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Fifth Edition

Conflicting Economic Signals
Despite last week™s return to optimism in the stock mar- exposure to the stock market in favor of bonds and
ket, nagging recession concerns continue to confound emphasizes financial stocks, which would benefit in a
Wall Street. low-rate environment.
With conflicting economic signals, investors find Ms. Cohen, conversely, maintains a healthy expo-
themselves in a quandary. Is the economy rapidly drop- sure to the stock market and emphasizes not just finan-
ping into recession, or close to one? Or is it simply taking cials, but also economically sensitive stocks such as
a modest breath before strengthening later this year? autos and housing-related stocks. She further expects
The recession quandary has split Wall Street strate- to emphasize later-cyclical commodity stocks as the
gists. One camp, which includes Charles Clough, chief year unfolds and the economic pace quickens.
strategist at Merrill Lynch & Co., argues that the econ- James Weiss, deputy chief investment officer for
omy is slowing much faster than realized. He says rising growth equities at State Street in Boston, and David
corporate inventories and a spent consumer are con- Shulman, chief strategist at Salomon Brothers, concur
tributing to a steepening slowdown. Moreover, the Fed- with much of Mr. Clough™s analysis of the economy.
eral Reserve is moving too slowly to stave off a period Mr. Weiss says the recent uptick in cyclical stocks
of extended sluggishness, and earnings will probably should be mostly ignored, and he favors steadier
suffer more than anticipated this year. growth in defensive sectors like health care and
The other camp, which includes Abby J. Cohen, beverages.
market strategist at Goldman, Sachs & Co., believes
SOURCE: Dave Kansas, “Conflicting Economic Signals Are Dividing
that the economy will rebound later this year.
Strategist,” The Wall Street Journal, February 26, 1996. Excerpted by
permission of Dow Jones & Company, Inc. via Copyright Clearance
EMPHASIZING FINANCIAL STOCKS Center, Inc. © 1996 Dow Jones & Company, Inc. All Rights Reserved
The divergent views play a crucial role in near-term
investing decisions. Mr. Clough has trimmed his

immediate, its formulation is so cumbersome that fiscal policy cannot in practice be used to
fine-tune the economy.
Moreover, much of government spending, such as that for Medicare or Social Security, is
nondiscretionary, meaning that it is determined by formula rather than policy and cannot be
changed in response to economic conditions. This places even more rigidity into the formula-
tion of fiscal policy.
A common way to summarize the net impact of government fiscal policy is to look at the
government™s budget deficit or surplus, which is simply the difference between revenues and
expenditures. A large deficit means the government is spending considerably more than it is
taking in by way of taxes. The net effect is to increase the demand for goods (via spending) by
more than it reduces the demand for goods (via taxes), therefore, stimulating the economy.

Monetary Policy
Monetary policy refers to the manipulation of the money supply to affect the macroecon-
omy and is the other main leg of demand-side policy. Monetary policy works largely through
its impact on interest rates. Increases in the money supply lower short-term interest rates, ul-
timately encouraging investment and consumption demand. Over longer periods, however,
monetary policy
most economists believe a higher money supply leads only to a higher price level and does
Actions taken by the
not have a permanent effect on economic activity. Thus, the monetary authorities face a dif-
Board of Governors of
ficult balancing act. Expansionary monetary policy probably will lower interest rates and
the Federal Reserve
thereby stimulate investment and some consumption demand in the short run, but these cir- System to influence
cumstances ultimately will lead only to higher prices. The stimulation/inflation trade-off is the money supply or
implicit in all debate over proper monetary policy. interest rates.

Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

390 Part FOUR Security Analysis

Fiscal policy is cumbersome to implement but has a fairly direct impact on the economy,
while monetary policy is easily formulated and implemented but has a less immediate impact.
Monetary policy is determined by the Board of Governors of the Federal Reserve System.
Board members are appointed by the president for 14-year terms and are reasonably insulated
from political pressure. The board is small enough and often sufficiently dominated by its
chairperson that policy can be formulated and modulated relatively easily.
Implementation of monetary policy also is quite direct. The most widely used tool is the
open market operation, in which the Fed buys or sells Treasury bonds for its own account.
When the Fed buys securities, it simply writes a check, thereby increasing the money supply.
(Unlike us, the Fed can pay for the securities without drawing down funds at a bank account.)
Conversely, when the Fed sells a security, the money paid for it leaves the money supply.
Open market operations occur daily, allowing the Fed to fine-tune its monetary policy.
Other tools at the Fed™s disposal are the discount rate, which is the interest rate it charges
banks on short-term loans, and the reserve requirement, which is the fraction of deposits that
banks must hold as cash on hand or as deposits with the Fed. Reductions in the discount rate
signal a more expansionary monetary policy. Lowering reserve requirements allows banks to
make more loans with each dollar of deposits and stimulates the economy by increasing the
effective money supply.
Monetary policy affects the economy in a more roundabout way than fiscal policy. While
fiscal policy directly stimulates or dampens the economy, monetary policy works largely
through its impact on interest rates. Increases in the money supply lower interest rates, which
stimulate investment demand. As the quantity of money in the economy increases, investors
will find that their portfolios of assets include too much money. They will rebalance their port-
folios by buying securities such as bonds, forcing bond prices up and interest rates down. In
the longer run, individuals may increase their holdings of stocks as well and ultimately buy
real assets, which stimulates consumption demand directly. The ultimate effect of monetary
policy on investment and consumption demand, however, is less immediate than that of fiscal

2. Suppose the government wants to stimulate the economy without increasing interest
rates. What combination of fiscal and monetary policy might accomplish this goal?

