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1. SECTION III
Portfolio
Management

2. CHAPTER 13
Analysing the Macro-Finance
Environment

3. Analysing the Macro-Finance Environment
▪ The learning objectives for this chapter are:
▪ 1. Explain the relation between the business and financial cycles.
▪ 2. Explain how the current stage of the financial cycle suggests which stock sectors
are most likely to outperform or underperform the overall stock market over the
coming year.
▪ 3. Explain what each of The Conference Board’s leading, coincident and lagging
indicators communicates about the strength and robustness of future, current, or
past economic activity.
▪ 4. Analyze the signals conveyed by each Conference Board indicator and reduce
these analyses to short written descriptions.
▪ 5. Synthesize these written descriptions into a Market Outlook Newsletter.
▪ 6. Recommend changes to a stock portfolio’s active sector weights based on the
analysis and conclusions contained in the Market Outlook Newsletter.
3

4. Economic Analysis: The First Step of a Top-
Down Fundamental Process
4
▪ Before analyzing individual stocks, we will gauge the strength and resiliency of
the U.S. economy to improve our investment decision-making process.
▪ If our analysis indicates that economic growth is slowing or contracting, but
equity values do not fully reflect the extent to which the slowing economy will
impact corporate profits and cash flows, we might increase our portfolio cash
position by selling off some of our weaker stocks (the ones we think are most
vulnerable to a downturn).
▪ Or, if we‘re managing a fund with a mandate to be fully invested in equities at all
times, we might practice sector rotation

5. Economic Analysis: The First Step of a Top-
Down Fundamental Process
5
▪ Sector Rotation Take profits in some of our high-risk positions in more
aggressive sectors. We can redeploy the proceeds from selling these securities
into safer, lowbeta stocks in defensive sectors such as consumer staples and
utilities
▪ Gauging the robustness of the U.S. economy is the first step in our process. The
second step involves using the results of our macro analysis to identify the
current stage of the U.S. business cycle—the alternating periods of expansion
and contraction that occur in free-market economies.
▪ Classify U.S. economy into one of four stages:
(1) full recession, (2) early expansion, (3) full expansion, or (4) early recession.

6. Economic Analysis: The First Step of a Top-Down
Fundamental Process
6
Stocks tend to lead the
economy by approximately
six to nine month on
average. For example, the
stock market usually reaches
a trough and begins rising
while the U.S. economy is
still in full recession mode
and contracting.
Similarly, stocks tend to top
out and begin their next bear
market decline while the
economy is still in full
expansion mode and
growing.

7. Sector Rotation
7
▪ If our analysis shows that the market has bottomed and is due to begin
rising in anticipation of an economic expansion, conventional wisdom
suggests that it‘s best to lighten up on defensive sectors and put new
money to work in aggressive or cyclical sectors
▪ If we think the economy is already expanding and the stock market is
well into its bull market phase, however, increasing our allocations to
industrial, basic material and energy stocks is recommended, because
inflation runs hotter later in the business cycle, and rising commodity
prices usually boost these companies‘ profits.
▪ We will analyze 21 economic indicators compiled by The Conference
Board, a private, nonprofit research organization based in the United
States.

8. Sector Rotation
8
▪ Reduce your written analyses to a −1, 0, +1 scale and
rate each indicator as mainly negative for the economy
and stocks (−1), neutral or not currently relevant (0), or
mainly positive (+1). The spreadsheet will compile and
graph the results of your rankings into a system for
analyzing the strength of economic activity known as a
diffusion index
▪ Computes two diffusion indexes. The first weights each
indicator equally, and the second uses The Conference
Board‘s weighting system. Both diffusion indexes have a
minimum possible value of −100%, which would
represent negative signals from every indicator, and a
maximum possible value of +100%, representing positive
signals from every indicator.

9. Sector Rotation
9
▪ Sample Rankings for the Lagging,
Coincident, and Leading Indicators.
▪ Sample Rankings for the Lagging,
Coincident, and Leading Indicators.
The graph progresses from lagging to coincident to leading indicators, so the
perspective is
(1) looking back at the recent behavior of the economy over the past six to nine months,
(2) looking at the current state of the economy, and
(3) looking forward to gauge the expected strength of the economy over the
next six to nine months.

