and cultures that require a more detailed investigation into the inter- country factors at work. Nevertheless, the overriding conclusion is that those countries that do not adapt to the forces wrought by globalization will suffer the consequences of lower growth and a greater burden on their citizens. And that will not lead to any good.
The major contributors to the increase in real GDP in the sec- ond quarter were personal consumption expenditures, exports, equipment and software, residential fixed investment, and govern- ment spending. The contributions of these components were partly offset by a negative contribution from private inventory in- vestment. Imports, which are a subtraction in the calculation of GDP, decreased.
The deceleration in real GDP growth in the second quarter primarily reflected a downturn in private inventory investment that was partly offset by a downturn in imports and an accelera- tion in exports.
The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.3 percent in the second quarter, 0.2 percentage point more than the preliminary estimate;
this index increased 2.9 percent in the first quarter. Excluding food and energy prices, the price index for gross domestic purchases in- creased 2.1 percent in the second quarter, compared with an in- crease of 3.0 percent in the first.
Real exports of goods and services increased 10.7 percent in the second quarter, compared with an increase of 7.5 percent in the first. Real imports of goods and services decreased 0.3 percent, in contrast to an increase of 7.4 percent.
What I find of particular value is the BEA data on corporate profits:
Corporate Profits: Second Quarter 2005 (Final)
Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $59.3 billion in the second quarter. In the first quarter, profits increased
$68.7 billion. Current-production cash flow (net cash flow with inventory valuation and capital consumption adjustments)—the internal funds available to corporations for investment—increased
$41.7 billion in the second quarter, compared with an increase of
$95.4 billion in the first.
Taxes on corporate income increased $9.9 billion in the sec- ond quarter, compared with an increase of $69.6 billion in the first. Profits after tax with inventory valuation and capital con- sumption adjustments increased $49.4 billion in the second quar- ter, in contrast to a decrease of $0.8 billion in the first. Dividends increased $11.4 billion, in contrast to a decrease of $94.4 billion;
current-production undistributed profits increased $38.0 billion,
compared with an increase of $93.5 billion. Domestic profits of fi- nancial corporations decreased $26.9 billion in the second quarter, in contrast to an increase of $36.0 billion in the first.
Domestic profits of nonfinancial corporations increased $82.5 billion in the second quarter, compared with an increase of $17.8 billion in the first. In the second quarter, real gross value added of nonfinancial corporations increased, and profits per unit of real product increased. The increase in unit profits reflected an increase in unit prices and decreases in both unit labor and nonlabor costs corporations incurred.
The rest-of-the-world component of profits increased $3.7 bil- lion in the second quarter, compared with an increase of $14.9 bil- lion in the first. This measure is calculated as (1) receipts by U.S.
residents of earnings from their foreign affiliates plus dividends re- ceived by U.S. residents from unaffiliated foreign corporations mi- nus (2) payments by U.S. affiliates of earnings to their foreign parents plus dividends paid by U.S. corporations to unaffiliated foreign residents. The second-quarter increase was accounted for by a larger increase in receipts than in payments.
Now, no one is trying to turn you into an economist. Heaven forbid!
But the data presented does help an investor to understand the forces at work within the economy at a given point in time. And, unlike many of Alan Greenspan’s speeches, the GDP report is not written in some arcane, hard-to-decipher language.
The preceding data paint a picture of an economy on fairly solid ground. Growth remains strong and inflation is fairly muted. Corporate profits are doing exceptionally well, notwithstanding how long the economic expansion has been under way and the impact of higher en- ergy prices.
Public sources of economic data such as the BEA report are abundant, with many of high-quality nature. All are free and easy to access. Some of them are listed in Appendix A, including those produced by private organi- zations. One such important private organization report that moves mar- kets is produced by the Institute for Supply Management (ISM).
Institute for Supply Management Reports
“Founded in 1915, the Institute for Supply Management™ (ISM) is the largest supply management association in the world. . . .” So states the opening text on the web site of the private organization that produces two of the most important monthly reports on the state of economic activity:
the ISM Report On Business®, one for manufacturing and the other on nonmanufacturing (known as the services report). Tracking the pace of economic activity, the reports provide a comprehensive survey of businesses and their perspectives and intentions in the coming months and years.
For example, “the Manufacturing ISM Report On Business® is based on data compiled from monthly replies to questions asked of purchasing executives in over 400 industrial companies.” Data on such areas as new orders, production, employment, supplier deliveries, and inventories are compiled and disseminated.
The Purchasing Managers Index (PMI) is the headline number that in- vestors eagerly await. It provides a composite picture of the trend of the manufacturing sector, expressed in the form of a diffusion index. To illus- trate, let’s look at the PMI for October 2005 from the ISM:3
The PMI indicates that the manufacturing economy grew in Oc- tober for the 29th consecutive month. The PMI for October regis- tered 59.1 percent, a decrease of 0.3 percentage point when compared to September’s reading of 59.4 percent. A reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is gener- ally contracting.
