SECTION FOURMACRO ECONOMICANALYSISFOR INVESTORSII-.docx

SECTION FOUR
MACRO ECONOMIC
ANALYSIS
FOR INVESTORS
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Words to the Wise
When a man of business, therefore, hears on every side rumors
of fortunes suddenly acquired; when he finds banks liberal, and
brokers busy; when he sees adventurers flush of paper capital,
and full of scheme and enterprise; when he perceives a greater
disposition to buy than to sell; when trade overflows its
accustomed channels and deluges the country; when he hears of
new regions of commercial adventure; of distant marts and
distant mines, swallowing merchandise and disgorging gold;
when he finds joint-stock companies of all kinds forming;
railroads, canals, and locomotive engines, springing up on every
side; when idlers suddenly become men of business,
and dash into the game of commerce as they would into the
hazards of the faro table; when he beholds the streets glittering
with new equipages, palaces conjured up by the magic of
speculation; tradesmen flushed with sudden success, and vying
with each other in ostentatious expense; in a word, when he
hears the whole community joining in the theme of "unexampled
prosperity," let him look upon the whole as a "weather-breeder,"
and prepare for the impending storm.
From “The Crayon Papers”, The Great Mississippi Bubble, by
Washington Irving, 1820
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Taking a World View
"…I think it is unrealistic and maybe hubristic to say, ‘I don’t
care about what is going on in the world. I know a cheap stock
when I see one.’ If you don’t follow the pendulum and
understand the cycle, then that implies that you always invest as
much money as aggressively. That doesn’t make any sense to
me. I have been around too long to think that a good investment
is always equally good all the time regardless of the climate."
Howard Marks, CEO of Oaktree Capital Management
[$80 billion under management]
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Macroeconomic Analysis
Analysts shouldn't operate in a vacuum.
We need to understand the economic, financial, political, social,
cultural, and historical environment in which companies
operate.
Analysts should begin with a top-down approach, and work all
the way down to the company level.
It’s important to remember that not all things that impact the
market are financial or economic.
Analysts must be able to distinguish between cause and effect.
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Analysis versus Forecasting
Analysis should not be confused with forecasting.

Analysis is the process of understanding how things work.
Forecasting is the attempt to make precise estimates of future
values or events.
Although analysis is the important first step in forecasting,
formal forecasts are not necessarily required.
Understanding trends and situations is more helpful than point
estimates of economic variables like GDP.
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BEWARE OF FORECASTS: This is from 1954
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Country Analysis
One of the most useful ways to understand an economy is to do
a complete country analysis.
Pick any country, and learn all you can.
Along with all of the necessary economic and financial analysis,
one must become familiar with a country’s major resources,
opportunities and growth areas, as well as the major distortions
and obstacles that may inhibit that growth.
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Country Analysis
For example, in addition to all of the usual economic indicators,
analysts should investigate these questions:
What’s the proportion of working age population versus total?

Is that stable, growing, or shrinking?
What natural resources does the country possess?
What is the status of the country’s infrastructure?
What is the level of poverty?
How quickly can the political system react?
How open is the political system? What’s the election cycle?
Is the country run by a single party, a number of ruling families
or individuals, or is it an open democracy?
What is the level of business freedom?
What are the country’s major imports and exports? Its terms of
trade?
How much is public and private sector debt as a % of GDP?
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ECONOMIC ANALYSIS
P O L I C Y
F A C T O R S
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Policy Factors
Fiscal policy
Tax Policy
Monetary policy
Regulatory Policy
Trade Policy
Accounting Policy
Business, Society, & Culture

These are the critical factors to consider when performing a top-
down analysis.
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Fiscal Policy (1 of 2)
What is fiscal policy?
The central government's budget and balance sheet.
i. Taxes and spending.
Budget deficit or surplus.
Borrowing and the debt situation.
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Fiscal Policy (2 of 2)
What is the correct size of the government in the economy?
This is the central debate in the U.S. today, and affects all
aspects of fiscal policy.
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Fiscal Trends
Source: Office of Management and Budget
NOTE: Years 2014+ are estimates
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Vrabac, Daniel J. (VDJ) -
http://www.whitehouse.gov/omb/budget/historicals
Vrabac, Daniel J. (VDJ) - File: ECO Fiscal Trends

