Economic Analysis in Fundamental Analysis

Economic Analysis

For the security analyst or investor, the anticipated economic environment, and therefore the economic forecast, is important for making decisions concerning both the timings of an investment and the relative investment desirability among the various industries in the economy.

The key for the analyst is that overall economic activities manifest itself in the behaviour of the stocks in general. That is, the success of the economy will ultimately include the success of the overall market.

For studying the Economic Analysis, the Macro Economic Factors and the Forecasting Techniques are studied in the following paragraphs.

Macro Economic Factors

The macroeconomy is the study of all the firms operating in an economic environment. The key variables to describe the state of the economy are explained as below:

Growth Rate of Gross Domestic Product (GDP)

GDP is a measure of the total production of final goods and services in the economy during a year. It is an indicator of economic growth. It consists of personal consumption expenditure, gross private domestic investment, government expenditure on goods and services and net export of goods and services. The firm estimates of GDP growth rate are available with a time lag of one or two years.

The expected rate of growth of GDP will be 7.5 percent in year 2005-06. Generally, GDP growth rate ranges from 6-8 percent. The growth rate of economy points out the prospects for the industrial sector and the returns investors can expect from an investment in shares. The higher the growth rate of GDP, other things being equal, the more favorable it is for stock market.

Savings and Investment

Growth of an economy requires a proper amount of investments which in turn is dependent upon the amount of domestic savings. The amount of savings is favorably related to investment in a country. The level of investment in the economy and the proportion of investment in capital market is major area of concern for investment analysts.

The level of investment in the economy is equal to: Domestic savings + inflow of foreign capital – investment made abroad.

Stock market is an important channel to mobilize savings, from the individuals who have excess of it, to the individual or corporate, who have deficit of it. Savings are distributed over various assets like equity shares, bonds, small savings schemes, bank deposits, mutual fund units, real estates, bullion etc. The demand for corporate securities has an important bearing on stock prices movements. Greater the allocation of equity in investment, favorable impact it have on stock prices.

Industry Growth Rate

The GDP growth rate represents the average growth rate of the agricultural sector, industrial sector and service sector. The current contribution of industry sector in GDP in the year 2004-05 is 6.75 percent approximately. Publicly listed company play a major role in the industrial sector.

The stock market analysts focus on the overall growth of different industries contributing in economic development. The higher the growth rate of the industrial sector, other things being equal, the more favorable it is for the stock market.

Price Level and Inflation

If the inflation rate increases, then the growth rate would be very little. The increasingly inflation rate significantly affects the demand of consumer product industry. The inflation rate in the Indian economy has been around 7 percent till the 1990s. In recent years, the inflation rate has fallen significantly. At present, it ranges from 4-5 percent (2005). The industry which have a weak market and come under the purview of price control policy of the government may lose the market, like sugar industry.

On the other hand the industry which enjoy a strong market for their product and which do not come under the purview of price control may benefit from inflation. If there is a mild level of inflation, it is good to the stock market but high rate of inflation is harmful to the stock market.

Agriculture and Monsoons

Agriculture is directly and indirectly linked with the industries. Hence increase or decrease in agricultural production has a significant impact on industrial production and corporate performance. Companies using agricultural raw materials as inputs or supplying inputs to agriculture are directly affected by changes in agriculture production.

For example, Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw material. Fertilizer and insecticides industries are supplying inputs to agriculture. A good monsoon leads to higher demand for inputs and results in bumper crops. This would lead to buoyancy in stock market. If the monsoon is bad, agriculture production suffers and cast a shadow on the share market.

Interest Rate

Interest rates vary with maturity, default risk, inflation rate, the productivity of capital etc. The interest rate on money market instruments like Treasury Bills are low, long-dated government securities carry slightly higher interest rates and interest rate on corporate debenture is still higher. With the deregulation interest rates are softened, which were quite high in regulated environment. Interest rate affects the cost of financing to the firms.

A decrease in interest rate implies lower cost of finance for firms and more profitability and it finally leads to decline in discount rate applied by the equity investors, both of which have a favorable impact on stock prices. At lower interest rates, more money at cheap cost is available to the persons who do business with borrowed money, this leads to speculation and rise in price of share.

Government Budget and Deficit

Government plays an important role in the growth of any economy. The government prepares a central budget which provides complete information on revenue, expenditure and deficit of the government for a given period. Government revenue come from various direct and indirect taxes and government-made expenditure on various developmental activities. The excess of expenditure over revenue leads to a budget deficit.

For financing the deficit the government goes for external and internal borrowings. Thus, the deficit budget may lead to a high rate of inflation and adversely affects the cost of production and a surplus budget may result in deflation. Hence, a balanced budget is highly favorable to the stock market.

Tax Structure

The business community eagerly awaits the government announcements regarding the tax policy in March every year. The type of tax exemption has an impact on the profitability of the industries. Concession and incentives given to certain industries encourage investment in that industry and have a favorable impact on stock market.

Balance of Payment, Forex Reserves and Exchange Rate

Balance of payment is the record of all the receipts and payments of a country with the rest of the world. This difference in receipt and payment may be surplus or deficit. Balance of payment is a measure of strength of the rupee on an external account. The surplus balance of payment augments forex reserves of the country and has a favorable impact on the exchange rates; on the other hand if the deficit increases, the forex reserve depletes and has an adverse impact on the exchange rates.

The industries involved in export and import are considerably affected by changes in foreign exchange rates. The volatility in foreign exchange rates affects the investment of foreign institutional investors in Indian Stock Market. Thus, a favorable balance of payment renders a favorable impact on stock market.

