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Fundamental Analysis I: Economic Analysis

Capital markets provide lucrative investment opportunities since they help in earning a return without actually indulging in any economic activities. Economic activities are, in fact, the base without which the supporting functions of capital markets will not find an existence. Nobody invests to lose money. However, investments (assets or securities) always entail some degree of risk either in productive economic activity or in an intermediary role. There are certain specific features that relate to investments in terms of securities in the capital market. They are as follows:

1. The higher the expected rate of return, the greater the risk.
2. Some investments cannot easily be sold or converted to cash. Sometimes, investments carry with them the characteristic of a penalty or charge if one disposes of an investment too soon before its maturity date.
3. Investments in securities issued by a company with little or no operating history or published information may involve greater risk.
4. Security investments, including mutual funds, can not be legally insured against a loss in market value.
5. Securities may be subject to tender offers, mergers, reorganisations, or third-party actions that can affect the value in terms of ownership interest. Hence, market anomalies might exist to public announcements and information about such transactions. This characteristic makes an investment decision process complex.
6. The past success of a particular investment is no guarantee of future performance.

The unique nature of capital market instruments forces investors to depend strongly on other fundamental factors to help them in their investment decisions. It can be presumed that if not for investment through capital markets, investors would have to invest in an economy directly. Companies are a part of the industrial and business sector, which in turn is a part of the overall economy. The performance of securities that represent the company can be said to depend on the performance of the company itself. The selection of an investment will hence start with fundamental analysis. Fundamental analysis examines the economic environment, industry performance, and company performance before making an investment decision.

A fundamental analyst believes that analysing the economy, strategy, management, product, financial status, and other related information will help choose shares that will outperform the market and provide consistent gains to the investor.

Fundamental analysis is the examination of the underlying forces that affect the interests of the economy, industrial sectors, and companies. It tries to forecast the future movement of the capital market using signals from the economy, industry, and company. Fundamental analysis requires an examination of the market from a broader perspective. The presumption behind fundamental analysis is that a thriving economy fosters industrial growth which leads to development of companies.

For the national economy, fundamental analysis focuses on economic data to evaluate the present and future growth of the nation. It usually compares one economy with similar or superior national economies. At the industry level, there is an examination of the supply and demand forces for the products offered, substitute products/industry, industry cycles, and so on. At the company level, fundamental analysis examines financial data, management policies, business vision, competitive strength, and so on. Thus, to forecast future share prices, fundamental analysis combines economic, industry, and company analysis to derive a share’s current fair value and forecast its future value from this information. If the current fair value is not equal to the current share price and the future estimates are favourable, fundamental analysts believe that the share is either over valued or undervalued and that the market prices will ultimately approach expected fair value. Based on the assumption that market prices do not accurately reflect all available information, fundamentalists see an opportunity to invest and capitalise on perceived price discrepancies.

Even though there is no common practice, fundamental analysts tend to look first into the national economy before analysing industry performance and then individual companies within an industry. This method is called a top-down approach to fundamental analysis.

The real problem in fundamental analysis is the evaluation of indicators. Economic indicators have to be compared over a period of time to assess the favourable/unfavourable climate. Industry groups are compared against other industry groups and companies against other companies. While analysing companies, usually companies are compared with others in the same industry group to identify performers. For example, a cellular service (BPL Mobile) would be compared to another cellular service (Airtel Digilink), not with an FMCG player (ITC). Whereas investors in the market look across all share instruments irrespective of the company or industry or economy.

ECONOMIC ANALYSIS

The economic analysis aims at determining if the economic climate is conducive and is capable of encouraging the growth of business sector, especially the capital market. When the economy expands, most industry groups and companies are expected to benefit and grow. When the economy declines, most sectors and companies usually face survival problems.

Hence, to predict share prices, an investor has to spend time exploring the forces operating in the overall economy. Exploring the global economy is essential in an international investment setting. The selection of a country for investment has to focus itself to the examination of a national economic scenario.

It is important to predict the direction of the national economy because economic activity affects corporate profits, not necessarily through tax policies but also through foreign policies and administrative procedures. A zero growth rate or a slow growth rate of the economy can lead to lower business profits, a prospect that can endanger investor outlook and lower share prices.

Economic analysis implies the examination of GDP, government financing, government borrowing, consumer durable goods market, non-durable goods and capital goods market, savings and investment pattern, interest rates, inflation rates, tax structure, foreign direct investment, and money supply.

King B.F., ( 1966) observed that, on an average, over half the variations in share price could be attributed to a market influence that affects all stock market indexes. However, shares are also subject to an industry influence, over and above the influence common to all shares. This industry influence explains, on an average, about 13 per cent of the variation in a share price. On the whole, according to his research findings, about two-thirds of the variation in share prices are the result of market and industry influences. Brainard W.C., Shoven J.B., and Weiss L., (1980) relate the share market returns to economic realities. Shiller R., (1981) concludes that both bond and share prices are far more volatile than can be justified on the basis of real economic events. Such conflicting results have been put forth by many research studies. (Homa K., and Jaffee D., (1971), Hamberger J.M. (1974) and Kochin L., (1972), Melkiel B. and Quand R. (1972), Rundolph J. (1972), Reilly F.K., Johnson G.L. and Smith R.E. (1970), and Branch B.).

A discussion of the macroeconomy usually has two components:

1. The national economy and
2. The effect of the international economy on the national economy.

The growth of the national economy is mainly determined by the domestic consumption pattern. Economists point out that higher consumption leads to economic growth. This is based on the argument that growth in consumption pattern fosters sales, which in turn induce production of goods and services in the economy.

In addition, the interaction of other economies with the domestic economy also has a large influence on a nation’s economic growth. The international trade policies, global demand/supply factors, and so on, hinder or foster relationships with other countries. A domestic economy, which has freely let in international players into its economic environment, will be subject to global trends more drastically than an economy that restricts the entry of foreign participants into its economy.

TOOLS FOR ECONOMIC ANALYSIS

The most used tools for performing economic analysis are:

Gross Domestic Product

Monetary policy and liquidity

Inflation

Interest rates

International influences

Consumer sentiment

Fiscal policy

Influences on long-term expectations

Influences on short-term expectations

Gross Domestic Product

Gross Domestic Product (GDP) is one measure of economic activity. This is the total amount of goods and services produced in a country in a year. It is calculated by adding the market values of all the final goods and services produced in a year.