Tax Policy (1 of 2)
The best tax policy is the one that interferes the least with
economic decisions, i.e., creates the least uncertainty for
economic agents.
An ideal policy would also have infrequent changes -- this
reduces (tax) risk when people and businesses must make long-
term decisions.
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Tax Policy (2 of 2)
Usually, tax policies will seek to achieve a social/political
agenda, e.g., taxing the wealthier citizens to support the less
fortunate, or reducing tax rates to spur spending and growth.
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Macro Tax Considerations
Marginal versus average tax rates.
Flat tax versus graduated tax; number of brackets.
The marginal tax rate can significantly impact economic
incentives; e.g. too high of a marginal rate may cause cheating
and an outflow of capital from an economy.
As an example, Britain in the 1960s and 1970s had a 95%
marginal tax rate… The U.S. in the early 1980s was at 70%.
[Today, the U.S. is near 40%.]
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The Beatles’ Riff on 95% Marginal Tax Rates in Britain
Let me tell you how it will be

There's one for you, nineteen for me
'Cause I'm the taxman, yeah, I'm the taxman
Should five per cent appear too small
Be thankful I don't take it all
'Cause I'm the taxman, yeah I'm the taxman
Track 1 on the Revolver Album, 1966
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Business Taxes
Tax policy is also used to influence business decisions.
Investment Tax Credits: focus on particular industries (energy
exploration) or equipment (computers). ITCs come and go, and
are often used as incentives during periods of economic slack.
Homeland Investment Act: repatriation of foreign profits.
Agricultural and natural resource quotas and price supports are
used to influence business decisions.
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Monetary Policy
Monetary policy is usually run by a country’s Central Bank
(U.S. Federal Reserve – 1913)
A central bank’s objective(s) is (are) typically determined by
the Congress or Parliament.
In the U.S.: inflation and economic growth / unemployment.
In some countries, inflation is the only objective (Europe’s
ECB).

Others: The will of the government.
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Central Bank Independence
A central bank’s degree of independence (from executive,
legislative and judicial interference) is critical to its success.
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Monetary Policy – Operating Variable
Every central bank has an operating variable. The operating
variable is the target the central bank uses to influence the
economy. Often it is an interest rate or money supply figure.
Sometimes, it is the currency.
The operating variable may change over time. The Fed has
transitioned through three main operating variables since 1979:
1979 to mid-1980s: The amount of reserves in the banking
system (which influences the money supply).
Mid-1980s to 2008: The Fed Funds rate.
2008 to Present: Fed Funds rate, IOER, Quantitative Easing.
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How the Fed Works (?)
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FRB Economic Projections
Source: Federal Reserve Board; Monetary Policy Report, July

15, 2014
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Federal Funds Rate
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FRB Excess Reserves
Trillions of dollars
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Regulatory Policy
In addition to investment-oriented regulations covered in
Investments 1, investors must also be aware of other regulations
that affect companies and issuers they analyze.
The best policies provide an environment that reduces the
incentive to cheat or harm citizens or businesses.
Many industries are highly regulated, e.g. financial, drug,
utility. Most businesses also have to comply with OSHA to
provide safer workplaces.
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Regulatory Policy
Regulations usually result from abuses that have occurred.
Sometimes regulations can go too far; sometimes they don't go

far enough.
The analyst must know what the regulatory policy of a
particular country or industry is in order to properly evaluate
equity and bond issuers.
Some U.S. regulatory bodies:
FCC, FDA, SEC, OSHA, PUCs, CFPB, EPA
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Trade and Exchange Rate Policy
It’s important for investors to understand a country’s trade
policy. How open is the economy? -- not just with regard to
goods and services, but also with regard to financial capital and
currencies.
Some countries may be fairly open for goods and services trade,
but fairly closed when it comes to the capital account (China).
In some countries, citizens (including businesses) are not
legally allowed to own foreign currencies, or their capacity to
do so is limited.
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WTO
The World Trade Organization (WTO) was set up for two
primary purposes – to encourage trade between nations by
reducing trade barriers, and to mediate trade disputes.
A country’s trade openness can be determined by analyzing the
following:
Tariffs on Imports

