ECONOMIC ANALYSIS

ECONOMIC ANALYSIS

Before you get down to building a portfolio you need to know how to pick a stock. This is where the EIC analysis; namely Economic Analysis, Industry Analysis and Company Analysis comes in handy.

The first phase of analysis, namely Economic Analysis helps you to assess the general economic situation and is done with the help of economic indicators. The second phase of analysis, namely Industry Analysis, helps you to assess the prevailing conditions and is done with the help of performance indicators. The last phase, namely Company Analysis, helps you zero in on the right company through the use of ratios and perceptions.

Economic analysis helps you decide whether it is worthwhile to invest in a particular economy.

Economic phase and investor psychology: To understand when to enter and when to exit the market we must appreciate two things:

• Trade cycle
• Investor psychology

The economy goes through four phases:

• Boom
• Recession
• Bust
• Recovery

Each of these phases sees a certain human psychology.

During boom, economic activity is at its tallest. This is the time when everyone and his uncle is excited about the economy and chants the growth story. There is all round optimism as companies record new highs in turnover and profits, they announce big expansion plans, they talk of major mergers and acquisitions and the economy looks to be on a song. During this phase, Greed is the underlying human sentiment. The investor pours tons of money into the market and stocks that are normally unworthy of a second look begin to shoot up in price. Investors shop for stocks as though there is no tomorrow. They believe that equity prices will defy the law of gravity.

Somewhere along the line some company steps out of line. It fails to meet its overstretched goal, walks out of the line and the tumble begins. The economy slowly slips into recession and suddenly the mood changes. Economic activity drops down and there are no more growth stories. Prices begin to tumble, volumes drop and there is the onset of the mood of despondency. During this phase, Fear grips the market. Stocks and Shares now appear as Shocks and Stares. You stare at a stock and are shocked that you were crazy enough to ever buy it at what now appears “those ridiculous prices”.

And then almost without warning the economy goes bust. Corporates are busy holding the fort. Talks about growth, merger, going global etc turn out to be just that – talk! Almost on cue, the stock market collapses. This is the phase of unmitigated pessimism, characterized by Panic. Investors now begin to sell in droves, as though the lights had gone out of their lives.

Finally after a time, slowly but surely, the economy begins to recover. Someone somewhere begins to realize that things cannot get any worse, steps up the gas and the recovery starts. In the stock market the mood turns to one of caution; which is just one mood ahead of greed. And the cycle goes on, all over again.

So how does this help you as an investor? Well the smart investor enters at the phase between Panic and Caution. This is when prices are unrealistically low because everyone is busy selling. The smart investor exits when the economy gets into the top of a boom. For this is when stock players are busy buying stocks left, right and center at unrealistically high prices. You tend to get the best bang for your money if you sell at this phase.

Using Economic Indicators:
So how does one go about identifying which way the economy is heading? There are three types of indicators namely: Leading indicators, Lagging indicators and Co-incidental indicators.

Leading Indicators tell you what is going to happen to the economy. Some leading indicators are Rainfall, Agricultural Production, Capital Investment, Business Profits and the Sensex. Coincidental Indicators tell you what is currently happening to the economy. Some co-incidental indicators are GNP, Industrial Production, Interest rates and Reserve funds with the banks.
Lagging Indicators tell you what has happened to the economy. Some lagging indicators are Rising unemployment, piled up inventory and the rising incidence of debtors.

A brief explanation of eight of the economic parameters follows:

1. Rainfall: Despite all the brouhaha about India emerging as a major economic power we are still very much an agrarian economy with about 22% of our normal GDP coming from agriculture and over 60% of our population dependent on it.. Again, despite technical advancements our agriculture is still heavily dependent on the monsoons. Good monsoons are good for the economy and thus good for the markets.

2. Agricultural Production: Rising agricultural production is a good sign for the economy as much of the Indian economy’s fortune is linked to agriculture.

3. Capital Investment: An increasing or abundance of capital investment means that the industry is gung-ho about the future. Else, these entrepreneurs who normally have a finger on the mood of the economy would not be making the investments. High capital investment means possible more production, more demand and supply, better prices in the future and consequently better business profits.

4. Gross National Product: GNP along with GDP is an indicator of a nation’s wealth. An increasing national wealth is a good sign of how the economy is doing. India’s GDP is growing at 9% and if it should touch 12% that would mean that we are on the high road to growth.

5. Interest rates: A fall in interest rates is healthy. It reduces the cost of production and paves the way for industry to compete globally. Fall in interest rates also mean that more money would flow into the stock market because investors who prefer lower risks would begin to feel that the interest rate on debt funds aren’t adequate compensation.

6. Balance of Trade: Balance of trade represents the excess of exports over imports. A favorable balance of trade is good for the market.

7. Taxes: Who does not welcome fall in taxes. Any reduction in tax, corporate or personal is welcome for the stock market.

8. Disposable Income: Higher disposable income brings more money into the market. After all how much of money earned can be spent? Research shows that in the end, sometime or other, higher disposable income finds its way into the equity market

The funny thing is that different economic indicators can give different and opposite clues. Like a good doctor, the good analyst should be capable of distinguishing the symptom from the disease