• It is a gross measurement because it includes the total amount of goods and services produced, of which some merely replace goods that have depreciated or have worn out.
• It is domestic production because it includes only goods and services produced within a country.
• It measures current production because it includes only what is produced during the year.
• It is a measurement of the final goods produced because it does not include the value of a good when it is sold by a producer, again when it is sold by a distributor, and once more when it is sold by the retailer to the final customer. GDP counts only the final sale.

GDP has several components. A component analysis is helpful to the investors, as other economic variables such as interest rates, and exchange rates have differential effects on the components of GDP.

The major components of GDP are:

1. Consumption spending
2. Investment spending
3. Government expenditure
4. Goods and services produced domestically for export
5. The production of goods and services consumed in the process of distributing imports to the domestic consumer

Consumption Spending

Consumption spending represents the production of those domestic goods and services which are consumed by the public. It is often sub classified into spending on durable goods, non-durable goods, and services.

• Durable goods are items such as cars, furniture, and household appliances, which are used for several years.
• Non-durable goods are items such as food, clothing, and disposable products, which are used for a short time.
• Services include the rent paid on premises (or estimated values for owner occupied housing, electricity, and other utilities), airplane tickets, legal advice and medical treatment and so on.

A buoyant market is very often represented by a significant percentage of consumption spending in the total GDP. This is because an increase in consumption spending leads to an immediate increase in capacity utilisation, in turn increasing the profitability of companies.

Investment Spending

Investment spending represents using capital for future productive purposes. Investment spending consists of non-residential fixed investment, residential investment, and inventory changes.

• Non-residential fixed investment is the creation of tools and equipment to use in the production of other goods and services. For example, the establishment of factories, installation of new machines, and computers for business use are non-residential fixed investment.
• Residential investment is the building of a new house or apartment.
• Inventory changes consist of changes in the level of stocks of goods necessary for production, and finished goods ready to be sold.

Investment spending does not necessarily lead to an immediate release of productive goods and services. There is a time lag before which investment spending results in increased profitability for companies.

Government Expenditure

Government expenditure consists of spending by the central, state, and local governments on goods and services such as infrastructure, research, roads, defence, schools, and police and fire departments. This spending does not include the amount spent in the form of relief or compensation, since they do not represent production of goods and services.

Government expenditure as a percentage of GDP will be more in the case of regulated markets and relatively less in a liberalised economy. A regulated market hence looks for the government expenditure component to determine the scope of industrial growth. In a fully liberalised market, however, the extent of government expenditure does not dramatically affect the overall GDP position and, hence, the capital market outlook.

Exports

Exports are items produced in a country and purchased by foreigners. Exports lead to an exchange of productive goods and services for an equivalent foreign currency. Exports increase the purchasing power of a nation in an international market.

Consumption in the Process of Import Distribution

Consumption of services in the process of import distribution also leads to local productivity. Imports are items produced by foreigners and purchased by local consumers. For the purpose of computing GDP, expenditures involving localisation or internalisation of the imported goods are considered.

The sources of growth identify industries or sectors deserving closer scrutiny for possible investment. Figure 9.1 shows the almost similar movements of GDP and average BSE Sensex index for the respective years. This can be interpreted to mean that the movement of GDP and capital markets is highly correlated and that the prediction of capital market movement through GDP expectations can be very useful and relevant for investors. In the figure, a sudden decline in the GDP movement during 1998–99 has unstabilised the BSE Sensex averages. The recovery of GDP during 2000–01 has been followed by a recovery of the BSE Sensex average.

Monetary Policy and Liquidity

Businesses need access to funds in order to borrow, raise capital, and invest in assets. Likewise, individuals also may need access to funds to borrow to purchase house, car, and other high-priced durable goods. If the monetary policy is very tight and banks have little excess reserves to lend, the sources of capital become scarce and economic activity may slow down or decline.

Although a good monetary policy and liquidity is essential for the economy, excess liquidity can be harmful. Excess money supply growth can lead to inflation, higher interest rates, and higher risk premiums leading to costly sources of capital and slow growth.

Money supply can be measured through M1, M2, and M3. M1 is the amount of currency in circulation, demand deposits, travellers’ cheques, and other deposits. M2 is defined as M1 plus small time and savings deposits. M3 measures the money supply that includes M2, plus large time deposits, repos at commercial banks, and institutional money market accounts. Of the three measures M3 is likely to reflect economic performance better then M1 and M2. Table 9.1 describes the components of these measures of money supply.

The graph in Figure 9.2 shows an almost similar yet smooth movement of money measures compared to BSE Sensex movements. A steep rise in BSE Sensex is accompanied by a corresponding rise in the quantum of M1 and M3. The extent of rise in M3 is more comparable with BSE Sensex.

Inflation

Inflation can be defined as a trend of rising prices caused by demand exceeding supply. Over time, even a small annual increase in prices of say 1 per cent will tend to influence the purchasing power of the nation. In other words, if prices rise steadily, after a number of years, consumers will be able to buy only fewer goods and services assuming income level does not change with inflation.

The economic effects of minor inflationary effects can be positive and often can be taken as a sign that the economy is in an expansionary phase.

Although inflation is mainly a monetary phenomenon, at times, outside factors, such as raw material shortages can increase the inflation rate. Inflation occurs when short-term economic demand exceeds the long-term supply constraint. The effects of inflation on capital markets are numerous. In terms of valuing financial assets, inflation reduces the value of fixed-income securities. An increase in the expected rate of inflation is expected to cause a nominal rise in interest rates. Also, it increases uncertainty of future business and investment decisions, which in turn, increases risk premiums. As inflation increases, it results in extra costs to businesses (they are generally unable to pass all the cost increases through to the consumer), thereby squeezing their profit margins and leading to real declines in profitability.

The Indian market shows an erratic movement in the inflation rate. See Figure 9.3. At a glance, it looks as if the inflation rate does not have any relationship with the movement of the stock market. Inflation tends to affect the purchasing power of consumers. When investment is a postponement of consumption, the investor expects more in future than what can be consumed right now. Hence, as interest rate expectations influence the market prices, inflation rate expectations also are theoretically expected to influence the market prices of shares. A constant inflationary situation in an economy will be foreseen as a positive influence on the investors and hence, market prices are likely to go up under such circumstances.