Duties on Exports
Quotas
Special treatment of favored industries
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Examining Openness of Trade
A few of the ways to see if an economy is more open or more
closed is to look at the following data:
Exports as a % of GDP
Imports as a % of GDP
Net exports as a % of GDP
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Judging Openness of Trade
If a country has large imports but few exports, it may tell you
that:
the country is not very competitive, or
has poor economic policies, or
that its trading partners are fairly closed (or maybe all of the
above!), or,
it could be very resource-dependent without having a
competitive export base.
The above measures won’t provide all of the answers, but they
are a start.
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The Trade Balance
In addition to the items above, analysts should also examine a
country’s terms of trade, the size of its current account (relative
to GDP), and the size of its capital account.
Terms of trade: Export prices / Import Prices
Current Account: Merchandise trade, interest, dividends
Capital Account: Equities, bonds, direct investments
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Exchange Rate Regimes
Different countries have different exchange rate regimes
Floating or Flexible: U.S., U.K., Europe
Fixed: Hong Kong, and China until 2006
Managed or crawling peg: Mexico after 1994 crisis; China
today?
Currency Board: Hong Kong today, Argentina till 2002
Intervention: Plaza Accord (1985); Louvre Accord (1987); ECU
snake 1979-1992, Japan in 2004, (China today?)
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Fixed and Floating
Source: Federal Reserve Bank of St. Louis
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Accounting Policy
Significant progress has been made attempting to reconcile U.S.
GAAP accounting policies with IFRS (International Financial
Reporting Standards, used in 110 countries around the world).
The SEC is considering switching to IFRS rules by 2015.
Financial analysts will need to keep up on how such a change
will impact U.S. companies that only use GAAP. As of summer
2015, there appears to be a movement to halt the convergence.
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Business, Societal, and Cultural Environment
When putting together a top-down economic analysis, it is
crucial to understand the environment in which companies and
other issuers work.
In many countries, especially in the emerging world, one must
understand the influence of powerful families – some of which
are political, some of which are business, and often the two are
intertwined.
Americans should not assume that everyone else thinks like we
do. They don’t. And it doesn’t necessarily mean that we are
always right.
Ideas cannot be imposed, they must be accepted.
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ECONOMIC ANALYSIS
E C O N O M I C
V A R I A B L E S

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Variables
The next step in economic analysis is observing and interpreting
economic trends.
There are a large number of economic variables available to the
analyst that will help your understanding of the economic
situation and provide a better feel for where things are heading.
As we learned in Investments 1, it’s important to remember
historical episodes that might have occurred decades or even
centuries ago, and not just rely upon recent events or recent
history.
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Indicators and Guidance
A large number of economic statistics have been developed to
provide guidance to the analyst. Guidance is the key word,
because there are no hard and fast rules that definitively tell
you where you are in a cycle.
The importance of some variables may change from one cycle to
the next, which makes interpretation sometimes more difficult
and possibly dangerous.
However, analysts must do their best in order to get to the final
stage – the proper valuation of assets.
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Nominal and Real
It’s important to remember that many economic variables are
measured in both nominal and real terms. Make sure you
understand when to rely on nominal numbers and when to rely

on real numbers.
As an example, in a normal economy, we typically only follow
real GDP growth. However, in a very low interest rate and/or
potentially deflationary economy like we have today in the U.S.
(and also in Europe and Japan), paying attention to nominal
growth can be very important.
Real growth is Nominal GDP less inflation. If we have
deflation instead of inflation, positive real growth may mask a
very weak economy. This could delay needed reforms and
strong government monetary and fiscal policies, or cause poorly
structured responses to the situation.
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Economic Data Summary
Source: Bloomberg
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Economic Variables
GDP
Debt
Interest rates
Inflation
Labor Force and Employment
Personal Income and Consumption
Savings rates
Housing
Surveys
Exchange Rates
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G D P
GDP (Gross Domestic Product): The measure of an economy's
total production of goods and services over a period of time.
Remember, GDP is a flow statistic, not a stock statistic. It
measures activity over a period of time rather than at one point
in time.
Therefore, GDP only includes new sales and current income,
and not sales of used ("pre-owned") items.
GDP also does not include existing wealth.
Analysts should focus on both real and nominal GDP.
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Nominal and Real GDP y-o-y
Source: BEA, Quadrant.io
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Vrabac, Daniel J. (VDJ) - Date file GDP data.xlsx
GDP: Nominal Trend Line
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Things To Remember about GDP (1 of 4)
The economy goes through various stages of expansion and
contraction, which tend to repeat over time. These are the
economic cycles.

