A Time To Be Rich

Chapter 6 and 7 : Lindsay Blum and Tara GattoChapter 8 : Jack MenkeChapter 9 : Rick Inciardi and Lauren MaughanChapter 10 : Richard GreinerChapter 11: Mark WyandChapter 12: Adam Dekel and David Grimner

A Time To Be Rich

Chapter 6: The Big Picture

Gross National Product (GNP) Number one choice of the markets for judging the

direction and speed of the overall economy GNP is a great place to start to learn about the

business cycle before you invest GNP – measures the total value of everything our

society consumes One of the most easily understood economic

indicators The first revised report is much more accurate than

the preliminary report Need to decipher that the numbers mean and the

changes from the preliminary to the revised to the previous year

Necessary to understand the 6 components for your own investment theory

Component 1: Final Sales Final sales = GNP – highly volatile business

inventories component Trends in final sales – good indicator of

where GNP will head in near term Look for divergent trend in final sales If both GNP and final sales rising – assume

economy in strong upward trend If both falling – assume economy is in a

strong downward trend

Component 2: Consumer Spending

Consumer Spending is made up of 3 basic segments: Services – ever growing, dominant portion of

total spending Nondurable Goods – food, clothing, and other

perishable items – 2nd largest total spending Durable Goods – smallest portion total spending

Only volatile segment of consumer spending

Component 3: Government Spending

Government spending/ government purchases – sums up federal, state, and local government expenditures

Stable underpinning for the economy and shows moderate increases from year to year

Generally can be expected to rise steadily Only unusual circumstances will prompt a

deviation from this steady trend

Component 4: Business Inventory

Monitors changes in inventory levels held by all types of businesses

GNP’s most volatile component Revisions can be massive – even within an

individual quarter between the preliminary GNP report and its first revision

Business inventories can swing widely at any point in the economic life cycle and affect future economic growth

Component 5: Housing Demand Officially called Residential Investment, includes both

new structures and repaired and alterations to existing ones

More sensitive to interest rates than most other parts of the economy influenced by price and tax factors

Demand for housing will rise when prices are expected to appreciate more rapidly

Housing signals in advance moves in the economy with a long lead time

Typically the first GNP component that will perk up as a prelude to an economic expansion

Component 6: Capital Spending

Capital spending or real nonresidential fixed investment

Capital spending measures major capital expenditures of businesses

Third largest component of GNP after government spending

Capital spending increases the productive capacity of the economy

Investment Strategy based on GNP To be successful at interpreting GNP – weave together

various pieces of information Must be flexible to reassess your big picture outlook

with every new piece of information Takes practice to develop the skill Important to stick to your investment plan is some

weekly or monthly economic indicators go against your conclusions based on GNP

Hold to your investment commitments until a reasonable amount of evidence proves your decision right or wrong

A Time to be Rich

Chapter Seven: Inflation’s Action-Packed Trends

How Inflation Affects Your Investments

Increases during Acceleration and Maturation

Two Basic Investment Sayings When inflation increases, return on real assets

(gold, real estate) > financial assets (stocks and bonds )

When inflation cools, situation reverses Inflation change has more profound impact

on bonds and gold than on stocks Sectors act differently to inflation

Measuring Inflation

Producer Price Index Consumer Price Index Commodity Price Indexes Oil Prices

Producer Price Index

4 Advantages: Tracks prices on wide array of raw

materials, intermediate goods and finished goods

Most market Sensitive Only minor revisions made Composed of useful sub indexes (ex.

Finished goods index)

Producer Price Index (cont.)

Disadvantages Focus on commodity prices disregards

service industries (retail trade, financial services, communications)

Getting all the information is difficult

Consumer Price Index Index of choice for taking the inflationary

prejudice out of other economic indicators Represents price changes for basic

necessities (ex. Food, clothing, housing) Fixed weighted index Advantage

Includes price changes for domestic and international commodities and service industries

Consumer Price Index (cont.)

Disadvantages: Includes fewer items than the PPI Computing the components are a

problem Ex. 1982, CPI’s housing component

overstated inflation

Out of sync with public’s perception of inflation

Commodity Indexes Spot Price Indexes

Tracks cash prices you need to pay for commodities today

Future Indexes Contract to buy a commodity at a future date at

today’s price Focus on futures indexes

Forward looking Close relationship to long-term bond yield

trends

Oil-A Special Commodity Impact on inflation

Energy comprises 8-10% of average cost of producing any item

Oil prices have intricate relationship with investment vehicles Takes time for markets to respond Ex. 1970’s, oil price increase immediately