Interest Rates

Interest rate is the price of credit. It is the percentage fee received or paid by individuals or organisations when they lend or borrow money. There are many kinds of interest rates—bank prime lending rate, treasury bill rate, and so on.

In general, increases in interest rates, whether caused by inflation, government policy, rising risk premiums, or other factors, will lead to reduced borrowing and an economic slowdown. Rising interest rates lead to a decline in bond prices and typically lead to a fall in share prices. When interest rates rise, the investors’ required rate of return on shares rise as well, causing the prices of securities to fall. Rising interest rates also make bond yields look more attractive relative to share dividend yields. One measure of interest rate that influences business demand for loans is the bank prime lending rate.

Prime rate is the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers). The rate is almost always the same amongst major banks. Adjustments to the prime rate are made by all banks at the same time; although, the prime rate does not adjust on regular basis.

Movements in long-term interest rates such as the 10-year treasury rate provide information about likely changes in the level of activity in the interest-sensitive sectors of the economy. For example, bond interest rates often move in tandem with the 10-year treasury rate, and changes in bond rates often precede changes in the level of activity in financial markets.

The weighted average Central government security interest rates in India is also an equivalent measure of the prevalent interest systems in the economy. The interest rate movement in India during 1996–97 (Figure 9.4) was comparatively higher than in the previous years and led to the fall in the share prices. Further decline in interest rates pushed the share movements up from 1997–2001. A further fall in interest rate is, thus, most likely to influence an up-trend in the share market.

International Influences

Rapid growth in the overseas market can create surges in demand for exports, leading to growth in export-sensitive industries and overall GDP. In contrast, the erection of trade barriers, quotas, nationalistic fervour, and currency restrictions can hinder the free flow of currency, goods, and services, and harm the export sector of an economy. Although some attempts at policy coordination have been made by the G-7 nations, most coordination has focused on strengthening or weakening the exchange rates of some of its members, most notably those of the United States and Japan. The business cycles of the developed, developing, and less-developed nations do not rise and fall together. Therefore, a strong economy such as that of the US can, at times, assist economies experiencing a recession by importing their products, and vice versa.

One important measure of influence of international economies is the exchange rate—the rate at which one currency may be converted into another. It is also called rate of exchange, or foreign exchange rate, or currency exchange rate. The purchasing power parity (PPP) approach derives from the assumption that, identical goods should be sold at identical prices globally. The existence of one price implies that exchange rates should adjust to compensate for price differentials across countries. In other words, if we are in a mango-world (where only mangos exist), and a mango is sold in the US at $1, and the same mango is sold in India for Rs 48, then the exchange rate has to be Rs 48 per dollar. Though it is unlikely that one country will have a total influence on the share market, any major fluctuations in the international scenario tends to affect the local market when it is open to international players. A liberalised economy hence, will have a high impact of international influences.

The movement of the exchange rate (Re/$) appears similar to the movement of the share market (Figure 9.5). A rising exchange rate also fuels the demand for securities in the share market.

Consumer Sentiment

Optimistic consumer sentiment may lead consumers to make a long-delayed purchase of durable goods or to be more free with their money at gift giving or vacation time. Such variations in consumer sentiment will lead to alternating periods of sales growth and decline for consumer-oriented industries, particularly manufacturers of consumer durables. It is also known that risk premiums are influenced by consumers and hence lead to change in investor attitudes over the course of a business cycle. As a result, consumer sentiment can be expected to affect both cash flow (that is, higher or lower sales and operating incomes) as well as the required risk premiums on financial market investments.

Consumer sentiment is usually expressed in terms of the future expenditures planned and the feeling about the future economy. A high interest rate and no tax savings opportunities would induce a consumer sentiment of current purchases. This would lead to a high current demand for products. A favourable savings environment with high interest rates would induce the customers to postpone current purchases for future spending.

The Asian Consumer Growth and Prospects Index measures the predicted consumer demand growth in 14 Asian countries. The Asia Market Research editors, staff and partners are developing this index. The index is designed to provide a forecast of relative index of consumer sentiment and demand for a year. At present, several algorithms are being used in the computation of the index and include subjective perceptions from 24 industry; market research, and management professionals in Asia; unemployment figures; salary growth; job vacancies; consumer confidence; sales growth in key consumer industries, country risk, GDP, and a lagged indicator of share market performance. The Consumer Growth Prospect Index is prepared every month. A sample of the relative consumer growth prospects is presented in Figure 9.6 below.

 

Fiscal Policy

The fiscal policy of the government involves the collection and spending of revenue. In particular, fiscal policy refers to efforts by the government to stimulate the economy directly, through spending.

Fiscal policy mostly affects short-run demand. Government spending can directly affect economic sectors and geographic regions. Assuming all other parameters as constant, some economists believe that a larger-than-expected increase in government spending may increase short-run demand while smallerthan-expected increase may harm short-run demand. Tax changes strongly influence the incentives to save, and invest and may, therefore, affect both short-term expectations as well as long-term supply.

Decisions by the government, usually relating to taxation and government spending, with the goals of full employment, price stability, and economic growth lead to a positive or negative outlook of the share market.

The domestic company tax structure in India when compared with the share price movements does indicate that a high tax rate has a negative impact on share market movement whereas a lower tax rate has resulted in the increase in share price movements (Figure 9.7). Domestic companies that have a public shareholding pattern represent the share market. Hence, a direct link can be established between the fiscal policy of the government towards such companies and the share market. The plotting of the tax structure of other types of companies also reflect a similar movement in India.

Long-term Growth Expectations

The long-term growth path of the economy is determined by supply factors. Growth will be constrained in the long run by limits in technology, size and training of the labour force, and availability of adequate resources and incentives to expand.

The rate of growth of output can be separated into two distinct categories: 1) growth from an increase in the factor inputs to production and 2) growth in output relative to the growth of all factor inputs, or total factor productivity (TFP). The implementation of technology acts to increase TFP, as does increased education and training of the workforce, reallocation of resources to their highest and most valued use, and increasing economies of scale.

The Cobb-Douglas production function to look at the contribution of each factor input to long-term growth is:

Total output (Y) is equal to the contribution to production of technology (T), multiplied by labour (L), by capital (K), and by other factors (E).