10. Writing Guidelines
10
▪ Your goal should be to construct short, well-organized, readable paragraphs. Your
paragraphs should be three to five sentences long (three is the minimum, five is the
maximum).
▪ Sentences 1 through 5 should be written to communicate the following information
▪ 1. As briefly as possible, describe what the indicator measures about past, current, or
expected future economic activity (for each lagging, coincident, and leading indicator,
respectively).
▪ 2. Interpret the behavior of the indicator during previous business cycles, noting if the
indicator consistently lags, coincides, or leads economic activity as expected.
▪ 3. Direct the reader to either observe something interesting about the current behavior of
the indicator, or to further consider how the variables presented should relate to each other
(why the variables are, or aren’t, behaving as expected).
▪ 4. Make a factual statement about the most important idea conveyed by the graph; be sure
the implications for stocks and the economy are clear.
▪ 5. Conclusion: Tell the reader the most important thing to remember about the indicator.
This is where you’re telling the reader what to think, based on your objective interpretation
of the data presented in sentences 1 through 4.

11. Conference Board indicators
11
10 leading
indicators
4 coincident
indicators
7 lagging
indicators
Supplemental
Economic
Indicators

12. Conference Board Indicator
12
▪ The Conference Board indicators are organized into three groups:
▪ 1. The 10 leading indicators are thought to change in advance of
economic conditions. These are used for forecasting the future strength
and direction of the business cycle.
▪ 2. The four coincident indicators are thought to change in sync with
economic conditions. These are used for interpreting current economic
strength or weakness.
▪ 3. The seven lagging indicators are thought to change after changes in
economic conditions. These are used for corroborating that the
economy has been expanding or contracting in accordance with our
expectations and previous analyses we may have conducted.

13. Leading Indicator
13
LE-1. The Average
Length of the
Manufacturing
Workweek
LE-2. Institute for
Supply Management
New Manufacturing
Orders Index
LE-3. University of
Michigan Consumer
Sentiment Index
LE-4. Interest Rate
Spread, 10-Year
Treasury Yield Minus
Fed Funds Rate
LE-5. Manufacturers’
New Orders for
Consumer Goods
and Materials
LE-6. Chicago
Federal Reserve’s
National Credit
Conditions Index
LE-7. Stock Prices,
S&P 500 Index
LE-8. Manufacturers’
New Orders,
Nondefense Capital
Goods
LE-9. Average
Weekly Claims for
Unemployment
Insurance
LE-10. Building
Permits, New Private
Housing Units

14. LE-1. The Average Length of the Manufacturing Workweek
14
▪ The manufacturing workweek is the most heavily weighted component
(weight = 27.8%) of the leading indicators.
▪ The interpretation of this indicator is if U.S. manufacturers need
employees to work longer hours, new manufacturing orders and overall
economic activity are accelerating, and additional hiring may follow.
▪ Conversely, when the workweek trends downward, the implication is
the new orders and overall economic activity are decelerating, and
layoffs may also occur soon.
▪ LEI index only takes the length of the manufacturing workweek into
account but ignores total employment in the sector. closely related
variables: total manufacturing and construction employment in the
United States.
▪

15. LE-2. Institute for Supply Management New Manufacturing Orders
Index (weight = 16.5%)
15
▪ ISM New Orders Index indicates whether manufacturing orders
are expanding or contracting. The index is constructed so that a
value greater than 50 means new orders are increasing, while a
number less than 50 indicates new orders are generally
decreasing.
▪ The index functions well as a leading indicator, reliably
decreasing prior to the start of recessions and increasing before
recessions end. After a strong positive surge following the
2008–2009 recession, the index has been trending downward,
however, with several readings below the key level of 50.