When GDP growth is at its low (negative growth), the economy
is at its trough (recession). When the economy is at its highest
rate of growth, it is at its peak. A return to recession from peak
completes the cycle.
There is no magic number for how long a cycle will run, nor
how strong its peak will be nor how low its trough.
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A recession is typically, but not always, defined as two
consecutive quarters of negative real GDP growth.
The NBER is the arbiter of when a recession begins and when it
ends.
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It is important for investors to have an opinion as to where we
are in the economic cycle.
The recent experience of the 2008 Global Financial Crisis raised
the awareness of the importance of investors understanding
macroeconomics (a reminder that occurs after every
economic/financial crisis).
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Watch out for inventories! When trying to determine current
underlying growth, it’s probably best to look at Final Sales
rather than GDP growth!!!

It’s important to remember that GDP is not all inclusive. Many
believe that it misstates the value of the economy due to
externalities like the environment and infrastructure age and
level of degradation
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GDP and Final Sales
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GDP: Degree of Development
All countries are not alike. Some are fairly stable at their level
of development, while many are in transition from one stage to
another.
One way to measure degree of development is through GDP per
capita.
This is calculated as GDP / population.
GDP per capita can help a company decide what products or
services to sell in a particular country or region.
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GDP per Capita (USD)
Source: World Bank
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GDP: Degree of Development

Distribution of wealth is also very important. The Gini
Coefficient measures the degree of income inequality in a
country.
The Gini coefficient is a number between 0 and 1 (or 100%),
where 0 corresponds with perfect equality (where everyone has
the same income) and 1 (100%) corresponds with perfect
inequality (where one person has all the income—and everyone
else has zero income).
Finally, we often group countries according to their stage of
development:
Developed (U.S., Europe, Japan)
Emerging (Brazil, China, Poland)
Lesser developed (most of Africa)
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Global Gini Coefficients
Source: CIA Factbook
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Debt
Reinhart and Rogoff in their book1 explained why this is such
an important variable.
As public debt to GDP rises toward and surpasses 100%,
economic growth (and potential economic growth) slows.
Private debt must also be watched – excessive private debt was
the problem in the U.S. going into the GFC, not public debt.

However, the bailout of the private sector resulted in a surge in
public (government) debt to GDP.
Watch the trend of debt-to-GDP in the economy, and watch the
individual components (government, private sector).
1 “This Time Is Different – Eight Centuries of Financial
Folly”
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Total Debt to GDP
Source: Federal Reserve Board; Vrabac calculations
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Private Debt to GDP
Source: Federal Reserve Board
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Public Debt to GDP
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Personal Mortgage Debt to GDP
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Financial Sector Debt to GDP
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Interest Rates
Interest rates have two components -- a real component, and an
inflation component:
i = r + e(p),
where i = the nominal rate of interest, r = the real interest rate,
and e(p) is the expectation of inflation. Note that this is
expected inflation, and not historical inflation.
The real rate of interest since 1960 has averaged about 2.97%.
Today, it is just over 1.00%1.
1 Using 10-year UST (H15) and headline PCE deflator.
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The Purpose of Interest Rates
Interest rates serve two primary purposes:
First, they act as a market clearing device for capital.
Second, they are a barometer of an economy's health.
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How Interest Rates Work
Because long-term assets and liabilities by definition have cash
flows out into the future, we must discount future cash flows
back to the present.

Higher long-term interest rates reduce the value of long-term
assets and liabilities, whereas lower rates increase their value.
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The Fed and Interest Rates
The Fed or central bank is able to control short-term interest
rates through monetary policy.
Short-term rates are mostly affected by central bank policy;
however, long-term interest rates are driven mainly by inflation
and the interaction of supply and demand for long-term capital.
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The Fed and Interest Rates
As we have witnessed in the period since the GFC, the Fed can
also intervene in the long-end of the yield curve. Currently it
does that through its quantitative easing policy when it buys
longer-term Treasuries and MBS.
The big decision being discussed by the Fed today is when to
end its quantitative easing program.
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Which Interest Rate? (1 of 2)
There are many different interest rates an analyst can follow.
The first one should be the policy rate set by the central bank of
each country. In the U.S. we have the Fed Funds rate and the
IOER rate. Private money market rates are set off of these rates
as well as off short-term U.S. Treasury rates.
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Which Interest Rate? (2 of 2)

