current Ratio is the largest, followed by CVS and then Walgreens. All of the pharmacies have current ratios larger than one meaning they are able to pay off their short term liabilities with their current assets. Example Quick Ratio: CVS has the largest quick ratio, followed by Rite Aid and then Walgreens Return on Assets. All of the ratios are less than one because of the type of business the companies do. A large portion of their currents assets is inventory and the quick ratio takes out inventory from the calculation. Example Return on Assets: All three companies have similar ROAs. In comparison to each other, Walgreens has the highest ROA meaning it is more profitable relative to its total assets than CVS and Rite Aid. *Note that a company’s ROAs are generally compared with other companies in the same industry because of the different business structures within industries. Example Return on Equity: Walgreens and CVS have similar ROEs of 0.12 and 0.10, respectively. This means that the companies are generating about 10-12% return on the shareholders’ equity investments. Rite Aid generated negative net income and negative shareholders’ equity so it is unprofitable. Example Price to Earnings: Walgreen’s P/E ratio (20.80) is the largest followed by CVS (15.63). Rite Aid has a negative P/E ratio (-7.93). Walgreen’s and CVS’s ratios indicate the investors expect both company’s earnings to increase. Rite Aid’s P/E ratio shows that there is little investor confidence for the company to increase its earnings. Bond Analysis Interest rates are the most important determinant of bond prices. Therefore, the most important bond market analysis is interest rate movements. In particular, “spreads” – the difference between two interest rates – are closely followed. • Term Structure is the study of how maturity affects interest rates. 1. Yield Curve: A line that plots interest rates of bonds of similar credit rating but with different maturities. The yield curve is most notably linked with US Government (Treasury) Bonds. The Treasury yield curve is used as a benchmark for determining interest rates for other bonds. Yield curves are more often described by their slope or shape – positively sloped, negatively sloped, or flat. The yield curve below represents a “normal” or positively sloped (shaped) curve. The bonds with shorter maturity have lower yields and the longer maturity bonds have higher yields. This is because there is typically greater risk associated with holding bonds for a longer time. A positively shaped yield curve also indicates that the market expects interest rates to increase in the future. Negative, or inverted, curves are indicative of a weakening economy where the market believes interest rates will decline in the future. 2. Credit Differentials: Studying two or more bonds with the same maturity but different credit quality to demonstrate how credit quality affects interest rates. Bonds Example: 10-Year AAA-rated bond vs. 10-Year Junk Bond Junk Bonds • The junk bond should always have a higher yield than the investment grade bond because of the added risk an investor takes on when buying the bond. However, what is significant is the size of the spread. • A very “wide” spread indicates that investors are demanding significantly higher yields (interest rates) to invest in the lower quality bond. • Conversely, a very “narrow” spread indicates that investors are willing to accept a lower amount of incremental (extra) yield to invest in the lower quality bond. • Typically in a recessionary economy, where consumer confidence is low, investors tend to be more risk adverse. • Consequently, in a strong economic environment, they will demand more incremental yield to invest in the lower quality bond and the spread will widen. 3. International Interest Rate Differential: The spread between US Treasury Bonds and Foreign Government Bonds from other industrialized countries shows the relative attractiveness of one nation’s bonds over another country's bonds.