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Friday, 14 December 2012

Basics of Reading the Economy and Shares Lesson 3

Lesson 3- Reading the Economy
Business within context of the economy

When you buy shares, you buy co-ownership of that business. How well that business performs, determines how well your share price will do. How well the business performs, is determined by good general and financial management, and the economic climate in which that management must run the business.

A good economic climate for business would include: Interest rates are relatively low, which means companies can obtain “cheap” loans to fund expansion or invest in machinery or extra stock. Because interest rates are low, consumer spending is high - meaning profits are easy to make. Inflation that is within the central bank’s plans is also good: This means the central bank would not have to curb high inflation by increasing interest rates. By raising interest rates, the average bond-paying consumer effectively has less money to spend. Therefore he is more cautious with how he spends his money. 

Producers and service providers now have to take care not to overprice their products or services so that the consumer goes elsewhere. So they limit price increases – thus curbing inflation. We will explain in this chapter how to understand these factors and what they mean to the share market.

A low oil price usually also has an effect on inflation: Rising oil prices causes high petrol and production prices, in turn causing a rise in products as production and transport costs goes up. The result is a rise in inflation. However, a drop in oil prices should be reason for lower transport costs resulting in getting products to the consumer at a lower cost. This could contribute to lowering inflation rates.
Oil prices are however out of the reserve bank’s control. Interest rates are not. The reserve bank lends money to the other banks, which then correlate their own lending rate with that if the reserve banks. These banks add a margin to make their money. However every reserve bank decision to change their lending rate, reaches the consumer through the other banks.
To be able to read the economy is a key skill for investing. The stock exchange performance is strongly linked to the country's economic climate.
There are several indicators that can help us gauge the economic climate. Lets first list them, then discuss these indicators in more details.
Indicators of economic climate:

1. Gross Domestic Product
2. Gross Domestic Expenditure
3. Balance of Payments
4. The Interest Rate & Inflation
5. Other Economic Indicators
6. Related indicators: Demography

1. Gross Domestic Product (GDP) is the sum total of the price of all services and goods produced within a specific country. It excludes the value of products and services of companies that operate outside of the boundaries of this country. It is measured over a certain period of time – of one year.

GDP is calculated by adding together a lot of numbers: this takes time and GDP figures are often released much later that the year of measurement. Other economic indicators can however be used as indicators of the economy’s health. We will look at these after our discussion about GDP.

The numbers used in calculating GDP are contained in this formula:
GDP = C + I + G + E – I
C = Consumer spending (= the purchase of comsumer goods and services by consumers)
I = Investment (= purchase of production equipment and property necessary to facilitate production)
G = Government purchases (= purchase of goods and services by government)
E = Exports (=Good and services produced locally but sold elsewhere in the world)
I = Imports (= Purchases of goods and services orignating abroad)

Analysis of this formula will show the investor changes in the above categories. These figures are published in publications such as the central- or reserve bank’s quarterly bulletin and summations might be found in financial magazines. By analyzing the line items and comparing with previous years, it’s easy to see the trend of Consumer spend, Investment, or Government spend.
Often GDP is also broken down into a sector-composition: Main sectors are:

Agriculture, Forestry, Fishing

Mining and Quarrying
Electricity, gas and water
Retail, wholesale, catering, and accomodation
Transport, storage and communication
Finance, Insurance, Fixed Property and business services
Community, social and personal services
Central Government
Other Producers

Again an analysis of these lines can lead the investor to understand changes in the composition of GDP and which sectors are hinting slowdown or increase of tempo.

How does GDP affect the share market?
An increase in GDP from the previous GDP figure, means that increased economic activity took place. This means more money is going around in the economy, from which a profit can be made.

In case where growth for the economy is forecast, it is likely for the stock market to also grow in value. For example, if the GDP forecast for 2007 is 4% higher than the actual 2006 GDP figures, the economic climate would support growth of the stock market.
However, the stock market is the first to feel an economic slowdown - up to 9 to 12 months ahead of a change in economic cycle. Therefore it’s important to also keep an eye on other economic indicators discussed later on.

2. Gross Domestic Expenditure (GDE)is the sum total of the payments for local products and services within a specific country. Effectively it measures the total amount inhabitants of this country within the country have spent over a year.

How does GDE affect the share market?
What is interesting about Gross Domestic Expenditure, is that it can be divided into sub sections, based on the durability of certain items on which money was spent
For example, you can distinguish between durable goods, such as cars or radio’s, and semi-durable goods. After that non-durable goods are listed, such as food. And after that comes services – that aren’t goods at all.

These can serve as indicators to the economy: The volumes of durable goods bought are likely the first to be reduced when the economy is under pressure. For example: If the economy goes down, car sales (Cars are durable goods) will faster go down than sales of food (Non durable goods). Therefore, if car sales are going down, you should be moving your shares to companies that produce non-durable goods, such as food.

In our example a reduction in car sales can forecast a downturn in the economy. In case of a slowdown, you might want to keep shares in a food producing company. However, if a real economic downturn is about to take place, it might be better to exit the share market and convert your shares to cash in the bank.