impacted the bond market Stocks rallied, but price increase added to

inflation, weakens marketstock market drops

A Time to be Rich

Chapter Eight: On Inflation’s Trail

Inflation

Impact of inflation should be based on longer time periods

3 month and 12 month periods Producer Price Index Consumer Price Index

Rising inflation

Confidence about future

Advanced buying

Large consumer spending

Can lead to overheating

Falling inflation

Less confident about future

Avoid buying/slow economic activity

Dollar appreciation

Causes delays

Dealing with Inflation

Market restraints should be avoided Inhibits improvement on products Weakens productivity (leads to large

trade deficit) Diminishes corporate profit Delays underlying problems

Investments

Overheating Gold and precious metals are buys Long term bonds and stocks become

unattractive Disinflation

Stocks and bonds are strong buys Gold, precious metals and real estate are

less desirable

Inflation

Time periods, not single events, of inflation changes should be looked at

Will continue to have an impact on the economy as a whole

A Time to be Rich

Chapter Nine: The Personality of the Fed

Federal Reserve Responsible for regulating our nation’s money

supply and the health and direction of the economy

Understanding and evaluating the Fed involves four considerations: How they talk Body Language Attitude How they handle stress

The Chairman’s Role

The role of the Chairman can be determined by three main factors: Examining the economic goals of the

President who appoints the Chairman Watch the foreign exchange markets

treatment of the dollar Examine the Chairman’s professional

background

The Chairman’s Job

Must pursue two conflicting tasks: Keeping inflation in check Providing sustainable, consistent growth

Must pay attention to the politics as well as the economics behind issues

Must deal with potential contradictory views of the 12 FOMC members

The Fed Speaks

The Fed issues the following statements at the following times: Discount rate statements – whenever the

discount rate changes FOMC Meetings Minutes – normally

published on second Friday of each month

Humphrey- Hawkins Reports – when the Fed meets with Congress twice a year

Body Language (daily market operations)

The purchase and sale of US government securities

Change in the Fed’s behavior occurs when: Dire inflationary trend Deep economic recession Foreign exchange rate crisis Domestic financial crisis

How to Respond to Crisis

When a major crisis occurs, e.g. large corporate bankruptcy, the Fed will act as lender of last resort

Contrary to popular belief markets perform well during crisis and gains can be substantial

How to Respond to Crisis Crisis induces panic for two reasons:

Press commentaries are all over and make the problem sound more severe

Idea in people’s head of a potential repeat of the Great Depression

Guideline to prosper in these periods: Do not panic Go for quality investments Reassess your macroeconomic views

How to Respond to Crisis Depending on phase of the cycle we are in,

act accordingly when crisis hits: Ease-off – Plunge is around the corner, and

therefore, investors should be ready to invest

Revival – investment posture should remain the same

Acceleration/ Maturation – stay away from stocks and bonds and stick to money market investments

A Time to be Rich

Chapter Ten: Two Well-Known Interest Rates and How They Work

Two Well-Known Interest Rates and How They Work

The Discount Rate Set directly by the Federal Reserve

Fed Funds Rate Controlled by the Markets

Reliability of these economic indicators

The Discount Rate Rate at which the Fed charges banks and large

institutions for short term loans. 3 types of changes to the discount rate

Leading: Fed Initiates a change in direction of overall IR’s (either way).

Lagging: Fed Shoring up prior tightening or easing of IR’s.

Missteps: Fed Quickly reverses direction of IR changes.

Primary Credit Rate, Secondary Credit Rate, Seasonal Credit Rate

Determining the Type of Discount Rate change

Examine the accompanying Statement. Watch the response of other IR’s to the

change in the Discount Rate. Look at the momentum of the overall

economy. Not always a sign of a change in the

economy.

The Federal Funds Rate The IR one bank charges another bank to

borrow on its reserve at the Fed. This rate changes daily based on the markets

and can fluctuate greatly because of: Seasonal factors Fundamental factors Unpredictable factors

Use a weekly or monthly average for accuracy. The Targeted Fed Funds Rate is not the actual

rate.

Reliability as Indicators Fed is not always correct. Discount Rate: Often Lags behind the economy. Fed Funds Rate: Current state of monetary

policy, not leading indicator. Cannot rely on either of these as sole indicators:

as always, use with a host of reliable indicators. Money supply and velocity are better indicators

of monetary policy.

Current Rates

LOW HIGH09/05/2006 5.26 5 5.375 0.04 5.2509/01/2006 5.25 4.5 5.375 0.07 5.2508/31/2006 5.31 5 5.625 0.08 5.25

08/30/2006* 5.25 5.125 7.25 0.15 5.2508/29/2006r 5.23 5.13 5.375 0.03 5.2508/28/2006 5.25 5.1875 5.375 0.03 5.2508/25/2006 5.25 5.125 5.375 0.03 5.2508/24/2006 5.25 5.19 5.375 0.02 5.2508/23/2006 5.25 5.16 6 0.1 5.2508/22/2006 5.24 5.16 5.5 0.03 5.25

DateDiscount Rate

Aug. 8 6.25%June 28-29 6.25%10-May 6.00%

TARGET RATE

Federal Funds Data

http://www.ny.frb.org/markets/omo/dmm/fedfundsdata.cfm

DATE DAILY1RANGE

STD. DEV.