Technology Effect

Technological change allows for increased output with prevalent factor inputs. Technological change is an important determinant of growth of output because it increases productivity and the efficiency of all other inputs to production. Technological change can be exogenous or endogenous. Endogenous change in technology is through an input to production, such as machinery or better managerial techniques. Exogenous change in technology is through external influence such as innovation and collaboration.

Labour Effect

Labour can be broken down into three factors: number of labourers, allocation of labour, and increased education of the labour force. Labour effect is measured by the product of population and labour participation rate. Labour participation rate, on the other hand, is determined by the percentage of labour force that is employed. The quality of the labour force will depend on the work force, hours worked per employee, total hours worked, extent of business training undergone by the labour force, and educational background of the labour force.

Labour Effect = Population × Labour force participation rate × Average number of hours worked per week × Labour productivity

Capital Effect

Capital formation is directly influenced by the rate of national savings. Private savings including household and business savings is equal to domestic investment. Capital effect can also be measured in terms of the net capital share held by the economy. This is determined by the quantum of capital employed in the economy, amount spent on technology and Research and Development, and industrial capacity utilisation.

Other Contributing Factors

Other long-term expectation contributors are the prevalent economic mix (manufacturing versus service) energy availability, economic stability, foreign competition, and incentives provided by the government. The incentives of the government could be in the form of regulation, tax policies, and government’s direct contribution to productive output. Besides, a country’s politics, societal influences and demographics may also affect long-term growth expectation.

Positive or negative changes in these factors may lead to changes in future economic growth.

Population multiplied by the proportion of the population that is in the labour force is equal to the number of workers in the economy; multiplying this by the average number of hours worked per week gives the total number of man-hours of labour effort over a week’s time. Labour productivity is defined as output per man-hour; thus, the total man-hours of labour multiplied by output per man-hour results in economic output.

The total per worker productivity index and share index movements in India are plotted in Figures 9.8. Both show a rising tendency. A higher output leads to a positive movement of the share prices.

Influences on Short-term Expectations

In contrast to long-term expectations, mainly driven by supply factors, short-term expectations about the economy are mainly caused by demand factors. Fluctuations in demand relative to long-term supply constraints create fluctuations in real GDP, which are known as business cycles. When demand exceeds supply, the result is inflation. When demand is less than supply, rising unemployment and recession may occur. Short-term economic forecasting focuses on sources of demand as a means to predict future trends in economic variables.

Increases and decreases in demand, relative to long-term constrained supply growth result in business cycles and associated fluctuations in cash flows, interest rates, and risk premiums. As part of the top-down investment approach, analysts hence examine short-term demand trends and influences. These influences can then be evaluated to estimate their influence on different economic sectors, industries, and investments.

A business confidence index (BCI) is published periodically by various organisations/institutions to assess the short-run expectations from the economic perspective. The FDI Confidence index in the US; lfo business climate index, Germany, Business Confidence index, Japan, South Africa, and so on give an insight into the short-term expectations of business in the respective economies. The National Council of Applied Economic Research (NCAER) computes a business confidence index through the business expectation survey in India. NCAER constructs a business confidence index based on business perceptions of four indicators: current investment climate, current capacity utilisation, overall economic conditions, and financial performance of firms in the next six months. Of these four components, three pertain to the outlook specific to the respondent company’s financial position, capacity utilisation and investment climate. These perceptions are based on questionnaires and interview responses of surveyed companies. The BCI is published quarterly and is an estimate of the short-term expectations of the business. The component’s change is also examined to assess the overall future impact on business. The improvement/ decline in the index hence is analysed in terms of micro/macro-level business performance. The extent of support from capacity utilisation and perception of investment environment to a large extent determines the fundamental economic backup of the BCI.

The survey also reports the business confidence index on a regional basis, that is, north, south, east, and western regions. The differentiation is also made in terms of industry segments hence, the confidence due to industry sector performance can be interpreted from the index. Based on this analysis NCEAR also presents its forecasts of economic and industry performance in the short-term.

Figure 9.9 compares the movement of the BCI along with the share market return. There is an unmistakable co-movement of the quarterly BCI index and the BSE sensex averages indicating that share markets do react to short-term expectations of the business. The declines in Quarter 4,1996, and Quarter 4,1998, and the subsequent rise in both the indicators lead to the conclusion that share market movements can be predicted with an estimation of the economic indicators.

A note on the confidence index movement and the economic interpretation of the confidence index components for the first quarter of January 2002 is given in the box above.

Forecasting Models

A close scrutiny of fundamental factors has led to investment suggestions in the secondary market. Many analysts have developed economic forecasting models/tools that help in forecasting the trend of the share market.

The application of statistical analysis and econometrics to forecasting is based on the premise that past data are indicators of future performance. An econometric model is usually expressed as a mathematical relationship, or a set of equations, based upon the past behaviour of a set of variables within some defined bounds of statistical probability, that is, a specified level of confidence. These models are formulated and used to predict the future behaviour of share prices. In its simplest form, a single variable is analysed based solely upon trends in its own past behaviour with no consideration given to external factors, influences, or other variables which may have significant impact upon its behaviour. Such models are termed “deterministic” and are based on the assumption that the past trends of the variable whose behaviour is being attempted to be explained contain all the information necessary to predict its future behaviour.

More complex econometric models incorporate the use of external or explanatory factors or variables in model construction and analysis. Such models are termed “stochastic” and assume that the behaviour of the variable that is being attempted to be explained is based upon other, external influences and therefore is, by itself, not predictable. This necessitates establishment of the correlation between and among variables. Such models additionally help to perform impact analysis, and develop a variety of “what if” scenarios to assess various output effects based on changes in inputs or explanatory factors.

A third type of econometric model is a hybrid of the deterministic and stochastic model structures. These models, termed structural time series models, are, essentially, deterministic (time series) in that they involve complex mathematical processes (algorithms) in attempting to explain the variable’s behaviour from its prior trends, for example, seasonality, trends, or repetitive cycles. However, they are also stochastic (structural) in that they incorporate the effects of external influences and explanatory factors, a fundamental shortcoming of the deterministic model.

In general, these models encompass structural time series modelling techniques using both the inherent predictable nature of the data along with external factors that may, to some extent, influence the behaviour of the variable used in forecasting. In practice, different types of models, for example, exponential smoothing, univariate autoregressive moving average, multivariate autoregression, ordinary least squares, simultaneous equation, and so on are chosen based upon the qualitative and quantitative characteristics of the data to be used.

