Economics is a fascinating subject. According to Wikipedia Economics is
The social science that studies the behavior of individuals, households, and organizations (called economic actors, players, or agents), when they manage or use scarce resources, which have alternative uses, to achieve desired ends.
If one has studied history of human civilization. It’s obvious that the progress of civilization in the past five thousand years has not followed a straight line, rather it has followed cycles under the influence of various competing forces such as
- Order and Liberty
- Paganism and Puritanism
- Equality and Concentration of wealth and power
- Growth and Decay
- Peace and War
The Economy is no exception. As Ray Dalio explains in his thirty minute video on how the economy works. The economy is made up of simple parts and a lot of simple transactions. These transactions are above all else driven by human nature. From history we have learnt the nature of humans tends to follow cycles. The three main cycles that drive the economy are
- The Productivity growth cycle
- The Short term debt cycle
- The Long term debt cycle
In this video Ray describes Productivity growth as a straight line, though it is true in the context of next few decades, history is witness to civilizations who reached their peak in productivity, technological and cultural accomplishments only to degenerate later. However the scale of productivity cycle is in centuries and it is safe to assume it as a straight line ( in any given direction ) for an economy in the medium term (i.e. next few decades or even a century )
If an investor understands how an economic cycles work, it can help her identify opportunities and anticipate and protect against short term financial crisis, such as the one in 2008.
As with any system, there are various indicators that can help us understand the economy and how its cycles work. These indicators are based on factors such as
- Productivity ( growth in output or gross domestic product )
- Expansion and Contraction ( consumption,inflation and debt cycles )
- Human sentiments based on fear and greed ( volatility and confidence indices )
Following is a list of indicators from the book Strategic Value Investing that can help an investor understand the current state of the economy. However a word of caution from John Maynard Keynes should serve as an important disclaimer to any investors betting in the market based on the information from these economic indicators.
Markets can remain irrational longer than you can remain solvent.
Gross Domestic Product (GDP) and Gross National Product (GNP) :
Gross Domestic Product (GDP) is the total value of all final goods and services produced with in a country and Gross National Product (GNP) is the total value of all final goods and services produced by entities owned by citizens of a country, regardless of where they are produced.
An important determinant of the future growth for a company is the future growth prospects of the economy as a whole. The expected growth in GDP(or GNP), both long term and short term, can be used as initial estimates of a firm’s growth rate. The growth rate of individual industries may vary, but GDP and GNP can be a good starting point in understanding the assessing the growth rates of industries and companies.
Resource : Valueline uses GDP to forecast the growth of specific industries and companies.
Business Cycle :
The long term trend of the economy is determined by the growth in productivity and availability of talent and resources. However in the short term, surrounding this long-term trend line are periods of above-average and below-average economic performance. This is also know as business cycle. The business cycle is typically separated into following components.
- Expansion-> Peak -> Contraction / Recession -> Through.
picture reference : www.econedlink.org
Some industries are more sensitive to the business cycle and are termed cyclical, an example of a cyclical sector is consumer discretionary as consumers spend less on automobiles, travel and other discretionary expenditures during a recession. Industries that are less sensitive to business cycle are non-cyclical and include sectors such consumer stables and pharmaceutical industries.
The expected inflation is an important aspect while evaluating the future trends in an economy and companies. The risk-free rate of interest is an input into the valuation of a company’s future cash flows. The nominal risk-free rate is a function of the inflation rate and the real interest rate required by investors to forgo consumption.
The higher the level of expected inflation the higher the required risk-free rate of interest.
One measure of inflation is the Consumer price index or CPI, which measures inflation of a market-basket of consumer goods. Inflation is also measured at the wholesale level by Producers price index of PPI
COBE Volatility Index :
The CBOE Volatility index, popularly known as VIX is a measure of market expectations of near-term ( next 30 days ) volatility conveyed by S&P 500 stock index option prices. VIX has been considered an indicator of investor sentiment as well as market volatility.
VIX measures over 30 corresponds to a large amount f investor uncertainty and implied volatility, while readings under 20 are found during relatively calm periods in the market.
Put-Call Ratio :
The Put-Call ratio or PCR is the ratio of put option trading volume to call option trading volume. A rising put-call ratio reflects concerns by option traders about the potential of falling prices of a share, indices or commodities.
Historically there are more calls than puts bought on a normal day and hence a PCR of approximately 0.80 is considered normal. Markets are considered strong ( and contrarians would contend overbought) when the ratio falls below 0.70
Investors can lookup PCR for a share or the market as a whole on the at schaeffersresearch
Barron’s Confidence Index :
Barron’s confidence index = Average yield on high-grade bonds / Average yield on intermediate-grade bonds
A rising confidence index would indicate that the consensus of bond investors has increasing confidence in the economy a the premium for bearing higher risk is declining. That is, investors are more willing to invest in higher risk bonds, driving their yields lower relative to lower risk bonds.
There has been a secular decline in the Barron’s confidence index in the past 25 years. The Barron’s confidence index is available at Sharelynx.com
American Association of Individual Investors Sentiment Index :
The American Association of Individual Investors (AAII) sentiment survey measures the percentage of individual investors who are bullish, bearish and neutral on stock market over the next six months. The survey results are available at www.aaii.com.
Since inception the sentiments are on average 39% bullish, 31% bearish and 30% neutral. However during the dot-com bubble the bullish sentiment reached it’s highest levels at 75% on January 6th 2000. The bearish sentiment reached a record high of 70.3% on March 5th 2009.
Mr. Market Cycles :
Regardless of the business cycle or the economic realities, stock market has its own cycles based on the sentiments of the investors. There are ways to understand the stock market by looking at few key indicators. This will help us to understand the current sentiment of the investors. If greed is the driving force stocks will be expensive and if fear is the driving force you will have better chances of finding bargains. It’s also useful to compare the P/E of a company relative to the overall market P/E ratio.
Current P/E ratio of S&P 500 ( including historic average and mean ) here
Current P/E ratio of Russell 2000