Also critically important are U.S. Treasury rates all along the
yield curve; analysts must also follow the shifting nature of the
yield curve.
Finally, we need to consider corporate bond rates of different
qualities and maturities, as well as mortgage-backed securities
rates, remembering that private rates take their cue from the
Treasury curve, which serves as the benchmark for other rates.
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Interest Rates
Source: Bloomberg
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I N F L A T I O N
Inflation is the rate at which the general level of prices are
rising.
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Why is Inflation Important?
The Federal Reserve has a target range for inflation between
2.0% and 3.0%. Inflation on either side of that range is
problematic for the Fed.
If inflation rises too quickly, interest rates will rise, dampening
economic activity.
Too much inflation will distort prices in the economy; inflation
creates additional demand, which fuels further inflation.
During inflationary periods, people start trying to buy ahead of
further price increases -- which exacerbates the problem and

possibly leads to shortages.
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Detrimental Inflation
Inflation creates uncertainty about the future, disrupting
business and consumer planning.
Through the impact of present value, excess inflation decreases
the wealth of an economy.
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Inflation: Alternative Definitions
CPI1 – the most commonly known definition.
PCE2 deflator – An alternative measure of consumer price
inflation.
Core inflation -- removes two of the most volatile components -
- food and energy.
Median and Trimmed measures – Alternative core inflation
measurements that seek to remove the most volatile components
so that the underlying level of inflation can be more easily
discerned.
The Fed prefers to look at the core PCE deflator.
1 Consumer Price Index.
2 Personal Consumption Expenditures.
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Why Core PCE?
A Federal Reserve Bank of Richmond study discussed the
following reasons:

For the purpose of monetary policy, it would not be desirable to
respond to temporary changes in measured (headline) inflation
that are likely to be reversed.
Over the long-term, food and energy prices have been shown to
have had only a small effect on long-run trend inflation.
Therefore, because energy and food prices in the past 40 years
have moved in a cyclical fashion, unless there are fundamental
reasons, the Fed chooses to ignore them.
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Core PCE Price Index
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CPI
Thru Aug 2014
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Deflation
TODAY, we may be facing a different beast – perhaps worse
than inflation. That beast is deflation, a decline in the general
level of prices1.
If deflation is caused by technological advances and increases
in productivity, then everyone can benefit.
However, if deflation is caused by imported goods and services
substituting for domestic ones, or due to a faltering economy,
then deflation is a very serious problem for policymakers and

individuals.
There is a big difference between deflation and disinflation;
disinflation is a diminishing of the rate of inflation, deflation is
an actual drop in the price level.
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Europe In Deflation?
Until recently it was debatable whether Europe's economy was
recovering. No longer. Its recovery has stopped. The question
now is whether the stagnation will tip over into something
worse.
The ECB's target is "close to, but below, 2 percent."
Source: ECB, thru July 2015
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Germany’s 10-year Interest Rate
Source: Quadrant.io
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Population, Labor, and Employment
Economies want to employ everyone that is willing and able to
work. The higher the level of employment, the stronger income
growth should be, and thus the stronger the economy should be.
Determining the level of employment is theoretically simple –
just count the number of people working. However, practically,
it is far more complicated.

1 Population here refers to the civilian non-institutional
population, age 16+.
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The Labor Force
Labor force measures are based on the civilian noninstitutional
population 16 years old and over. Excluded are persons under
16 years of age, all inmates of institutions and persons on active
duty in the Armed Forces. All other members of the civilian
noninstitutional population are eligible for inclusion in the
labor force, and those 16 and over who have a job or are
actively looking for one are so classified. The remainder--those
who have no job and are not looking for one--are counted as
"not in the labor force.“
Many who do not participate in the labor force are going to
school or are retired. Family responsibilities keep others out of
the labor force. Still others have a physical or mental disability
which prevents them from participating in labor force activities.
The labor force today in the U.S. is approximately 1561 million
people.
1 Source: Quadrant.io; August 2014
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Labor Force Participation Rate
The LFPR is simply the Civilian Labor Force divided by the
population. Economists want to see a stable to growing LFPR.
For a few decades following the 1970s, the LFPR rose as
women entered the workforce in huge numbers, the baby
boomers reached peak working age, and immigration soared.
The LFPR today is at 62.8%; this is down from a high of 66.4%