A PMI in excess of 42.7 percent, over a period of time, gen- erally indicates an expansion of the overall economy. The Octo- ber PMI indicates that both the overall economy and the manufacturing sector are growing. The past relationship be- tween the PMI and the overall economy indicates that the aver- age PMI for January through October (55.4 percent) corresponds to a 4.6 percent increase in gross domestic product (GDP) on an annual basis. In addition, if the PMI for October (59.1 percent) is annualized, it corresponds to a 5.9 percent in- crease in GDP annually.
The Last 12 Months
Month PMI Month PMI
Oct 2005 59.1 Apr 2005 53.3
Sep 2005 59.4 Mar 2005 55.2
Aug 2005 53.6 Feb 2005 55.3
Jul 2005 56.6 Jan 2005 56.4
Jun 2005 53.8 Dec 2004 57.3
May 2005 51.4 Nov 2004 57.6
Average for 12 months—55.8 High—59.4
Low—51.4
Note the connection between the report and a potential GDP projec- tion as stated in the last line: “. . . if the PMI for October (59.1 percent) is annualized, it corresponds to a 5.9 percent increase in GDP annually.”
Here an investor has a valuable piece of information made freely available to all and one that we can use to help determine the state of the aggregate economy. Moreover, when you explore each of the aforementioned seg- ments (new orders, production, employment, etc.) you can gain a depth of understanding of the strength and trends in the economy. Take for example that all-important subject of pricing power.
From the same report,4here is the segment on prices:
Prices grew significantly again in October as the Prices Index rose to 84 percent, up six percentage points from 78 percent in Sep- tember. In October, 70 percent of supply executives reported pay- ing higher prices and 2 percent reported paying lower prices, while 28 percent reported that prices were unchanged from the preceding month.
A Prices Index above 47.1 percent, over time, is generally con- sistent with an increase in the Bureau of Labor Statistics (BLS) In- dex of Manufacturers Prices. In October, 18 industries reported paying higher prices: Textiles; Furniture; Petroleum; Rubber &
Plastic Products; Glass, Stone & Aggregate; Chemicals; Primary Metals; Paper; Fabricated Metals; Transportation & Equipment;
Food; Apparel; Instruments & Photographic Equipment; Miscel- laneous*; Industrial & Commercial Equipment & Computers;
Printing & Publishing; Electronic Components & Equipment; and Wood & Wood Products.
Prices % Higher % Same % Lower Net Index
Oct 2005 70 28 2 +68 84.0
Sep 2005 60 36 4 +56 78.0
Aug 2005 36 53 11 +25 62.5
Jul 2005 24 49 27 –3 48.5
In a global economy, the threat to the bottom line due to an inability to raise prices when warranted is real. Remember that competitive forces that are strong can shift the value produced to the buyer. If companies and
industries are engaged in a highly competitive atmosphere, their ability to keep the value produced is diminished. Therefore, the ability to raise prices is vital to the bottom line of most businesses. The preceding data suggest that the ability to sustain price increases has improved dramatically over the past four months. Whether this trend holds remains to be seen, as a global economy is a very dynamic place.
The Non-Manufacturing Report On Business®provides similar infor- mation, this time on the state of business in the services area of the econ- omy. For example, Table 5.3 provides a clear composite picture of the areas surveyed and their data. One can easily get a good picture of where the economy is headed, at least over the near term.
TABLE 5.3 ISM Non-Manufacturing Report
Non-Manufacturing Series Series Percentage
Index Index Point Rate of Trend
Index October September Change Direction Change (Months)
Business 60.0 53.3 6.7% Increasing Faster 31
Activity/
Production
New Orders 58.2 56.6 1.6 Increasing Faster 31
Employment 52.9 54.9 –2.0 Increasing Slower 25
Supplier 58.5 56.0 2.5 Slowing Faster 50
Deliveries
Inventories 50.0 50.0 0.0 Unchanged N/A 2
Prices 78.0 81.4 –3.4 Increasing Slower 29
Backlog of 55.0 52.0 3.0 Increasing Faster 9
Orders
New Export 54.5 55.0 –0.5 Increasing Slower 4 Orders
Imports 53.5 58.5 –5.0 Increasing Slower 30
Inventory 55.0 64.0 –9.0 Too High Lesser 101
Sentiment
Customers’ N/A N/A
Inventories
Source: Reprinted with permission from the publisher, the Institute for Supply ManagementTM.
Demographics
The study of socioeconomic groups characterized by age, income, gender, education, occupation, and so on is known as demographics.
