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MACROECONOMY AND STOCKS Portfolio Management Ali Nejadmalayeri Active vs. Passive Factors in Return: 1. Market 2. Industry • • • • Growth Cyclical Stable Energy Factors in Risk: • Beta or Market Risk • Extramarket Covariance or Industry Risk • Residual or Specific 3. Individual Active Management Passive Management Active Strategies • Market Timing: – Set strategies based on “Market” movement • Selective vs. Diversification: – Able to find “gems” or simply hedge risk • Group Rotation: – Shift between overrepresented (over-bought) and underrepresented (over-sold) industries or group, e.g., shifting from growth to value at the end of 1999 Group Rotation • In equilibrium each sectors represents certain percentage of the total market cap. The proportion of the value of these sectors to other sectors, however, changes thru time. If the proportion is mean reverting, i.e., hovers around some long-run average, then when one sectors gets overloaded, it ought to come down and vice versa. – ETFs based strategies – Services provided for rotating the sectors Sector Rotation This chart is based on Sam Stovall's S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle. Economic Indicators GNP gap: E(RM) Var(RM) M1 E(RM) Var(RM) E(RM) Var(RM) Inflation Tbill growth in money supply E(RM) Interest rate change GNP CPI Others: Liquidity, P/E ratio, Housing , etc. From Flannery and Protopapadakis (2002) Review of Financial Studies Economic Indicators • Leading, Lagging, and Coincidental • Traditional Leading Indicator: – The average manufacturing-worker workweek (from the employment report) – Initial jobless claims – Manufacturers' new orders for consumer goods and materials (from the factory orders report) – Vendor performance (from the Purchasing Managers' Index report) – Manufacturers' new orders for nondefense capital goods (from the factory orders report) – Building permits (from the housing starts report) – The level of the S&P 500 – The inflation-adjusted measure of the M2 money supply – The interest-rate spread between the 10-year Treasury note and the fed funds rate – The expectations portion of the University of Michigan's Consumer Sentiment Index Why Macroeconomy? • Consumer consumption (70% of GDP) – Nondurable goods 29% • Food, clothing, gasoline, drugs, cleaning supplies, ... – Durable goods 12% • Motor vehicles, furniture, sporting, tools, books, … – Services 59% • Housing, medical, education, transport, recreation, finance, … • Government Spending (19% of GDP) • Capital Spending (16% of GDP) – Equipment and Software 50% – Residential structures 35% – Nonresidential structure 15% Cause and Effects Courtesy of www.aheadofthecurve-thebook.com Obsession with “R” Word Courtesy of www.aheadofthecurve-thebook.com Consumption & Productivity Courtesy of www.aheadofthecurve-thebook.com Productivity & Cap Spending Courtesy of www.aheadofthecurve-thebook.com Consumption & Cap Spending Courtesy of www.aheadofthecurve-thebook.com Consumption, Earnings & Stocks Courtesy of www.aheadofthecurve-thebook.com