pre-GFC (December 2006), and well below its all-time peak of
67.3% in January 20001.
1 Data are as of August 2014.
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The Importance of the LFPR
In recent years, especially following the GFC, the LFPR has
begun to fall. This masks weakness in the economy in terms of
the measured unemployment rate. The Fed is very concerned
about the decline in the LFPR.
Dropping by 0.1% may not seem like much, but with a
population of 248 million, every 0.1% drop in the LFPR
represents 248 thousand jobs! So, had we maintained the pre-
crisis LFPR of 66.4%, there would be 8.93 million more people
working today!!! 1.
1 Data as of August 2014.
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LFPR
Data as of August 2014
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Employment
Defining employed and unemployed (from the BLS):
People with jobs are employed.

People who are jobless, looking for jobs, and available for work
are unemployed.
People who are neither employed nor unemployed are not in the
labor force, e.g., students, stay-at-home parents, retirees, those
under 16.
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How Do We Count the Employed?
How do we determine who is employed and who isn’t?
Surveys of consumers (household) and businesses (payroll
survey – which is somewhat more accurate, according to
studies).
These two surveys often give conflicting views of the
economy’s direction.
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Employment Data
The investment world tends to follow the change in employment
as a gauge of economic health rather than total employment.
Employment is measured by the Non-Farm Payroll data that is
released monthly by the BLS. In the markets today, this is
considered by many to be one of the more important data
releases.
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Monthly Non-Farm Payroll

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Unemployment Data
Accompanying the employment report is the unemployment
report; unemployment is usually stated as a percent of the labor
force rather than as a whole number.
The BLS publishes several unemployment figures. The most
commonly reported unemployment rate is called U-3.
The latest (January 2015) unemployment rate is 5.7%.
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Alternative Unemployment Measurement
Another measure of unemployment is U-6; this measure picks
up discouraged workers and those working part-time who want
to work full-time, among others. It gives a truer representation
of labor slack in the economy.
The latest U-6 figure (often called unemployment plus
underemployment) is 11.3% (January 2015).
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U-3 and U-6
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Employment-to-Population
Some economists and analysts are closely following the
Employment to Population ratio as an indicator of overall

economic health. The higher this ratio, the better.
Unfortunately, this ratio has been falling over the past several
years; it currently stands at 59.0% (August 2014), down from its
recent peak in December 2006 of 63.4% (the all-time high of
64.7% was reached in April of 2000).
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Employment to Population
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Unemployment Duration
Since the GFC, economists have become very concerned about
the length of time people stay unemployed. As the time of
unemployment lengthens, skills atrophy, workers fall behind
new technology, and people age out of the workforce.
All of these have a detrimental effect on productivity.
By a few different duration measures, we remain at very
elevated levels of long-term unemployment.
This may create a higher level of structural unemployment,
which also impacts potential GDP.
II-4-‹#›
Duration of Unemployment
II-4-‹#›

Average Weekly Hours
The BLS publishes the average weekly hours and also overtime
hours worked by the private sector. Analysts watch this number
closely to see if labor demand is picking up or slackening. As
of August 2014, this number remains remarkably stable, at 34.5
hours per week.
II-4-‹#›
Average Weekly Hours
II-4-‹#›
Average Weekly Earnings
Analysts also watch the amount of average hourly earnings and
average weekly earnings in the private sector. Again, these
indicators give a view on the demand for labor. They can also
be important to determine how consumption in the overall
economy will be doing.
II-4-‹#›
Earnings, Inflation, and Real Wages
Median weekly earnings were up 1.7% in the fourth quarter of
2014 versus the fourth quarter of 2013.
The rate of inflation measured by the CPI over this time period
was 1.2%.
The difference between weekly earnings growth and the CPI
gives us an idea of how real earnings are doing.
II-4-‹#›

