Understanding Economic Forecasting

Almost every financial services firm has an extensive economic forecasting effort. It is usually part of a so-called top-down investment process, which starts with an outlook for the economy and monetary conditions, continues to the strongest industries, follows with detailed company study for stock selection and may include an overlay of technical analysis to provide a timing dimension. Some would add analysis of social and political conditions even before economic studies (see Politics and Investing).

Economic forecasts derive from models usually of the aggregate national or global economy, but sometimes of parts of those economies: particular industrial sectors, regions of the world or even single products or firms. Basic approaches to forecasting simply extrapolate the past; more sophisticated models attempt to understand the sources of past changes and build them into their forecasts. The latter requires knowledge of economic history and economic principles, though, even then, forecasting is by no means an exact science. But while the accuracy of economists' predictions is frequently a target of jokes, forecasting remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic institutions, thinktanks, governments, central banks and international organizations like the OECD and the IMF. In these places, modeling can, to a certain extent, be conducted free of the constraint of producing quick and usable data on a daily basis. But in the investment world, forecasts are required to be done early and often. A relatively short-term outlook is normally the limit of their aspirations what will happen to interest rates within the next month? with decision-makers demanding rapid output that they hope will be directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded in the hope that it may bring advantage to its owners and their clients. But, at the same time, investment economists like to maintain a public profile for marketing purposes, and are often called on by the media to give their opinion on the latest macroeconomic developments. Their interpretations of economic data may give some clues as to how the financial markets will react, though more often than not, they are explaining why the markets have already reacted as they did. Invariably too, there are disagreements about what various indicators mean, depending on different beliefs about the economy, and whether the firm is taking an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates the average of their predictions for real GDP growth, consumer price inflation and current account balances in a variety of countries. More specialized services like Consensus Economics survey over three hundred economists each month and offer details on average private sector predictions.

Looking Rationally at Market Highs and Lows

You’re investing hard-earned money, so you want to enjoy a sense of comfort and confidence in your investments’ potential to perform as expected over time. I emphasize the phrase over time because chasing short-term performance can drive you crazy.
Investments can look mighty risky if you track their performance every day. In contrast, risk tends to flatten out a bit if you look at it year to year. In fact, since the late 1920s, few classes of investments have lost money over a 10-year period. Of course, some individual investments have lost money, but the general rule applies: Holding on to investments for a longer period of time will reduce your exposure to losses. Do you want to avoid undue risk? Invest for the long-term — or, at the very least, five years. If you need to tap your investments earlier than that, stick to shorter-term cash equivalents, such as money market mutual funds (which invest in high-grade bonds with shorter maturities), certificates of deposit, and money market accounts. Learning how to gauge the market is different from thinking you can predict the market. No one —not even the most savvy broker — knows with any real certainty how well or how poorly the market will fair in the future.

First Steps in Stock Investing

If you’re willing to roll up your sleeves and do the research necessary to invest in individual companies, a stock may be a good fit for your new portfolio. The key is to avoid excessive risk. The best way to minimize risk is to buy a solid company — one that is essentially a blue chip or a largercompany growth stock.

Look for a stock with consistent performance that appears to sustain and even increase over time. The Dow Jones Industrial Average is the index of blue chips, listing the likes of IBM, Kodak, McDonald’s, and Sears. These stocks tend to hedge investors’ first exposure to equity investing by paying dividends that offset any lackluster performance. You may also want to seek out a value stock — a stock that has been underperforming its peers, but that seems poised to turn things around. An index called “Dogs of the Dow,” which is compiled by Dow Jones and printed in The Wall Street Journal, lists specifically those stocks that are on the outs. Of course, none is guaranteed to become the next best stock to own.

You have to judge for yourself by looking at a company’s long-term growth and earnings; its price-to-earnings (P/E) ratio; and any company news that can give you insight into debt level, acquisitions on the horizon, and competitive edge of products, services, and management. (The P/E ratio is derived by dividing a stock’s share price by its earnings-per-share price. The result shows how much investors are willing to pay for each $1 of earnings)

Annual reports, which you can request from a company’s own investor relations department, can give you some of these details; but for the rest, you have to sift through analysts’ reports and check the charts that are available from firms such as Morningstar (www.morningstar.com) and Standard & Poors (www.stockinfo.standardpoor.com). These services can show you a stock’s ups and downs over the years and even over the past month.

Analysts’ reports can project a company’s earnings, dividends, and price growth over the next few months and years. Don’t forget to check on competitors, too. Because all performance data is relative, a company that may seem like a great catch may actually be inferior to its peers, but you won’t know that if you don’t check. For example, if you’re thinking about investing in McDonald’s, make sure that you check out the stocks for Wendy’s, too.