In his well-written call to arms, Running on Empty: How the Democra- tic and Republican Parties Are Bankrupting Our Future and What Ameri- cans Can Do About It, Peter G. Peterson, former chairman of the Federal Reserve Bank of New York and former United States Secretary of Com- merce, discusses the issue of the aging of America. The book helps described the interrelationship (and the consequences) of an aging population and gov- ernment policy and how they can affect the economic vitality of the United States. Here are a few excerpts that I think will help illustrate the point:
For nearly all of human history, until the industrial revolution, people aged sixty-five and over never amounted to more than 2 or 3 percent of the population. In America today, they amount to 12 percent. By the year 2040 they will be reaching 20 percent and may be closing in on 25 percent. . . .
For the moment, America is still enjoying the last few years of what has been called a “demographic Indian summer.” With the large postwar boom generation in the workforce and a small Depression-era generation retiring, the elder share of the U.S.
population has been flat since the mid-1980s. But when boomers start turning sixty-five less than a decade from now, the demo- graphic climate will change abruptly. . . .
This explosion in the number of elderly Americans will place an unprecedented economic burden on working-age adults. As re- cently as 1960 there were 5.1 taxpaying workers for every Social Security beneficiary. This ratio, now 3.3, is officially projected to fall to 2.2 by 2030. By then each two-earner working-age couple will have to support at least one anonymous retiree. . . .
The graying of America therefore translates into a huge and growing bill to taxpayers for senior entitlements. Between now and 2040, Social Security outlays as a share of worker payroll are officially projected to rise from 11.1 to 17.8 percent. Both parts of Medicare will rise from 5.6 to 18.2 percent.5
In a segment titled “The ‘Grow the Economy’ Fantasy,” Peterson criti- cizes the very popular political solution (and I might add one that is also very popular among many Wall Street types) that growth will save the day:
The projections are stark. America will have to undertake funda- mental reform of senior benefits or else experience a fiscal meltdown
within a few decades. Given this choice, it’s not surprising that many leaders of both political parties prefer denial.
The magic bullet most often extolled by Republicans (as well as some Democrats) is faster economic growth. If the economy grows faster than projected, say these GOP optimists, today’s ben- efit promises will become affordable.6
Leaving aside the conclusion reached by Pete Peterson, the important takeaway for readers is the process of linking a demographic trend, the aging of America, with its political and economic consequences. These excerpts help point out that linkages do exist and insight can be gained if one can see the bigger picture by examining the segments of the economy. And that brings us to a very important concept and a poem by a nineteenth-century American poet, John Godfrey Saxe, based on a fable told in India many years ago.
The Elephant and the Blind Man7 It was six men of Indostan To learning much inclined, Who went to see the Elephant (Though all of them were blind), That each by observation Might satisfy his mind.
The First approached the Elephant, And happening to fall
Against his broad and sturdy side, At once began to bawl:
“God bless me! but the Elephant Is very like a wall!”
The Second, feeling of the tusk, Cried, “Ho! what have we here So very round and smooth and sharp?
To me ’tis mighty clear This wonder of an Elephant Is very like a spear!”
The Third approached the animal, And happening to take
The squirming trunk within his hands, Thus boldly up and spake:
“I see,” quoth he, “the Elephant Is very like a snake!”
The Fourth reached out an eager hand, And felt about the knee.
“What most this wondrous beast is like Is mighty plain,” quoth he;
“ ’Tis clear enough the Elephant Is very like a tree!”
The Fifth, who chanced to touch the ear, Said: “E’en the blindest man
Can tell what this resembles most;
Deny the fact who can This marvel of an Elephant Is very like a fan!”
The Sixth no sooner had begun About the beast to grope,
Than, seizing on the swinging tail That fell within his scope,
“I see,” quoth he, “the Elephant Is very like a rope!”
And so these men of Indostan Disputed loud and long, Each in his own opinion Exceeding stiff and strong,
Though each was partly in the right, And all were in the wrong!
Moral:
So oft in theologic wars, The disputants, I ween, Rail on in utter ignorance Of what each other mean, And prate about an Elephant Not one of them has seen!
Whole textbooks are written about the economy. It is therefore impos- sible to cover all that needs to be known about the U.S. economy, let alone the world economy, in one chapter. Moreover, important areas such as per- sonal income and consumer spending provide valuable information on their respective segments and on the economy (domestic and global) as a whole.
To endeavor to grasp the big picture from the trunks and legs and ears of the global elephant is a fool’s errand if an investor does not place the infor- mation in context and take a step back to see how it all interrelates.
So, here are a few points that I offer to those seeking to grasp the big picture:
■ Become a student of the global economy and globalization.
■ Identify and monitor a few key economic indicators.
■ Determine how each economic indicator you are analyzing impacts the valuation model inputs.
By keeping the bottom line in sight and stepping back to see how the segments of the big picture can and do interrelate, the seemingly impossible task of understanding the global economy can become surmountable.
We now need to move from the really big picture to just the big pic- ture. And in doing so, we are entering the world of economic sectors and subsectors.