Average Weekly Earnings y-o-y
II-4-‹#›
Analyst Caveat
Always be wary of data. When it comes to the monthly NFP
report, which the market treats like news from on high, it must
be remembered first that this is a residual number (see JOLTS),
and second that there is statistical manipulation.
The monthly NFP is revised often, and usually in a big way.
That’s because the surveys can’t possibly capture all the goings
on in the labor market, especially at smaller firms.
II-4-‹#›
PERSONAL INCOME
Personal income is the largest income component in the U.S.
GDP data.
It is important to know the real growth rate and what is behind
it -- gains in continuing income, e.g. wages, or one-off
payments like bonuses or capital gains or lowered tax rates.
II-4-‹#›
Personal Consumption
We also need to look not just at the headline Personal Income
figure, but also Personal Disposable Income and its growth.
This is the amount the consumer actually has available to spend
and save.
Personal Consumption today represents over 60% of GDP in the
U.S. Personal Consumption is the largest of the expenditure

categories in GDP:
(C + I + G + Xn)
II-4-‹#›
Personal Income and Consumption
Data as of July 2014
II-4-‹#›
Disposable Personal Income Growth
II-4-‹#›
SAVINGS
Savings is the amount of money left from income after taxes
and spending.
Importantly, it is the amount of capital that is available for
investing in economic growth.
The largest savings component comes from individuals.
Businesses can also save (retained earnings), and so can
government (budget surpluses).
II-4-‹#›
True Savings (1 of 2)
Some economists and analysts believe that asset price
appreciation (e.g. equity and housing price gains) should be
counted as savings.

I completely disagree with this view. There is a BIG difference
between realized and unrealized savings.
Unless you sell an underlying asset, any gain is unrealized, and
should not be counted as savings.
II-4-‹#›
True Savings (2 of 2)
This was made very clear in the aftermath of the GFC.
Those who thought they were saving through house price
appreciation spent all of their after-tax income.
Many even went further into debt to spend more!
These people received a tremendous wealth shock when house
prices fell.
The personal savings rate today is 4.9% as of December 2014,
well below historical average of 8.4% (data starting 1959;
Quadrant.io)
II-4-‹#›
Savings Rate Chart
II-4-‹#›
Housing (1 of 3)
It is certainly true that the post-2007 housing crisis has
impacted individuals’ ability to borrow, which reduces
consumption. During asset manias (like housing in the early to

mid 2000s, and stocks in the late 1990s), people used those
rapid increases in asset prices to rationalize additional
borrowing to add to consumption. This is never a good thing
(recall those debt-to-GDP charts from earlier in the
presentation!).
II-4-‹#›
Housing (2 of 3)
Fed studies during the housing run-up of the mid 2000s showed
that consumers used the increase in the value of their homes to
supplement their incomes in order to keep up strong personal
consumption -- in some (alarming) cases, well beyond their
incomes. (Remember, the savings rate was near zero at the time
due to the mania). This was the MEW effect.
II-4-‹#›
Housing (3 of 3)
Some of the more popular housing index measures are the Case-
Shiller indexes, the FHFA indexes, Housing Starts and Permits,
New and Existing Home Sales, Applications, Delinquencies,
Mortgage Rates, and MEW.
II-4-‹#›
Case-Shiller Home Price Index
Data as of June 2014
II-4-‹#›
C-S Percent Change

II-4-‹#›
FHFA Home Price Index y-o-y
II-4-‹#›
Mortgage Rates
II-4-‹#›
Housing Affordability
Note that this index assumes a buyer can afford a 20% down
payment.
A value of 100 means that a family earning the median income
can afford to buy a median-priced home.
II-4-‹#›
Housing and the Wealth Effect
With the rapid run-up in house prices prior to the GFC, and the
subsequent unprecedented decline, various housing market
measures have become more important statistics for the market
to consider -- especially given the impact on consumption.
For several years now there has been a discussion of the “wealth
effect” from rising asset prices. This effect (if positive) meant
that consumers felt more secure, and would more readily spend
when asset prices are rising -- boosting the economy.
At first, analysts believed that rising stock prices had the

biggest wealth effect. However, other studies indicated that the
wealth effect from housing may be 2 to 4 times larger than that
of stocks. More recent studies have said that the wealth effect
of both is negligible. The debate continues.
II-4-‹#›
Surveys
In order to provide more timely data on the economy,
economists use surveys of businesses and consumers in order to
try to get a feel for the economy’s direction. Some of the most
oft-cited surveys are the regional Federal Reserve Bank surveys
of economic activity and the ISM surveys of the industry and
service sectors of the economy, and the University of Michigan
consumer surveys.
Because surveys can be done frequently, analysts put more
weight on these data than they deserve based on their ability to
forecast. (This is a good example of a behavioral bias of
analysts – the availability bias.)
II-4-‹#›
Exchange Rates
While not so much an economic variable as they are an asset or
medium of exchange, changes in currency values affect our
daily lives – through imported goods and services, as well as
impacting our wealth through our investments.
Directional moves (e.g., the RMB) can make some foreign
companies “richer” in terms of dollars, allowing them to buy
U.S. companies, real estate, and other assets – potentially
impacting the prices paid by U.S. citizens.
II-4-‹#›