16. LE-3. University of Michigan Consumer Sentiment Index (weight =
15.5%)
16
▪ Consumers spend more when they‘re feeling optimistic and
spend less when they‘re pessimistic. Given that consumer
spending accounts for approximately 70% of U.S. GDP, this
indicator sends a strong signal about the likely future trajectory
of consumer spending in the United States.
▪ While consumer sentiment has rebounded from the depths of
the great recession, it still has a long way to climb before it
registers the same sort of enthusiasm consumers felt during the
1980s, 1990s, and most of the 2000s. The overall trend
following the 2008–2009 recession remains positive,

17. LE-4. Interest Rate Spread, 10-Year Treasury Yield Minus Fed Funds
Rate (weight = 10.7%)
17
▪ The “spread” or difference, between the yield (interest rate) on a 10-year
Treasury note and the shorter-term Federal Funds rate is a proxy for one of the
most popular business cycle forecasting indicators, the slope of the Treasury
yield curve.
▪ The Treasury yield curve plots the interest rates on government securities at
range of maturities from 3 months to 30 years.
▪ The yield curve is influenced by two main factors.
▪ The first is Federal Reserve policy, which primarily impacts rates on the short end
of the curve.
▪ The second is the preferences of borrowers and lenders (based on their
expectations of future inflation and interest rates), which affect the
intermediate- and long-term interest rates that comprise the middle and end
sections of the curve.

18. LE-5. Manufacturers’ New Orders for Consumer Goods and Materials
(weight = 8.1%)
18
▪ The rationale behind this indicator is straightforward: If
consumers are willing to commit to larger-ticket purchases,
known as durable goods (because the items last longer than one
year), they are probably feeling more confident about future
economic activity.
▪

19. LE-6. Chicago Federal Reserve’s National Credit Conditions Index
(weight = 7.9%)
19
The Chicago Fed index is also a diffusion index, but instead of being
anchored around a neutral value of 50, in this case the anchoring
point is zero. A value below zero indicates ―loose‖ financial
conditions, meaning that as the index value declines, borrowing
conditions are getting easier, and as the index climbs above zero,
borrowing conditions are getting tighter.
▪

20. LE-7. Stock Prices, S&P 500 Index (weight = 3.8%)
20
It has long been thought that the stock market is a forward-
looking discounting mechanism, where stock returns
anticipate changes in economic conditions six to nine months
ahead.
As with many of the longer time series analyzed in this
chapter, we will consider both nominal and real values of the
S&P 500 index.

21. LE-8. Manufacturers’ New Orders, Nondefense Capital Goods
(weight = 3.6%)
21
▪ Capital goods are the long-lived assets in which
businesses invest. Increased long term investment by
businesses signals optimism for the U.S. economy
▪ Real capital spending remains in a long-term decline
(because business spending on capital goods has
been increasing more slowly than the rate of
inflation). The series behaves similarly to the nominal
and real S&P 500 index.

22. LE-9. Average Weekly Claims for Unemployment Insurance (weight =
3.3%)
22
▪ When the economy is weakening, business lay off
more workers and initial filings for unemployment
insurance increase. Conversely, economic expansions
are characterized by increases in employment and
decreases in unemployment insurance claims.

23. LE-10. Building Permits, New Private Housing Units (weight = 2.7%)
23
▪ This indicator is thought to be predictive of future building
activity.
▪ An increase in the number of permits for new private housing
signals optimism on the part of homebuilders and prospective
buyers.
▪ A decrease in the number of permits signals pessimism.

24. Coincident indicators
24
CO-1. Nominal
and Real Total
Retail Sales
CO-2.
Employees on
Nonagricultural
Payrolls
CO-3. Personal
Income Less
Transfer
Payments
CO-4. Index of
Industrial
Production

25. CO-1. Nominal and Real Total Retail Sales (weight = 53.2%)
25
▪ Using the closest match from the FRED database, substituting
total retail sales including food services for The Conference
Board‘s manufacturing and trade sales indicator.
▪ The total retail sales series has a straightforward interpretation:
when total sales are rising, consumers and businesses feel more
confident about current (and probably future) economic activity,
and vice versa when sales are falling.

26. CO-2. Employees on Nonagricultural Payrolls (weight = 26.0%)
26
▪ Total nonfarm payrolls measures the total number of
people in the United States with a job, full- or part-
time, temporary or permanent. This indicator is
closely watched by investors.
▪ When employment is rising, it signals a bullish
attitude on the part of both businesses an consumers,
and vice versa when the economy is shedding jobs
and layoffs are increasing.