3. The Exchange Rate and Balance of Payments
Countries export to each other and import to each other. For example, South Africa might export maize to America, and import coffee from Brazil.
When South Africa exports maize to America, it receives payment in Dollars. In other words, there is an in-flow of money into the country. When South Africa imports coffee, money flows out of the country to America. Since money is also a commodity, the value thereof goes up or down according to supply and demand. In the case where America imports more and more from South Africa, they will want to buy Rands with which to pay for their imports. Therefore the Rand price goes up in Dollar terms, since demand is higher.

The Balance of payments tells us in which directions money flowed mostly. If the balance of payments has a deficit (shortfall), it means that the value of products imported was higher than that which was exported. Therefore more money left the country, which will likely cause a smaller supply, which could make that money more pricey. A prolonged deficit could cause the currency to strenghten: for example:

Assume the exchange rate is R6.00 for $1.00. If you calculate how much dollars must be paid to buy one Rand, you divide the one dollar by the six Rands:
$1.00 divided by R6.00 = $0.16
South African imports more and more from the US, and the balance of payments shows that there is a growing deficit. In other words, every month more and more money leaves the country, and supply gets reduced. The price for buying a Rand becomes $0.20 cents instead of $0.16 cents. Working this back to Rand : Dollar exchange rate, it becomes R5.00 for $1.00.

4. The Interest Rate and inflation
Interest rates are part of government’s monetary policy to manipulate the economy. Within their ability, government aims at achieving economic conditions favorable to the country. If inflation is too high (meaning prices on consumer goods are climbing at a high rate), the central reserve bank can increase interest rates. Banks, who loan their money which they loan out to businesses and individuals, also have to raise their interest rates to pay for the higher interest levied by the reserve bank.

The consumer now pays a higher monthly amount on interest on his house and car, and has less money to spend on consumer goods. So, demand for consumer goods decrease, and the prices come down.

Different theories exist about the relationship between Interest rates and share prices.  Some theorize that as the interest rate goes up, the economy is stifled, so the share market reacts with a slowdown. The opposing theory is that a lower interest rate would cause investors who have invested in interest-bearing securities to rather move their money to the stock exchange, because of higher anticipate rewards. This again would push up share prices.

Understanding the economy. All these economic indicators are explained so that you may understand the economic context within which business takes place. In addition to watching out for these statistics, you can watch out for other economic indicators to identify trends.

5. Other economic indicators
Because GDP data is so comprehensive and takes so long to calculate, other indicators can be used to gauge the economy. These indicators are often listed in financial magazines with the share prices. Some of the most important ones are:
-          Foreign reserves
-          Motor car sales
-          Money Supply
-          Building plans approved for residential homes
-          Inolvencies
-          New companies registered
Although these indicators are by-products of actual economic factors, they do have the ability to signal trends. Changes in these indicators allude to changes in the underlying economic factors.

Let us use the example of car sales. Car sales are just a small section of the expenditure on current durable goods. However, the number of cars sold can be calculated swiftly, and the number of cars sold was also found to correlate to the total expenditure on current durable goods. Therefore it is considered as representative to the bigger durable goods expenditure picture. A slowdown in car sales could therefore signal that consumers are feeling the effects of inflation, interest rates or a combination of these and other economic pressures. 

As an investor, this could stir you to make a decision about staying in shares that are dependant on buoyant consumer spending, or rather move to shares earn you income by exporting to countries where purchases of exported minerals or capital goods are doing well while the Dollar is relatively weak.

Similar to car sales, construction data is an indicator of capacity expansion in the economy: New buildings and homes are adding room (capacity) for more consumers or producers that are important role players in the economy.
House price data alludes to the demand for credit within the economy: Most consumers finance at least a portion of their house cost. Rising prices tell a story of consumers spending more money on houses; this spending is likely funded by credit.

As shown, these indicators are really the symptoms of principle economic factors. But interpreted, they can signal changes in economic climate before the actual economic data gets released to confirm the facts. As an investor be cautious to take cognizance of this data, react where necessary, and when in doubt confirm your suspicion by looking for factually published economic data contained within the framework of the above numbered items.
A last indicator to watch out for is job data. The markets carefully watch such data to draw conclusions from it: Fewer jobs predict a slowdown in economy, and visa versa

6. Related indicators:  Demography
Population forecasts are important to the share market, although few investors take the trouble to take the real long-term view and invest according to data such as demographic data.

For example population forecasts can give you an idea of numbers of people are likely to appear in certain age groups in the not too distant future. Currently 15% of the population might be between 12 and 16 years of age, however improved healthcare to a wider population causes reasonable expectation that this could grow to 25% of the population within 5 years, whereas people within the 16-45 age are likely to have smaller salary growth due to economic slow down and higher interest rates expected within the next two years.

Such statistics, if accurate, would make the clever investor move into stocks that sell popular brand name teenage clothing and sports gear, and out of stocks that produce luxury goods for the middle-income class.

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