Which Currencies to Watch?
All investors should be aware of the major currencies:
Trade-Weighted Dollar (Broad),
Euro,
Yen,
Renminbi,
British Sterling.
U.S. citizens and companies also need to watch the Canadian
Dollar and the Mexican peso – our two largest trading partners.
Emerging market currencies are also gaining in importance, e.g.
the Brazilian real, Russian Ruble, Indonesian rupiah, Indian
rupee
II-4-‹#›
INVESTMENT
ECONOMICS
SUMMARY
II-4-‹#›
Investment Economics (1 of 3)
There are a lot of policies and variables to consider. Because
these are dynamic, and reported at different times and with
different frequencies, the analyst can often be frustrated and
overwhelmed.
II-4-‹#›
It’s important to develop a set of variables and policy monitors
that you believe are important in helping to make your

investment decisions.
You should find a few economists who are dependable and not
always bullish (you can’t take a step on Wall Street with
planting a foot on a bullish economist).
II-4-‹#›
Always be on the lookout for new ways to look at the world.
However, there is a lot of data out there that get a lot of
attention, but are not worth an analyst’s time.
II-4-‹#›
Investment Economics
Not everything that can be counted counts, and not everything
that counts can be counted.
-- William Bruce Cameron, Sociologist
(this quote is often mistakenly attributed to Albert Einstein)
II-4-‹#›
Some Data Sources
Quadrant.io
http://research.stlouisfed.org/fred2
http://www.federalreserve.gov
http://www.cbo.gov
http://www.bea.gov

http://www.bls.gov
II-4-‹#›
1
-
1
1
-
1
BA 553 INVESTMENTS
SECTION
1b
FIN 445 ECONOMICS PROJECT
FALL 2015
A thorough investment analysis begins with a top-down
approach. A good understanding of the economy – where we’ve
been, where we are, and where we may be going – is critical to
successful long-term investing.
In this project, you will analyze what you believe to be the five
(5) most important economic variables based upon what we
studied in class. You are not limited to those discussed in class,
but if you choose any other variables you’ll need to explain
thoroughly why they are (more) important.
Assignment:
First, select the five economic variables you will use and list
them in the order in which you will discuss them. Put them in
the order of what you believe to be their importance for your
outlook. (5 points)

Second, discuss the meaning of each variable. Chart and
interpret its history, provide a rationale for its importance, and
rationalize your ranking order. (35 points)
Third, using all of the variables you have chosen, put together
an analysis of where in the cycle you think the economy is
today. Be sure to discuss the history of the variables and how
that affected your analysis. (45 points)
Fourth, based on your analysis of where we’ve been and where
we are, and using the same variables, discuss what you think
will happen in the economy over the next 12 to 24 months. (15
points)
General Instructions:
Be sure to use graphs and data to support your arguments. You
can find the data and charts you need using Quadrant.io, FRED
and other sources. Use the most recent data points possible.
Use as much history as you believe necessary to make your
points. Be sure to endnote from where you obtained your
information.
This assignment should not exceed 8 pages excluding graphs
and data. If you want, you can put the charts and data in an
appendix in the back. So to clarify, you may have up to 8 pages
of prose, plus additional pages for charts and data.
Additional Instructions:
Answer each of the four sections thoroughly. Use complete

sentences and paragraphs. Please endnote any source you use to
justify your answers (including class notes and the textbook).
Feel free to bring in other sources to support your answers (just
be sure to endnote those sources).
You must turn in a printed copy in class the day the project is
due. You must also email a copy of your project to
[email protected]prior to the beginning of class the day the
project is due.
Use ARIAL type font, 12 point, double-spaced.
All guidelines regarding exams, projects, and assignments
contained in the syllabus apply to this Project.

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