While many of us buy and sell stocks without giving a lot of thought to the big picture, or macroeconomics, the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" argued that we should.
In chapter four of their 2014 book, Stephen Horan, Robert R. Johnson and Thomas Robinson claimed strategic investors should take the extra time and effort to help ensure better results. Here are a couple of reasons why:
- Assessments of different world economies help us make international and domestic allocation decisions.
- Cash flow evaluations are more accurate when we know how much the economy is expected to grow.
- The inflation rate—and the expected inflation rate—affect interest rates and economic activity.
GDP and GNP
Two of the best-known economic indicators are gross domestic product and gross national product.
GDP tells us the total value of all final goods and services within a country for a specific year. This is known as “nominal GDP” and is measured in current dollars, while “real GDP” shows the value of the economy in after-inflation dollars.
GNP refers to the total value of all final goods and services produced with investments by citizens of a country, no matter where the production takes place. For example, a mining operation in Canada, owned by an American corporation, would be part of U.S. GNP, but not U.S. GDP.
Absent other compelling data, the expected growth in GDP or GNP can be used to make initial estimates of a company’s future growth.
Business cycles
GDP is also a factor in measuring business cycles and long-term trends in the economy. While the U.S. economy has trended upward in the long term, it also experienced ups and downs along the way, and these ups and downs are known as business cycles. This graph from the book shows the basics of cycles:
Before buying a new stock, you will want to know whether it is cyclical and what will happen if you buy at different points in the cycle. For example, buying an auto stock at a trough could be a good value proposition; buying at the top of the cycle could mean disastrous results in the short term.
Inflation
Expected inflation matters when investing because, as the authors explained:
“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. Inflation impounded into the risk-free rate impacts all companies and industries.”
Other economic indicators
In addition to GDP, investors look to other economic indicators when making decisions. These are divided into three categories: (1) Leading indicators, which move in advance of the business cycle, (2) lagging indicators, which generally lag the business cycle and (3) coincident indicators, which move with the cycle.
These indicators include sentiment indices, which are quantitative measures of fear and greed. As Warren Buffett (Trades, Portfolio) famously wrote in his 2005 letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.”
The authors noted that sentiment indexes are most useful when they are well outside their normal range. Some well known indexes are the Put-Call Ratio, the CBOE Volatility Index (VIX, Financial), the Barron’s Confidence Index and the American Association of Individual Investors Sentiment Survey (AAII).
- The Put-Call Ratio refers to the proportions of put options and call options being bought. The value of put options increases as share prices go down and are often seen as insurance for stocks. On the other hand, the value of call options increases as stock prices go up. When the market is optimistic, investors buy more calls than puts and vice versa. So if investors begin buying higher volumes of puts, it suggests they are concerned about future market corrections or worse.
- The VIX, as the CBOE Volatility Index is commonly known, measures the market’s expectations about near-term volatility (as measured by option prices on the S&P 500 stock index). When the VIX is rising, the market is believed to be growing more nervous.
- The Barron’s Confidence Index is based on bond yields. Specifically, the average yield on high-grade bonds is divided by the average yield on intermediate-grade bonds. If this index is rising, then it’s believed that bond investors have increasing confidence in the economy; if the index if falling, confidence is slipping away.
- The AAII, or American Association of Individual Investors Sentiment Survey, measures how individual investors are feeling. Each week, “serious” individual investors are surveyed and the report shows what percentages of them feel bullish, bearish or neutral about the market. Between the survey’s inception in 1987 and 2014, the averages were: 39% bullish, 30% bearish and 31% neutral. Investors were most optimistic on Jan. 6, 2000, when bullish sentiment reached 75%, and most pessimistic on March 5, 2009, when 70.3% of investors felt bearish.
Conclusion
Analyzing economic conditions can seem intimidating, but as authors Horan, Johnson and Robinson showed, it need not be so.
Simply watching the growth or contraction of GDP will give us as sense of the state of the economy in which our companies of interest operate. Similarly, familiarization with a few indicators will give us a sense of which way the market might head in the near future.
None of these macroeconomic measures is a sure thing; all are basically measures of probability. But knowing what they are and where they’re headed should help us do better analysis and make better decisions.
Read more here:
- Strategic Value Investing: Bottom-Up or Top-Down?
- Ă‚ Strategic Value Investing: Barriers to Success
- Strategic Value Investing: Value Investing for Higher ReturnsÂ
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