The development of statistically based econometric model result in two basic types of structures::

1. Structural or cross-sectional models, which are used to explain causal relationships between a specific independent variable or set of such variables and a single dependent variable; and
2. Time series models, which are oriented more towards forecasting a target variable and using past trends in the data itself to make predictions about its future behaviour.

Structural or Cross-sectional Econometric Models

By their very nature, structural econometric models are very complex and generally require that precise rules be followed with respect to the selection of explanatory variables, the requirement of minimal influence among the selected explanatory variables, and in the direction of the flow of causation. A fundamental assumption of this type of modelling process is that the independent variable or variables cause changes to occur in the dependent variable, and not vice versa.

One of the most important features of this type of structural analysis is the model’s ability to describe the separate and unique influences that each independent variable will have on the dependent variable. However, if the explanation of an independent variable’s contribution to the dependent variables behaviour is not significant statistically, then related independent variables may be used together as a factor and thereby improving, the model’s predictive capabilities. In this instance, all correlated variables are grouped together as a factor that has a predictive power better than the individual variables separately.

A fundamental objective in such econometric modelling process is to include all important explanatory variables while simultaneously not crossing the threshold of using too many variables (a condition called over-parameterisation) and particularly too many correlated independent variables. The inclusion of correlated independent variables is called multicollinearity. Multicollinearity and over parameterisation reduces the relevance of the econometric model and does not lead to a good solution.

Through the use of more than one explanatory variable (multivariate or multiple regression analysis) and multiple equation structures (simultaneous equation models) the structural econometric model has the ability to “model” or simulate highly complex and interdependent business and economic relationships.

Structural econometric models are best suitable to the analysis of highly complex economic structures and systems and can provide more precise and detailed estimations of interactions and linkages between and among variables chosen for the model. However, when placed in a forecast role, these models may prove cumbersome and relatively inefficient due to their inherent data requirements and the need to develop individual forecasts for the explanatory variables.

 

Time Series Econometric Models

Time series econometric models are designed for only one fundamental purpose namely, forecasting. They are generally inappropriate in being able to explain with any degree of precision the nature of relationships between specific explanatory independent variables and the dependent variable. Consequently, time series models are generally not well suited to impact analysis and they do not adjust well to external shocks and influences. Therefore, such models have only limited usefulness in a “what if” or scenario-based modelling environment. Nonetheless, time series forecast models are still used due to their simplicity in application to time series data and their ability to analyse complex underlying trends, cycles, and season-ality in the data series.

Early time series forecast methods, for example, the autoregressive integrated moving average (ARIMA) process, using the univariate (single-variable) Box-Jenkins technique, were popular because of its simplicity as a forecasting tool. Its use in forecasting necessitated little or no complex model specification, nor any extensive knowledge of economics or consideration of external influences, linkages, or correlation with respect to the variable to be analysed and forecasted. This econometric modelling and forecasting process is however deterministic because the model’s structure is determined solely by the historical characteristics of the data. The underlying assumption in the ARIMA model is that “history will repeat itself”. Hence to adequately fit this forecasting model, historical data must show predictable trends and consistent patterns of trend, seasonality, and (long-term) business cycle.

Time series econometric models do not incorporate important economic happenings and external influences. Consequently, they have been found to be inadequate in adjusting to sudden shocks in the forecasting environment. Besides the ARIMA, other models have also helped analysts to determine the market forecasts.

Structural Time Series Models—A Hybrid

Structural time series models are the multivariate autoregressive models. These models are of a multivari-ate form using sophisticated autoregressive methods as applied to a number of variables simultaneously.

The multivariate time series process incorporates economic relationships and interdependencies through variable interactions. In the initial development of the model, all variables are considered endogenous, that is, all model variables are presumed to be determined within the model’s structure and used simultaneously to explain one another. Once relationships among and between variables are statistically tested as significant and the final variables selected, then the influence is specified by more formally establishing which variable or variables are to be considered exogenous, that is, determined outside the model structure.

The multivariate time series modelling process has the unique capability of taking distinct groups of time-series data and, through an inherent optimisation process of the model, determine statistically relevant inter-dependencies and correlations. Forecasts may then be developed either deterministically, that is, internally by the model based on the prior behaviour of the independent variables, or jointly, (deterministically and stochastically) based on external explanatory variable forecasts.

Despite the sophistication and ease of use of such modelling techniques, there exists a controversy over the appropriateness of applying time series modelling. This is mainly due to the fact that the explanatory variables in a multivariate time series modelling cannot be viewed discreetly with respect to their impact on the dependent variable. Consequently, the multivariate time series model allows for only a “joint causation” to be inferred, whereas with the structural econometric models a unique dependency and impact for each explanatory variable can be statistically determined.

Campbell R. and Harvey (2002) used vector Autoregressive Model to explain liquidity and market returns. For each country i, the base Vector Autoregressive (VAR) model is

where (0, i) denotes a vector of country-specific fixed effects for each endogenous variable; (1) denotes a vector of cross-sectionally restricted liberalisation (Lib) coefficients for each endogenous variable; and (i, t, ) the VAR innovation conditional variance-covariance matrix for each country (i). ‘A’ is the cross-sectionally restricted VAR matrix. The estimation results for both the bivariate and trivariate VAR models augments the set of endogenous variables with equity market turnover. The study established that market illiquidity continues to significantly predict excess returns across countries considered.

Economic data for such model is available with respect to specific time duration, for instance, the information may be published on a quarterly or annual basis while share market investment decisions are made on a daily or hourly basis. While the use of such models could improve predictability of share prices, it is also possible to infer the share price movement through simple scenario analysis. Given an economic scenario, the study of share market behaviour does lead to some interesting conclusions. For instance, general inflationary situations are not welcomed by the share market. Similarly, high interest rates lead to a bearish share market situation. A summary of the economic situation and the resultant impact on the share market is summarised in Table 9.2 below.