Infrastructural Facilities and Arrangements

Infrastructure facilities and arrangements play an important role in the growth of industry and agriculture sector. A wide network of communication system, regular supply or power, a well-developed transportation system (railways, transportation, road network, inland waterways, port facilities, air links and telecommunication system) boost industrial production and improves the growth of the economy.

Banking and financial sector should be sound enough to provide adequate support to industry and agriculture. The government has liberalized its policy regarding the communication, transport and power sector for foreign investment. Thus, good infrastructure facilities affect the stock market favorable.

Demographic Factors

The demographic data details about the population by age, occupation, literacy and geographic location. These factors are studied to forecast the demand for consumer goods. The data related to the population indicates the availability of the workforce. The cheap labor force in India has encouraged many multinationals to start their ventures. Population, by providing labor and demand for products, affects the industry and stock market.


The sentiments of consumers and businesses can have an important bearing on economic performance. Higher consumer confidence leads to higher expenditure and higher business confidence leads to greater business investments. All this ultimately leads to economic growth.

Thus, sentiments influence consumption and investment decisions and have a bearing on the aggregate demand for goods and services.

Economic Forecasting Techniques

To estimate the stock price changes, an analyst has to analyze the macroeconomic environment. All the economic activities affect the corporate profits, investor’s attitudes and share price. For the purpose of economic analysis and in order to decide the right time to invest in securities some techniques are used. These are explained as below:

Anticipatory Surveys

Under this prominent person in government and industry are asked about their plans with respect to construction, plant and equipment expenditure, inventory adjustments and the consumers about their future spending plans.

To the extent that these people plan and budget for expenditure in advance and adhere to their intentions, surveys of intentions constitute a valuable input in the forecasting process. It is necessary that surveys of intentions be based on elaborate statistical sampling procedures, the greatest shortcoming of intentions, surveys is that the forecaster has no guarantee that the intention will be carried out. External shocks, such as strikes, political turmoil or government action can cause changes in intentions.

Barometric or Indicator Approach

The barometric technique is based on the presumption that relationships can exist among various economic time series. For example, industrial production over time and industrial loans by commercial banks over time may move in same direction.

Historical data are examined in order to ascertain which economic variables have led, lagged after of moved together with the economy. A leading indicator may be leading because it measures something that overshadows a change in production activity.

There are three kinds of relationships among economic time series:

  • Leading series: Leading series consists of the data that move ahead of the series being compared. For example- applications for the amount of housing loan over time is a leading series for the demand of construction material, birth rate of children is the leading series for demand of seats in schools etc. In other words, leading indicators are those time series data that historically reach their high points (peaks) or their low points (troughs) in advance of total economic activity.

  • Coincident series: When data in series moves up and down along with some other series, it is known as coincident series. A series of data on national income is often coincident with the series of employment in an economy (over a short-period). In other words, coincident indicators reach their peaks or trough at approximately the same time as the economy.

  • Lagging series: Where data moves up and down behind the series being compared, example, data on industrial wages over time is a lagging series when compared with series of price index for industrial workers. They reach their turning points after the economy has already reached its own.

Diffusion Indexes

Some of the indicators appear in more than one class, and then the problem of choice may arise. Furthermore, it is not advisable to rely on just one of the indicators. This leads to the usage of what is referred to as the diffusion index.

A diffusion index copes with the problem of differing signals given by the indicators. It is a percentage of rising indicators. In this method a group of leading indicators is initially chosen. Then the percentage of the group of chosen indicators which have fallen (or, risen) over the last period is plotted against time to get the diffusion index.

For example, if there are say 9 leading indicators for forecasting the construction activity of dwelling units and if by plotting we find that say, 6 indices show a rise, then we can calculate that diffusion index is (6/9*100) = 66.7 percent. When the index exceeds 50 percent, we can predict a rise in the forecast variable.

Money and Stock Prices

Monetary theory in its simplest form states that fluctuations in the rate of growth of money supply are of utmost importance in determining GNP, corporate profits, interest rates, stock prices, etc. Monetarists contend that changes in the growth rate of money supply set off a complicated series of events that ultimately affects share prices. In addition, these monetary changes lead stock price changes.

Thus, while making forecasts, changes in the growth rate of money supply should be given due importance. Some thinkers states that stock market leads changes in money supply. However, sound monetary policy is a necessary ingredient for steady growth and stable prices.

Econometric Model Building

The econometric methods combine statistical tools with economic theories to estimate economic variables and to forecast the intended economic variables. The forecast made through the econometric method is much more reliable than those made through any other method.

For applying the econometric technique, the user is to specify in a formal mathematical manner the precise relation between the dependent and independent variable. In using econometrics, the forecaster must quantify precisely the relationships and assumptions he is making. This not only gives him direction but also magnitudes.

An econometric model may be a single-equation regression model or it may consist of a system of simultaneous equations. Single equation regression serves the purpose of forecasting in many cases.

But where the relationship between economic variables are complex and variable are so interrelated that unless one is determined, the other cannot be determined, a single-equation regression model does not serve the purpose. In that case, a system of simultaneous equations is used to estimate and forecast the target variable.

Opportunistic Model Building

An opportunistic model building or GNP model building or sectoral analysis is a widely used forecasting method. Initially, the forecaster must hypothesize total demand and thus total income during the forecast period. Obviously, this will necessitate assuming certain environmental decisions, such as war or peace, political relationships among the level of interest rates.

After this work has been done, the forecaster begins building a forecast of the GNP figure by estimating the levels of the various component of GNP like the number of consumption expenditures, gross private domestic investment, government purchases of goods and services and net exports. After adding the four major categories the forecaster comes up with a GNP forecast. Now he tests this total for consistency with an independently arrived at a priori forecast of GNP.

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