27. CO-3. Personal Income Less Transfer Payments (weight = 13.6%)
27
▪ With its consumer-driven economy, U.S. GDP grows by a greater
amount when consumers spend freely. Personal income is the
main source of consumer spending.
▪ Transfer payments are redistributions of tax revenue by the
government, including Social Security, welfare, and business
subsidies. Personal income less transfer payments measures
the extent to which incomes in the United States are growing
from market-based sources, excluding any government
redistribution of income.

28. CO-4. Index of Industrial Production (weight = 7.3%)
28
▪ The index of industrial production measures physical
output at all stages of production in the
manufacturing, mining, and gas and electric utility
industries.
▪ Although the industrial sector represents only a
fraction of the total U.S. economy, this index is
thought to have a strong positive correlation with
changes in totaloutput.

29. Lagging Indicators
29
LA-1. Average Prime
Rate
LA-2. Ratio of
Consumer
Installment
Credit/Personal
Income
LA-3. Consumer
Price Index for
Services
LA-4. Inventory to
Sales Ratio,
Manufacturing and
Trade
LA-5. Commercial
and Industrial Loans
LA-6. Unit Labor
Cost, Manufacturing
LA-7. Average
Duration of
Unemployment

30. LA-1. Average Prime Rate (weight = 28.2%)
30
▪ The average prime interest rate is a benchmark interest rate used by lenders for
setting the interest rates at which new loans are created.
▪ Highly creditworthy businesses and individuals might borrow at ―prime minus 1,
while less creditworthy borrowers might pay prime plus 1 to 2%, or more,
depending on circumstances. The indicator trails the economy as banks adjust
the price of credit.
▪ Once the economy has been expanding for a while, and the demand for credit is
growing, banks can mark up the price of credit and charge more. After the
economy has slowed, and demand for credit weakens, banks need to put credit
on sale to attract new borrowers, and interest rates fall.
▪ Total commercial and industrial loans are also depicted in the graph, because The
Conference Board‘s Lagging Economic Index considers only the level of the
interest rate; it does not consider whether total loans outstanding are expanding
or contracting.

31. LA-2. Ratio of Consumer Installment Credit/Personal Income (weight =
21.0%)
31
▪ The ratio of consumer credit to personal income , behaves like a
lagging indicator because consumers wait to increase borrowing
for at least several months after a recession ends, when they
can see tangible signs of economic recovery. Additionally, this
ratio tends to reach a trough after personal income has risen for
a year or longer, as consumers try to maintain a balance
between their income and debt levels.

32. LA-3. Consumer Price Index for Services (weight = 19.6%)
32
▪ Service sector inflation is expected to increase several months
after the start of a recession, and decrease several months after
the start of an expansion.
▪ This inflation measure displays a long-term decline, along with
the general level of inflation and interest rates. The service
sector CPI works well as a lagging indicator, and has decreased
sharply during the most recent expansion, which corroborates
that the U.S. economy has been in an expansionary phase.

33. LA-4. Inventory to Sales Ratio, Manufacturing and Trade (weight =
12.6%)
33
▪ The ratio tends to peak in the middle of a recession,
as businesses find it harder to sell existing inventory.
The ratio declines during periods of economic
expansion.
▪ The secular downtrend in the inventory to sales ratio
is driven by continuous improvement in supply chain
management and just-in time inventory practices.

34. LA-5. Commercial and Industrial Loans (weight = 9.7%)
34
▪ Total commercial and industrial loans are along with total
consumer credit. Total business loans are expected to
peak after an expansion (as declining profits increase the
need for borrowed funds).
▪ Troughs usually occur a year or more after a recession
ends. Both consumer and business credit continue
expanding following their post-recessionary trough, which
provides further confirmation that the U.S. economy has
been in an expansionary phase.