A Time to be Rich

Chapter Eleven: Money, the Root of Economic Change

What is the Monetary Base?

Currency in circulation plus banks' required and excess deposits at the

central bank

The Monetary Base’s Importance

Trends indicate direction of economy Surges, contractions, etc.

A crucial tool for the Fed to direct economy Stimulating or cooling

The Money Multiplier

Dollars created by the Fed turn into more dollars by the fractional-reserve banking system.

That is, dollars multiply into more dollars as they pass through the economy

Components of the Multiplier

M1: Currency, checking accounts, traveler’s

checks M2:

M1 plus “near money”; CDs money market funds

M3: M2 plus illiquid monies; CDs with long-

term maturities

M1: The Fed’s Primary Focus The Fed will set targets for M1 growth

projections Undershooting or overshooting

necessitates tightening or easing of rates

If Fed exceeds target, Plunge to Revival More concerned with growth than

inflation

M1 Continued Since WWII, real M1 declined an

average twelve months BEFORE the onset of the typical recession

Turned up four months before each recovery began

Bottoms out in early Plunge, peaks in late Maturation

M2 and M3

Better used as confirmation that M1 is providing good insight

M3 has been weak in correlation until a few years ago (a couple decades ago for us)

Investment Implications

Some basic rules: Monetary changes work with lags Trends overtime more important than

single day actions Fed’s two goals: growth and inflation

control Fed can surprise

M.B., the Business Cycle, and Investment Decisions

Easy off/early Plunge: M1 weakens dramatically, will fall short

of Fed targets

Due to Fed’s overzealous actions

Interest rates eventually begin to fall

RED FLAG for Plunge

M.B., the Business Cycle, and Investment Decisions

Plunge: Fed is over inflation Discount rate cutes follow Mortgage rates come down Investors should move to bonds once:

Significant decline in M1, decline in FF rate, corroboration from other economic and inflation indicators

M.B., the Business Cycle, and Investment Decisions

Revival: Fed worried about weak economy Growth allowed to exceed target Central bank concentrating on stabilizing

economy All RED FLAGS for a Plunge-to-Revival

transition

M.B., the Business Cycle, and Investment Decisions

Acceleration: Interest rates begin to rise Credit demands grow M1 and MB expand rapidly Fed equally concerned about nourishing

growth and maintaining targets RED FLAG for revival-to-acceleration

Bailing Out for different investors

Bond prices begin to decline, so… Highly Conservative:

When a two- to three- month rise in the FF rate is seen

Cautious: Adjustments made after FF rises and

complete after first discount rate increases

The Final Transitions

Maturation Fed worried about inflation M1 will eventually decline so large, it

wipes out some earlier increases Typically extends into Ease-off

Ease-off: Fed is a determined inflation fighter

A Time to be Rich

Chapter Twelve: Money, Money Everywhere

Money, Money Everywhere

1) Velocity of Money, the Fed; link with Economic Life Cycle

2) Affect on Interest Rates3) “Weak vs. Strong Money”4) Credit Indicators; link with Economic Life Cycle

Money Velocity and the Fed

Fed determines monetary policy, we determine money velocity

Relationship determines economic performance Dependent on both factors

Affect on Interest Rates

Direct relationship between velocity and interest rates Useful in anticipating rate changes

Look for opportunities in stocks Ex.: Identify Maturation phase; notice

decrease in velocity; decrease in interest rates; change into Ease-Off

“Weak vs. Strong Money”

Weak Money: Believers in Fed power over interest rates and role of credit

Strong Money: Believers in Fed power over money supply Disagree: The two are not mutually

exclusive of each other; money supply determines amount of credit available and, therefore, interest rate levels

Life Cycle Link

Velocity rises after expansion begins and falls after recession begins Velocity decreases after onset of Ease-off Falls through Plunge, Early Revival Stabilizes, then rises through late

Revival, Acceleration, Maturation Increased velocity magnifies

increased money supply; Fed steps in

Credit Indicators Total Private Borrowing

Broad measure of total borrowing within economy

Released Quarterly by Fed Board Rises rapidly during Acceleration and

Maturation and continues more slowly through Ease-Off

To analyze: compare with year ago level Ex.: 3Q ’06 and 3Q ’05

Precautions

Lag behind cycle changes in economic cycle Need to combine with other indicators

and historical data

Questions?