 

Table 9.2 Behaviour of Economic Indicators and their Suggestive Impact on the Share Market

Economic Indicator	Situation	Impact on the Share Market
1. Gross domestic product	Growth Decline	Positive (Bullish market) Negative (Bearish market)
2. Inflation	Constant Prices Inflationary/deflationary prices	Positive (Bullish market) Negative (Bearish market)
3. Unemployment	Increase Decline	Negative (Bearish market) Positive (Bullish market)
4. Individual savings	Increase Decline	Positive (Bullish market) Negative (Bearish market)
5. Interest rate	High Low	Negative (Bearish market) Positive (Bullish market)
6. Exchange rate	Favorable (Strong against foreign currency) Unfavorable (Weak against foreign currency)	Positive (Bullish market) Negative (Bearish market)
7. Domestic corporate tax rate	High Low	Negative (Bearish market) Positive (Bullish market)
8. Balance of trade	Positive trade balance (exports greater than imports)	Positive (Bullish market)
	Negative trade balance (imports greater than exports)	Negative (Bearish market)

The above Table 9.2 is relevant assuming all other economic indicators do not change for a given situation. A combination or set of these economic conditions defines an economy at any point of time. Hence, any economic indicator need not necessarily support the share market behaviour suggested earlier, though theoretically it might be possible. In addition, a change in one economic variable has a multiple impact on other economic indicators either positively or negatively. This compels investors to look for an economic scenario rather than the particular directional movement of a single economic indicator.

Investors can work out a qualitative set of economic situations and the possible investment. Since model building using quantitative methods needs a lot of assumptions and involves procedural difficulties, howsoever simple the model, qualitative ideas can provide a logical and simplistic tool for investors. Table 9.3 gives a sample set of economic outlooks and the corresponding investment opportunities. While a quantitative economic model is able to analyse and give greater explanatory arguments, the qualitative suggestions are based on perception and on the consideration that the impact of other factors that are not considered on such situations is neutral.

 

Table 9.3 Select Economic Situations and Investment Opportunity

Bearish	Bullish
Economic situation
Declining GDP combined with price increase. Withdrawal of international funds leading to trade imbalances.	Increasing GDP due to active industrial investment along with stable price levels.
Investment opportunity
Buy shares of local dominant players in FMCG sector since these firms will cater to the immediate consumption needs of the economy.	A buoyant market attracts large players with high market participation. They tend to show a competitive edge over other small players. Blue chip companies tend to show a superior performance in such market situations.
Economic situation
Expected higher inflation fuelled by wage increases, high-capacity utilisation. Corporate profits are very high.	Strong money attracts investors to the stock market. No fears of inflation because 1) Producers do not pass higher material costs to consumers 2) Inflation is falling and productivity is rising 3) Government keeps inflation in check. Corporate profits continue to rise.
Investment opportunity
Buy shares in comparies with low expectations, as bad economic news would not hurt these companies as the deviation from expectation would be very low.	Buy cyclical shares like automobiles, and invest in interest rate sensitive industries such as banking, insurance and financial services. These shares will show consistent growth rates.
Economic situation
Fear of higher inflation because of (1) Higher unit-labour costs due to strong economy (2) Low unemployment. Interest rates rise because of higher inflation and because of greater borrowing demand by companies trying to meet product demand.	Inflation is not a foreseeable problem because the government budget deficit is falling and the government had made fighting inflation a high priority. Corporate profits remain stable and then rise due to strong economic growth overseas that in turn increase demand for local products.
Investment opportunity
Since valuation levels (P/E, Price/Book value) fall, shares with lower valuations such as small capitalisation stocks are best investment.	Growth stocks, shares with substantial sales and earnings arising out of global markets are best investments. Cyclical shares are also suitable at this time.
Economic situation
Inflation rises due to wage increase. Corporate profits are high as opportunity for lower inflation and the benefit out of low earnings are over. A strong money hinders exports and profits for local companies. Interest rates rise because of inflation.	Inflation rises due to wage increase, but belief that they would occur later. Able to identify opportunity for lower inflation and interest rates (due to falling deficit and government’s watch over inflation) and higher corporate profits.
Investment opportunity
Invest in commodities and infastructure and other inflation-sensitive sectors.	Technology and financial services sectors with strong earnings growth is likely to exceed the growth of the economy.
Economic situation
Concerns of market liquidity disappear as investors try to exit the market all at the same time after a substantial market correction. Market valuation measures extremely high by historical standards. Investors ignore risk and their reaction is to sell stocks immediately.	Inflation is under control. Interest rates steady or dropping. Corporate profits continue to rise. The market is fairly priced. Market valuations appear high only if the current environment of low interest rates is ignored.
Investment opportunity
Underweight stocks. Should prefer bonds or short term instruments.	Smaller capitalisation stocks, since their valuations are not as high as large company stocks. Some cyclical stocks such as automobiles, airlines, and retailers would do well. Technology and financial services sectors can be preferred.
Economic situation
Low levels of M1, declining personal savings, lower interest rates and saturation in housing construction activities.	Increased personal household savings and increase in housing construction activities.
Investment opportunity
The household expenditures also decline; hence, there will be no overall sectoral performance in the capital market. However, small capitalisation stocks might be a good investment option since the impact on these will be less.	The fund availability from the household sector will increase the scope of business for the financial sector. Hence, financial services and real estate company shares will perform well in this economic situation.
Economic situation
Decline in personal disposable income, high corporate taxes, and high interest rates. The rise in prices may be due to the inability of the corporate houses to bear the additional operational cost burden.	Increase in personal disposable income, low corporate tax rates, and low interest rates.
Investment opportunity
The capital market might require a longer duration to recover. The high interest rates might attract the investors into the bond market than the equity market.	Shares in the capital goods sector register a good performance in such economic situations. Manufacturing and base industries will perform well.
Economic situation
Negative balance of payment situation, high unemployment levels, and a weak rupee in the international market.	Surplus trade balances with a strong rupee in the forex market.
Investment opportunity
There is a lot of strain on the government to service foreign debt and other expenditures and hence the market might not give attractive investment opportunities. However, small cap basic sectors might be undervalued and hence could give an investment opportunity to the investors.	Export-oriented company shares will give good investment opportunities.
Economic situation
Economic recession with the characteristic of high unemployment levels, low savings, low interest rates, with a negativebalance of trade.	Economic boom marked by positive balance of trade, low unemployment levels, high investments, and a strong rupee in the forex market.
Investment opportunity
Both the bond market and the equity market register a downtrend in such circumstances. Shares of companies with an international exposure can be preferred. International diversification will provide the necessary support to withstand economic recession.	In an economic boom situation, it is difficult to identify an undervalued stock, hence shares with fundamentally strong characteristics ought to be preferred. Shares that are expected to register supernormal growth rates should be selected for investment.