35. LA-6. Unit Labor Cost, Manufacturing (weight = 6.2%)
35
▪ Total commercial and industrial loans are along with total
consumer credit. Total business loans are expected to
peak after an expansion (as declining profits increase the
need for borrowed funds).
▪ Troughs usually occur a year or more after a recession
ends. Both consumer and business credit continue
expanding following their post-recessionary trough, which
provides further confirmation that the U.S. economy has
been in an expansionary phase.

36. LA-7. Average Duration of Unemployment (weight = 3.7%)
36
▪ Decreases in the average duration of unemployment
tend to occur after an economic recovery gains
traction and employers begin hiring in earnest.
▪ The series is graphed along with the labor force
participation rate in which measures the percentage
of the U.S. population that is working either full or part
time or actively seeking work.

37. Supplemental Economic Indicators
37
S-1. Unemployment
Rate and U6
Unemployment Plus
Underemployment
Rate
S-2. Inflation
S-3. Oil and Gas
Prices
S-4. Total U.S.
Federal Debt and the
U.S. Debt/GDP Ratio

38. S-1. Unemployment Rate and U6 Unemployment Plus
Underemployment Rate
38
▪ The official unemployment rate doesn‘t count discouraged
workers—unemployed individuals who have stopped looking for
work altogether. Discouraged workers have become a much
larger component of the United States‘ potential workforce
since the end of the last recession.
▪ The U6 series is an ―underemployment‖ rate, measuring the
percentage of the population that is either unemployed,
underemployed, or so discouraged that they have stopped
looking for work altogether. The U.S. economy will find it difficult
to sustain robust, rapid growth until more jobs are created.

39. S-2. Inflation
39
▪ Core consumer and producer price indexes, which
measure inflation on the retail and wholesale levels,
respectively. Core inflation measures exclude the
effects of changing food and energy prices, which are
excessively volatile and make the inflation series
harder to interpret.
▪ The Fed‘s loose monetary policy is expected to
contribute further to rising inflation in coming years.

40. S-3. Oil and Gas Prices
40
▪ Rising energy prices act like a tax increase on businesses and
consumers—there‘s less to spend on other things when
more has to be spent on energy.
S-4. Total U.S. Federal Debt and the U.S. Debt/GDP Ratio
▪ In their landmark study (which has recently faced substantial
criticism), Rogoff and Reinhart (2009) show that nations‘
economies grow more slowly when their debt-to-GDP ratio
exceeds 100%. Figure 17.40 shows that, as of early 2012, the
United States surpassed the key 100% debtto- GDP ratio.

41. Points to be Remember
 U.S. economy into one of four stages:
(1) full recession, (2) early expansion, (3) full expansion, or (4) early
recession.

42. 10 leading indicators
LE-1. The Average
Length of the
Manufacturing
Workweek
LE-2. Institute for
Supply Management
New Manufacturing
Orders Index
LE-3. University of
Michigan Consumer
Sentiment Index
LE-4. Interest Rate
Spread, 10-Year
Treasury Yield Minus
Fed Funds Rate
LE-5. Manufacturers’
New Orders for
Consumer Goods
and Materials
LE-6. Chicago
Federal Reserve’s
National Credit
Conditions Index
LE-7. Stock Prices,
S&P 500 Index
LE-8. Manufacturers’
New Orders,
Nondefense Capital
Goods
LE-9. Average
Weekly Claims for
Unemployment
Insurance
LE-10. Building
Permits, New Private
Housing Units

43. Coincident indicators
CO-1. Nominal
and Real Total
Retail Sales
CO-2.
Employees on
Nonagricultural
Payrolls
CO-3. Personal
Income Less
Transfer
Payments
CO-4. Index of
Industrial
Production

44. Lagging Indicators
CO-1. Nominal
and Real Total
Retail Sales
CO-2.
Employees on
Nonagricultural
Payrolls
CO-3. Personal
Income Less
Transfer
Payments
CO-4. Index of
Industrial
Production

45. Lagging Indicators
S-1. Unemployment
Rate and U6
Unemployment Plus
Underemployment
Rate
S-2. Inflation
S-3. Oil and Gas
Prices
S-4. Total U.S.
Federal Debt and the
U.S. Debt/GDP Ratio

46. Thanks