Identifying potential stock investments

What do you need to know to determine which stocks are potential investments? To get started, stick with stocks relating to your own interests or knowledge. If you frequent particular stores or restaurants and you use and like their products, find out if they are publicly held companies. Start identifying and watching these stocks. That advice doesn’t mean that you should buy their stock right away. You still have some homework to do.
The following list tells you what to look for when investigating potential stock investments. S&P’s Personal Wealth newsletter, which is available at most libraries (and online at www.personalwealth.com), along with the ValueLine newsletter (www.valueline.com) and any brokerage firm analyst report can provide you with much or all of the following pertinent facts and measures

• Find out if the industry is growing. Some industries aren’t. News stories on the industry in question can tell you the state of the industry and so can the company’s annual report. Company shareholder departments and the Securities and Exchange Commission (SEC), the Washington, D.C.-based regulator that oversees public companies, can provide you with copies of annual reports and the quarterly reports (called 10Qs) that companies must file. You can also find them on the Internet at www.freeedgar.com.
• Find primary competitors. Don’t look at a stock in isolation. A company that looks enticing by itself may look like a 100-pound weakling when you evaluate its strengths and weaknesses next to the leading competitors in the industry. Check out at least two competitors of any stock you’re evaluating.

• Check out annual earnings and sales. This is key in deciphering how quickly a company is growing over oneyear, three-year, and five-year time periods, and whether its earnings are keeping pace with sales. Look for growth rates of at least 10%.
• Look at the stock’s price-to-earnings (P/E) ratios. This is the primary means of evaluating a stock. The P/E ratio is derived by dividing a stock’s share price by its earningsper-share. The result tells you how much investors are willing to pay for each $1 of earnings. Those stocks that have faster earnings growth rates also tend to carry higher P/Es, which means that investors are willing to pay through the nose to own shares. The value of a P/E ratio, however, can be subjective. One investor may think that a particular company’s P/E ratio of 20 is high, while another may consider it low to moderate.
• Find out the price-to-book value (P/B) ratio. The P/B ratio is the stock’s share price divided by book value, or a firm’s assets minus its liabilities. This ratio is a good comparison tool and can tell you which companies are assetrich and which are carrying more debt. A low P/B ratio can be an indicator that a stock may be a good value investment.
• Check out the stock’s price-to-growth flow ratio. This ratio is the share price divided by growth flow (annual earnings plus research-and-development costs) per share. This is a useful measure for assessing fast-moving companies, especially in the technology sector, where management often puts profits back into product development.
• Look at the stock’s PEG ratio. The PEG ratio is a company’s P/E ratio divided by its expected earnings’ growth rate and is an indicator of well-priced stock. In a soaring stock market, like the one that dominated the 1990s, a PEG ratio below 1.5 suggests that a stock may be a good value. A PEG ratio above 2 can indicate that a stock may be overheated.
• Look ahead. Projections of five-year annual growth rates and five-year P/E ratios can tell you whether analysts believe that the companies you’re evaluating can continue to grow at their current rate, can beat it, or will start to fall behind. Make a list of the stocks you are interested in and watch their performance over time. Doing so gives you a feel for how the stocks respond to different types of economic and market news. You can also see which stocks’ prices move around and are more volatile.

So does your own analysis indicate that you have a winner on your hands or a dog? If you’re unsure, sit tight and watch what happens in the weeks and months ahead. Watching several stocks over a period of time not only tells you how well they’re doing, or not doing, it can also show you how well you’re honing your own stock analysis skills.

Recognizing different types of stock

Companies issue two basic kinds of stock, common and preferred, and each provides shareholders with different opportunities and rights:

• Common stock: Represents ownership in a company. Companies can pay what are called dividends to their shareholders. Dividends are paid out from a company’s earnings and can fluctuate with the company’s performance. Note: Not all companies pay dividends. Common stock offers no performance guarantees, and although this kind of stock has historically outperformed other types of investments, you can lose your entire investment if a company does poorly enough to wipe out its earnings and reputation into the foreseeable future. Common stock dividends are paid only after the preferred stock dividends are paid.
• Preferred stock: Constitutes ownership shares as well, but this stock differs from common stock in ways that reduce risk to investors, but also limit upside potential, or upward trends in stock pricing. Dividends on preferred stock are paid before common stock, so preferred stock may be a better bet for investors who rely on the income from these payments. But the dividend, which is set, is not increased when the company profits, and the price of preferred stock increases more slowly than that of common stock. Also, preferred stock investors stand a better chance of getting their money back if the company declares bankruptcy.