Applications of Economic Analysis

An illustrative economic analysis of India during the share market recovery period is given in Table 9.4:

 

Economic Analysis and International Investment

A scrutiny of the economic analysis by investors also helps them in the management of international portfolios. Hamao, Masulis, and Ng (1990) studied the spillover effect of information from one economy to another across countries in the investment market. Asset pricing tests specify common factors which each country has sensitivity to. (Ferson E and Harvey C.R., 1993).

There are three important reasons for investors to prefer a global portfolio (Figure 9.10). The world’s capital value is distributed across nations and a single country’s contribution is very negligible. If investors want to realise the economic gains irrespective of a single country’s performance, they have to invest in a global setting. By limiting investments only to one market, a majority of investment opportunities are lost. Second, international share markets and their underlying economies often move independently from country to country. By using international markets, investors increase the likelihood of participating in markets that are appreciating, especially when the domestic market is undergoing a correction. Third and most importantly, international portfolios can result in greater diversity and reduced investment exposure risk.

Global capital markets have enlarged investment opportunities and thus are the sources of funds for companies which increasingly face global markets for their services and products. Huge capital movements show that investors are constantly searching for ways to minimise risk and maximise returns. In the light of the substantial growth of assets in institutional funds, foreign institutions finance investors to have diversified portfolios internationally.

Individual investors have become more willing to invest globally. Policies such as deregulation, technological improvements, and overall economic interdependence among domestic markets have also helped them in venturing into international share markets. Earlier, when investment possibilities were regulated and domestic portfolios offered reasonable risk-return portfolios, the demand for international investment was lower. However, the recent overall globalisation of products and integration of economies has led to increased interest in international diversification which, in practice, have become a necessity to meet the objectives of investors. Internationalisation has happened in all domains of financial activity. Domestic governments no longer control markets and the global financial market itself has assumed a greater role in the global economy. The pressure caused by this is significant for both governments and corporations, which increasingly raise funds directly from global capital markets.

For companies, business opportunities have become global. Global activity consists of increased market growth and profit opportunities, and globalisation offers possibilities for diversification and spreading risk. Information reaction of financial markets of a specific economy spread instantly around the world. This, in turn, has a great effect on national economies. For example, if interest rate variation among countries almost disappear, investment activities in the global scene will alter dramatically.

Institutional investors have an impact on international and national capital markets. The volatility of a market increases when such significant players use the same technology and employ similar strategies for portfolio diversification and therefore make similar moves on the markets. In addition, liquidity may be negatively affected if large investments are traded infrequently.

International portfolio investments hence are different from foreign direct investments. In many economies financial assets with institutional investors exceed that of the aggregate Gross Domestic Product (GDP) for the countries concerned and play an important role in the global financial system. In 1990, the financial assets of institutional investors in the Organisation for Economic Cooperation and Development (OECD) countries amounted to nearly US$ 14,000 billion. By the end of 1995, the assets had grown to over US$ 23,000 billion. In 1995, the total assets of institutional investors were equivalent to 106.7 per cent of the aggregated GNPs of the OECD countries. In the US, the assets of institutional investors almost doubled between 1990 and 1995, and reached US$ 11,871 billion in 1995. Japanese institutional investors represented the second highest share of institutional assets among countires, with US$ 3,954 billion in 1995. Within the EU area, UK institutional investors had the biggest assets, US$ 1,789 billion. The development can be seen in Table 9.5. The average annual growth of holdings by the institutional investors reached 10.5 per cent in the 1990–1995 period.

 

Table 9.5 Growth in the Assets of Institutional Investors

Country	1990(US$ billions)	1995(US$ billions)
U.S.	6,991	11,871
Japan	2,428	3,954
U.K.	1,117	1,789
OECD	13,857	23,388

 

In 1996, the financial assets of institutional investors were worth over US$ 26,000 billion. Institutional investors in the US controlled over half of all the assets, investors in Europe over US$ 7,000 billion, and in Japan nearly US$ 4,000 billion.

Cross-border Investments

As noted earlier, international transactions must distinguish between foreign direct and portfolio investments. Portfolio investments have overtaken the actual amount of foreign direct investments. The growth of international portfolio investment has been faster than the growth of foreign direct investments. During the 1990s, the net international assets of Japan have increased while US liabilities have increased at the same time. This can be explained to a large extent by the fact that Japanese investors were major investors in US government securities. UK has remained at relatively stable levels. The increase of portfolio investments has occurred through deposits and bank lending.

Cross-border transactions in bonds and equities have grown from less than 10 per cent of GDP in 1980 to 213 per cent in US and 96 per cent in Japan in 1997. As Table 9.6 shows, between 1990 and 1997, transactions decreased in relation to GDP in Japan, but continued to increase remarkably in the US. For example, in 1997, the foreign securities transactions between foreign investors and US totalled US$17,000 billion.

 

 

Table 9.7 shows the development in using capital markets as a source of funding. In the US, the percentage growth has been astonishing, more than 600 per cent. As international borrowing has increased, lending, as the source of funding, has also increased. This establishes clearly the point that companies increasingly turn to international markets in order to raise funds. This is seen as an expansion of cross-border trading of financial assets.

 

 

The development of international equity issues of companies between 1990 and 1995 in the US, UK and Japan is seen in Table 9.8.

 

 

The nominal increase in the outstanding issues of international debt is even higher than the increase in equity issues. In the US, international debt increased from about US$ 176 billion in 1993 to nearly US$ 603 billion in 1998.

International Comparison of Institutional Investors

Institutional investors can be examined in a global context, either from country to country or by type of investors. As can be seen from Table 9.9, all types of investors in the US account for more of the overall global assets than their counterparts in other countries. Japanese institutional investors held the second largest amount of assets, followed by UK investors. Compared by type of investors, US pension funds held 62 per cent of global pension assets in 1995, followed by UK pension funds. Of the assets of insurance companies, US companies accounted for 35 per cent and Japanese insurance companies 24 per cent. Investment companies in the US accounted for 57 per cent of the assets of investment companies globally followed by Japanese investment companies.

