Economics
3. The business cycle and the implications to investment timing
Economics can be a paradoxical science; whatever you would normally think to be a correct and logical relationship turns out to be the complete opposite. The majority of nonfinancially interested individuals (NFIIs) would regard a strong growth economy as the best possible scenario for an increasing valuation of financial assets. However, this scenario could actually portend greater
inflation (the nemesis of financial assets) and higher interest rates (to combat these higher rates, see
"Purchasing Power Parity" later in this chapter) and lower valuations for financial assets because the cash flows generated within will be discounted at higher rates, resulting in lower present values (see Chapter 3).
Another NFII may associate a strong U.S. dollar with increasing interest rates because "higher
interest rates generate a greater demand for the domestic currency." But one theoretical application of international parity conditions states that as domestic interest rates increase (vis-à-vis foreign interest rates), the value of the domestic currency (vis-à-vis the foreign currency) actually should weaken to allow parity (at which no arbitrage or "free-profit" opportunities exist) between both nations.
Opportunities also exist whereby a well-positioned (within the Wall Street community) VFII can profit through rare mispricing or inefficiencies that exist, albeit for only a brief moment, between foreign currencies and interest rates. This type of arbitrage, defined as the ability to purchase a certain asset on one market and then sell the very same asset on another market at a higher price without any risk, is known as interest rate arbitrage. However, like any inefficiency in the market, the opportunity quickly disappears as the buying action of profit-hungry investors force the inefficiency back into parity.
Determining the Health of the Economy
At this point, we face one of the more daunting tasks of any investor—surveying the health of the current economy. This text covers macroeconomics only on a cursory basis because the myriad of economists, investment strategists, and others of this guru sect force efficiency (or information flow) in the marketplace. The volumes of research orchestrated by these men and women drive the
investing public's info flow into a state of efficiency. With all this information at their fingertips, how could investors of sound mind and reasonable resources make mistakes?
In the ivory towers of Wall Street, the sources of this economic research have a difficult time determining the health of the economy. A report by Stephen McNees (see Bibliography) states that there is a wide disparity between the forecasts of these professionals and the actual outcomes.
Although these forecast errors are often adjusted through the revision process, there is no guarantee of continued improvement. Furthermore, for certain financial variables (e.g., interest rates, stock prices), naive models (simple statistical models) are typically no better than the professional
forecasts. Some releases of macroeconomics variables (e.g., gross national product, consumer price index) are consistently bested by the professional's forecast, but the margin for superiority is small.
So what is an investor to do? If trained economists can't judge the health of the economy with consistent accuracy, what is the likelihood that today's typical investor can?
Well, candidly, he cannot. But what the investor can do is understand the underlying tenets of macroeconomic relationships and therefore learn to judge the value of financial assets under certain scenarios. For example, the investor who notices a trend of increasing new home sales can surmise that the revenues (and possible, as a consequence, the
share price) of companies in the building products and mortgage industries should increase. To further fine-tune his hypothesis, this VFII could employ some simple regression analysis (see the appendix in Chapter 4) to calculate the correlation (if any actually exists) between an increase in this macroeconomic variable and the earnings of the companies that fuel this business. However, the flag of caution is raised, for it may not be as simple as just described. Perhaps there is a lag between the increase in new home sales and the effects on the suppliers to that industry. Or this macroeconomic trend may be an aberration. How "good" is the release? Is it two months old? Is this indicator subject to revision, and if so, what has been the trend in this regard?
This chapter summarizes the major economic releases. Like the information throughout this book, this summary can serve as a factsheet or guideline. An investor today need not understand all the intricacies involved with economic indicators but rather must grasp the effect on financial assets when these releases are made public.
Consider this example. An investor has decided to position $100,000 into zero-coupon treasuries maturing in 25 years (February 15, 2022) for his pension account. The cost of each bond is
approximately (as of 1/15/97) $174.24 ($1,000 face value at maturity) and therefore has a stated yield to maturity of 7.090% (ignoring any fees, commissions, or markups).
Price Yield to Maturity
$174.24 7.09%
The following chain of events occurs:
1. Friday at 8:30 A.M. (EST), the Department of Labor reports a significant and unexpected (and this is the key—for if it was expected, then the bond market would have already
adjusted) decrease in the number of unemployed (or increase in the nonfarm payrolls). This is a negative for the bond market because stronger growth (the more people employed the more they can spend) usually leads to higher inflation. Inflation is the nemesis of the fixed income market, for it depreciates the buying power of a fixed rate of return.
Unemployment Rate Inflation Decreases Increases