A company’s stock is also categorized depending on its perceived expected performance. Basically, a company’s stock falls into one of two categories: growth or value Over time, you’re likely to buy a mix of both types of stocks for your portfolio, so knowing the different characteristics of each is important. Understanding growth and value stocks can help you evaluate your options more carefully.

Growth companies are typically organizations with a positive outlook for expansion and, ultimately, stock prices that move upward. Investors looking for growth companies usually are willing to pay a higher price for stocks that have consistently produced higher profits because they’re betting the companies will continue to perform well in the future.

Because they use their money to invest in future growth, growth companies are less likely to pay dividends than other, more conservative companies; when they do pay dividends, the amounts tend to be lower. An investor who buys a growth stock believes that, according to analysis of the company’s history and statistics, the company is likely to continue to produce strong earnings and is therefore worth its higher price.

The stock of a growth company is, however, somewhat riskier because the price tends to react to negative company news and short-term changes in the market. Also, the company may not continue to produce earnings that are worth its higher price.

In contrast, value stocks are out of favor, left on the shelf by investors who are busy reaching for more expensive and trendier items. For that reason, you spend fewer dollars to buy a dollar of their profits than if you invest in a growth stock. When investors buy value stocks, they’re betting that they’re actually buying a turn-around-story — with a happy ending down the road.
Value companies carry risk, too, because they may never reach what investors believe is their true potential. Optimism doesn’t always pay off in profits.

Understanding how stocks work

Companies issue stock to raise money to fund a variety of initiatives, including expansion, the development of new products, the acquisition of other companies, or to pay off debt. In an action called an initial public offering (IPO), a company opens sale of its stock to investors. An investment banker helps underwrite the public stock offering. By underwrite, I mean that the investment banker helps the company determine when to go public and what price the stock should be at that time.

When the stock begins selling, the price can rise or fall from its set price depending on whether investors believe that the stock was fairly and accurately priced. Often, the price of an IPO soars during the first few days of trading, but then can later fall back to earth.

After the IPO, stock prices will continue to fluctuate, based on what investors are willing to accept when they buy or sell the stock. In simple terms, stock prices are a matter of supply and demand. If everyone wants a stock, its price rises, sometimes sharply. If, on the other hand, investors are fearful that, for example, the company’s management is faltering and has taken on too much debt to sustain strong growth, they may begin selling in noticeable volume. Mass sales can drive the price down. In addition to specific company issues, the price can drop for other reasons, including bad news for the entire industry or a general downturn in the overall economy.

Stocks are bought and sold on stock exchanges, such as the New York Stock Exchange, Nasdaq, and the American Stock Exchange. Companies that don’t have the cash reserves necessary to be listed on one of the exchanges are traded overthe-counter, which means that they receive less scrutiny from analysts and large investors such as mutual fund managers.

In addition, professional analysts who are paid to watch companies and their stocks can give a thumbs-up or a thumbsdown to a stock, which in turn can send stock prices soaring or plummeting. These stock analysts sit in brokerage firms on New York’s fabled Wall Street and various cities’ Main Streets. The analyst’s job is to watch closely the actions of public companies and their managers and the results those actions produce.

By carefully monitoring news about a company’s earnings, corporate strategies, new products and services, and legal and regulatory problems and victories, analysts give stocks a buy, sell, or hold rating. Such opinions can have a wide-sweeping impact on the price of a stock, at least in the short-term. Rumblings, real or imagined, can send the price of a stock, or the stock market overall, tumbling downward or soaring skyward.

The price of stock goes up and down — a phenomenon known as volatility — but if the news creating the stir is short-term, panic is an overreaction. You don’t want to sell a stock when its price is down, only to see it make a miraculous recovery a few days, weeks, or even months down the road. Smart investors who have done their research and are invested for the longer-term won’t be impacted by short-term price dips or panics. Unless of course, you use the opportunity to buy a stock you’ve already researched and were going to buy anyway. The old adage — buy low, sell high — holds as true today as it did 75 years ago.

How low can stock prices go? In October 1987, stock prices tumbled by 22.6%. This decline meant that the value of a $10,000 investment dropped to $7,740. Many stocks recovered, but some did not.
You can lose all your money with a stock investment, and that risk is why you need to analyze your choices carefully.
The three most basic types of risks associated with stock investments are

• You may lose money.
• Your stocks may not perform as well as other, similar stocks.
• A loss may threaten your financial goals.

Stock investing carries certain risks, but they can be minimized by careful investment selection and by diversification, a technique for building a balanced portfolio.

Sizing Up Stocks

A stock is a piece of paper that signifies that you own part of a company. The market price of a stock is directly related to the profits and the losses of the company. In other words, when the company profits, the worth of your stock increases. When the company falters and its profits decline, so does the worth of your stock.
Investors who buy stock own shares of the company. That’s why they’re called shareholders.