 

 

Insurance companies continue to be the most significant institutional investors in the OECD countries, representing 35 per cent of investments in 1995 (35 per cent in 1990). Pension funds accounted for 25 per cent (27 per cent), investment companies 24 per cent (19 per cent) and others 16 per cent (18 per cent). During 1990–1996, the financial assets of investment companies grew by 16 per cent, pension funds 10 per cent, insurance companies by nearly 10 per cent in OECD countries. The total financial assets of insurance companies increased from about US$ 5,000 billion (1990) to US$ 8,500 billion (1996), pension funds from about US$ 3,800 billion (1990) to US$ 6,800 billion (1996) and investment companies from US$ 2,700 billion (1990) to US$ 6,400 billion (1996).

Portfolio composition differs among institutional investors. Firstly, holdings of equities are limited in most OECD countries, with the exception of the US and UK. However, there is growth in the share of equities in institutional portfolios. Generally, UK and US investors invest mainly in equities whereas, Japanese investors, are more risk averse and prefer to invest in fixed income assets. The portfolio compositions in different countries show interesting differences.

The share movements of India (---) when compared with UK (―), US (- -), and Singapore (⋯⋯) present a marked difference in price movements till August 2000. See Figure 9.11. In recent years the co-movements of the shares have been similar, perhaps indicating the increase in international portfolio investments. The US, UK, Mexico, and Singapore markets registered a positive return in April 2001 while the Indian market had a negative return. On the other hand, in December 2001, the Indian capital market registered a positive return compared to the negative returns of the US, UK, Mexico, and Singapore markets. Investors can use these changes in returns from a specific market in relation to other markets to gain consistently from the international portfolios.

Many international economies are experiencing more rapid growth than India. By participating in foreign markets, investors benefit from the rapidly increasing growth of other countries and their markets. The same holds good even for economically advanced nations such as the US. Economic recessions force investors to look beyond the domestic market to protect their interests. Investors greatly increase the chances of their investment success by looking beyond the domestic market for investment opportunities. Figure 9.12 shows the relative performance of grouped international markets. The overall returns are used to segregate markets into top, average, and bottom performers. The figure shows that the top and bottom share markets performed both significantly better and worse than the overall market averages. The top ranking stock exchanges have comparatively higher high and lower low returns than the bottom-ranking stock exchanges. The average international returns move more closely with the bottom ranking share exchanges.

An international investment process must first identify those international stock markets that are expected to outperform the world averages. Once identified, macroeconomic factors such as economic growth, average earnings growth, and inflation should be considered before funds are invested. The selection of individual shares within those international markets can be made using suitable models/ techniques. By investing this way both the most promising shares within the most promising international markets are identified.

An examination of economic indicators across markets validates the viewpoint that investors can gain from international investment portfolios. In Figure 9.13, the GDP increase as a percentage over the previous year plotted for developing, advanced and industrialised Asian countries projects the higher GDP potential of developing nations. Industrialised Asian countries have also registered remarkable growth but for the year 1998, due to the Asian crises, the GDP has shown a negative return. The GDP of advanced countries such as the US, Japan, and those of the European Union do have a profit opportunity in investing in the product market of developing countries. The GDP growth of advanced economies is actually lower than the world average, indicating the compulsion of the nations to move their investment portfolios to high-growth economies.

The trend of the growth rates of economies in terms of advanced, developed, and transition countries shown in Figure 9.14 also confirms the previous chart. The developing countries project a superior growth rate compared to the advanced economies. The transition economies, on the other hand, moved dramatically from negative growth to positive growth, equivalent to the developing countries growth rate.

The per capita output of the three types of economies is shown in Figure 9.15. The trend lines are similar to the medium growth rate trends seen in Figure 9.14. The dramatic difference in the output per capita in the initial years has narrowed down in the latter years, indicating that economies have shifted their investment preference from lower to higher returns.

Figure 9.16 gives the inflation rates of select groups of economies. Asian countries record a favourable inflation rate while others recorded a high rate of inflation. Middle East and Europe as well as African countries have the highest inflation rates. The Central African Republic, however, has a volatile movement of inflation rate. The favourable growth rates as well as low inflation rates could have contributed towards the preferable investment opportunities in the Asian region.

The lifestyle of the low income developing economies when explicitly distinguished in terms of life expectancy and illiteracy levels, indicates comparatively lower levels than that of developed nations with high income as shown in Figure 9.17. The low-income countries heavily weigh down the entire world averages. Though personal benefit to the individuals in the economy has not happened, advanced economies have certainly gained from the growth rate of the developing economies. Most of the developing economies can be categorised into the middle-and lower middle-income groups. The advanced nations, on the other hand, enjoy a better lifestyle, irrespective of the low growth rates registered by the economic indicators.

A comparison of the trend of economic indicators with that of the international stock market index indicates a coherent movement between the two. Economic analysis certainly helps in distinguishing across-the-economy investment environments. Economic analysis also serves as a logical forecasting tool for stock market movements. The argument that real productive markets support financial markets is confirmed from the analysis of economy-wise analysis of real productivity indicators. Though the conduct of economic analysis may predict the overall performance of a specific stock market, it is not the only tool available to an investor. A fundamental analysis is incomplete without industry and company analysis.

SUMMARY

Fundamental analysis provides an overall view of the economy, industry, and company specific factors favouring stock market investment. The first analysis that is preferred in a top-down method is economic analysis. Such an analysis scrutinises both the macro and micro economic performance of the country represented by the stock market. Economic analysis establishes the relationship between movement of factors such as gross domestic product, monetary policy, inflation, interest rate, international influences, consumer sentiment, real effects, fiscal policy, and influences on long-term as well as short term expectations on stock market performance.

The behaviour of stock prices relative to that of economic factors can be established and can be used by investors to select the right investments.

CONCEPTS

• Gross Domestic Product	• Monetary policy
• Fiscal policy	• Inflation
• Consumer sentiment	• Money measures
• Econometric models	• Cross-border investments

SHORT QUESTIONS

1. What is the purpose of economic analysis?
2. What are the sources of information for economic analysis?
3. What are the indicators of consumer sentiment?
4. How does inflation affect savings and investment?
5. What is the Cobb-Douglas production function?

ESSAY QUESTIONS

1. Discuss the techniques of economic analysis.
2. How does economic analysis help in investment decisions?