Supply-Side Policies
Fiscal and monetary policy are demand-oriented tools that affect the economy by stimulating
the total demand for goods and services. The implicit belief is that the economy will not by it-
self arrive at a full employment equilibrium and that macroeconomic policy can push the
economy toward this goal. In contrast, supply-side policies treat the issue of the productive
capacity of the economy. The goal is to create an environment in which workers and owners
of capital have the maximum incentive and ability to produce and develop goods.
Supply-side economists also pay considerable attention to tax policy. While demand-siders
look at the effect of taxes on consumption demand, supply-siders focus on incentives and mar-
ginal tax rates. They argue that lowering tax rates will elicit more investment and improve in-
centives to work, thereby enhancing economic growth. Some go so far as to claim that
reductions in tax rates can lead to increases in tax revenues because the lower tax rates will
cause the economy and the revenue tax base to grow by more than the tax rate is reduced.

3. Large tax cuts in the 1980s were followed by rapid growth in GDP How would
demand-side and supply-side economists differ in their interpretations of this
CHECK phenomenon?
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

11 Macroeconomic and Industry Analysis

We™ve looked at the tools the government uses to fine-tune the economy, attempting to main-
tain low unemployment and low inflation. Despite these efforts, economies repeatedly seem to
pass through good and bad times. One determinant of the broad asset allocation decision of
many analysts is a forecast of whether the macroeconomy is improving or deteriorating. A fore-
cast that differs from the market consensus can have a major impact on investment strategy.

The Business Cycle
The economy recurrently experiences periods of expansion and contraction, although the
length and depth of these cycles can be irregular. These recurring patterns of recession and re-
covery are called business cycles. Figure 11.4 presents graphs of several measures of pro- business cycles
duction and output for the years 1967“2001. The production series all show clear variation Repetitive cycles of
around a generally rising trend. The bottom graph of capacity utilization also evidences a clear recession and
cyclical (although irregular) pattern. recovery.
The transition points across cycles are called peaks and troughs, labeled P and T at the top
of the graph. A peak is the transition from the end of an expansion to the start of a contraction. peak
A trough occurs at the bottom of a recession just as the economy enters a recovery. The The transition from
shaded areas in Figure 11.4 all represent periods of recession. the end of an
As the economy passes through different stages of the business cycle, the relative profitabil- expansion to the start
of a contraction.
ity of different industry groups might be expected to vary. For example, at a trough, just before
the economy begins to recover from a recession, one would expect that cyclical industries,
those with above-average sensitivity to the state of the economy, would tend to outperform other
industries. Examples of cyclical industries are producers of durable goods, such as automobiles The transition point
or washing machines. Because purchases of these goods can be deferred during a recession, sales between recession
and recovery.
are particularly sensitive to macroeconomic conditions. Other cyclical industries are producers
of capital goods, that is, goods used by other firms to produce their own products. When demand
cyclical industries
is slack, few companies will be expanding and purchasing capital goods. Therefore, the capital
goods industry bears the brunt of a slowdown but does well in an expansion. Industries with above-
In contrast to cyclical firms, defensive industries have little sensitivity to the business cy- average sensitivity to
the state of the
cle. These are industries that produce goods for which sales and profits are least sensitive to
the state of the economy. Defensive industries include food producers and processors, phar-
maceutical firms, and public utilities. These industries will outperform others when the econ-
omy enters a recession.
The cyclical/defensive classification corresponds well to the notion of systematic or mar-
ket risk introduced in our discussion of portfolio theory. When perceptions about the health of Industries with below-
average sensitivity to
the economy become more optimistic, for example, the prices of most stocks will increase as
the state of the
forecasts of profitability rise. Because the cyclical firms are most sensitive to such develop-
ments, their stock prices will rise the most. Thus, firms in cyclical industries will tend to have
high-beta stocks. In general then, stocks of cyclical firms will show the best results when eco-
nomic news is positive, but they will also show the worst results when that news is bad. Con-
versely, defensive firms will have low betas and performance that is relatively unaffected by
overall market conditions.
If your assessments of the state of the business cycle were reliably more accurate than those
of other investors, choosing between cyclical and defensive industries would be easy. You
would choose cyclical industries when you were relatively more optimistic about the econ-
omy, and you would choose defensive firms when you were relatively more pessimistic. As
we know from our discussion of efficient markets, however, attractive investment choices will
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

392 Part FOUR Security Analysis

Dec. Nov. Nov. Mar. Jan. JulyJuly Nov. July Mar. Mar.
55. Gross domestic product, 1996$, Q (ann. rate, bill dol.)[C,C,C]
8,500 8,500

7,500 7,500
6,500 6,500
5,500 5,500

4,500 4,500

4th Quarter 2001
3,500 3,500

73. Industrial production index, durable manufactures [C,C,C] (dark line)
190 190
74. Industrial production index, nondurable manufactures [C,L,L] (light line)
170 170
150 150
130 130
110 110
90 90

70 70
December 2001
50 50

75. Industrial production index, consumer goods [C,L,C]
120 120
110 110
100 100
90 90
80 80
70 70
December 2001
60 60

82. Capacity utilization rate, manufacturing (percent) [L,C,L]
90 90

85 85

80 80

75 75
December 2001
70 70

68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02


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