 Hello and welcome to the session. This is Professor Farhad and the session we would look at some indicators of the domestic macroeconomy and how does it affect our investment analysis. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,900 plus accounting or I think tax finance as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people and check out my website, farhadlectures.com. Now, why do we look at the domestic economy? Well, as we can see clearly from this graph that there is a positive relationship between stocks and earnings per share and stocks here represented by the S&P 500 line. And basically what we see as company earns more, their earnings per share goes up, whether they earn 12 times their EPS, 18 or 25, the stock market also go up and tend them. Now, this relationship, it's not a perfect relationship because when it comes to the stock market, you have to account for other factors such as interest rate, risk, inflation and many other variable. But there's a strongly a positive relationship. So the normal PE ratio, which is we didn't talk about the PE ratio, we'll talk about the price earning ratio or the multiplier ranges between, seems ranges between 12 and 25. Those are the normal PE. Don't worry, we'll talk about that later on. This is just to give you an overall picture. So the earning multiplier rule, which is the PE ratio, aka PE ratio, is not perfect. Of course it's not perfect. But there is clear that the level of the broad market and the aggregate earnings do trend together. And that's obvious. That's how we measure stocks. The stock price should react to the earnings. So as the company earns more, the stock price should go higher. Now, how much higher? Well, it's a multiple of their earnings. It's a 12 times multiple, 18 or 25. It ranges in those two figures. So the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole. Now, how do we do so? Well, we have to look at certain market economic indicators. And this is what we need to look at in this session. The reason I started with this is just to tell you that you have to understand that stocks don't exist in vacuum. They exist in an economy. And within that economy, you have to understand the factors. And we're going to look at six factors real quick. GDP, employment, inflation, interest rate, budget and sentiments. And I'm going to start with GDP. What is a GDP? It's the measure of the economy's total production of goods and services. Now, if you have a rapid increase in GDP, a rapid increase in the economic output in goods and services, what does it say? It's a state, the economy is expanding and there's a big opportunity for companies to increase sales. If people have more income, the economy is growing, you should be able to increase your sales. And the recent past of China, for decades, decades with an S, they had double digit growth under GDP. Now, obviously it's slowing down because they become so large. You cannot keep on growing using double digit. Another popular measure similar to GDP is the industrial production. And what does it look for? This looks a little bit more specific. This statistic provides a measure of the economic activity on the manufacturing side of the economy. That's if you are more interested in the manufacturing, somehow your company is related to manufacturing, therefore you would look more at this indicator. Employment, basically, we want to know what's the proportion of the population that's producing and that has a lot of consequences. It's the rate of the total labor force, who's either working or actively seeking employment yet to find work. We want to know about employment. So the employment measure, the employment rate measures the extent to which the economy is operating at full capacity. If we have low employment rate, let's say 4%, we are operating at full capacity. That's good. That means people have money, you can sell product there, but also if you want to move your company there, you might have to pay a premium for labor because you already have low unemployment. So you won't be able to find people to work for you and if you want to recruit them, you have to pay a premium. Now, this is by book measures. This is basically academic. Well, in the real world, it seems we have, sorry, we had recently low unemployment and wages did not go up. So there's some things going on with the economy that's still not explainable. That's related to inflation, but that's beyond the scope of this course. But the point is, you know, when I say something, this is the general rule, for a short period of time, it may not work perfectly. So the unemployment rate is a statistic related to workers only, but further insight into the strength of the economy can be gleaned from the employment rate of other factors of production. So that's the thing. That's what's happening now. That it's not only the employment rate that matters, it's the technology that we are using. Maybe the technology that we are using, it's allowing people to produce rather than 10 widgets 50 years ago. So now the same person can increase 50 widgets. So we don't have to get more employees to produce the widget with technology. We can produce more widgets. So we are, we are more productive. Also, we could look at look at the factory capacity utilization rate, which is the ratio of actual output from factories to potential output. So how much they can produce and how much are we producing tells us something about employment. And again, with technology, we can produce more, we can produce more with less people with less people. Why? Because we have something's helping us. We are scaling our output with technology. Inflation, that's another important. And recently for the past four or five years or even a decade, it's a mysterious, it's a mysterious indicator. It's the rate at which the general level of prices is rising. And, you know, generally we say if we have more money in the economy, inflation should start to creep up. But that's not what's happening, especially now. What's what's going on with the Corona virus? Basically, the Federal Reserve and the government are spending and printing money like there's no tomorrow, but we don't see any sign of inflation. Because high inflation often associated with overheated economy, which means what? Which means the demand we have, the demand for goods and services is outstripping productive capacity. So people are demanding because they have money. There's a lot of money, but there's not enough productive capacity. If there's not enough productive capacity, what happened is you have a few dollar, a limited amount of dollar chasing a limited amount of goods. Well, what's going to happen, the prices will go up. But that's not what's happening. It doesn't matter why, because somehow we are producing more. We are not outstripping our productive capacity. Although we're throwing more money into the economy, we are more productive. So just kind of the simplest way to explain to you, let's assume you're selling burgers. Okay. And I like to give this example just to kind of explain how inflation works. And let's assume you sell you're selling a burger just for the sake of illustration. You are selling the burger at $2 per burger. And you're selling right now per day. You have a productive capacity. You can sell 100 burgers. You can sell 100 burgers. Now, here's what happened. Suddenly, people have more money or they have more money or more people move into your area or whatever the reason is. Now you have a demand for 200 units of burgers. Now you're selling it for two, but now what happens is there is a demand of 200 units. What's going to happen is this, generally speaking, what would we say? We would say you're going to raise your prices. Why? Because you have more demand. But this is the mysterious that's happening in the economy. Somehow, with my burger stand, I can produce the 200 units of burger to serve all my customers without raising my prices. And this is what's happening throughout the economy, although we have more demand for goods because we have more money in the economy. But somehow the productive capacity is kind of basically answering that demand. So there is no pressure on prices. Therefore, if there is no pressure on prices, there is no inflation. That's one theory. Another theory is unions are becoming less and less powerful. What does that mean? Back in the old days, well, maybe 20, 25 or 30 years ago, union were powerful. So they demanded companies to pay more for employees. So the cost of operating the business was higher. As a result, companies would raise their prices. As a result, inflation will... Basically, when you pay more for your employees, they have more money. Then the companies will raise their prices because their costs are operating higher. People will have more money to chase fewer goods because you did not really increase the productivity. You only increase prices. Inflation will creep up. One theory is because of unions are not as strong. Inflation is not a problem so far. I'm knocking on the wood, okay? We'll see how it goes. I'm doing this recording October 2010. Maybe you're listening to this October 2020. I'm sorry, not 2020. I apologize, 2020. So October 2021, a year from now, this whole picture might be upside down. Who knows? Okay? Because a lot of people are saying eventually we're gonna hit hyperinflation. And some people are saying exactly the opposite. We're gonna go through deflation. Again, this is not a macroeconomic course, but it's something for you to think about just as an individual. So most governments walk a fine line. We're not really walking a fine line right now under economic policies. They hope to stimulate the economy enough to maintain full employment, but not so much to bring inflationary pressure. Actually, what's happening now with our economy, the US, we're printing money, government spending like crazy to keep full employment. And there is no pressure on inflation. That's the mystery. That's what no one can, you know, there's some potential theory. But if inflation kicks, if inflation kicks, we're gonna be in big trouble. I mean, again, that's my opinion. That's my opinion. But we'll see. We'll see how it goes. The perceived trade off between inflation and unemployment is at the heart of macroeconomic policy dispute. So there's again, there's no, there's no clear cut answer. There's a considerable room for disagreement as to the relative cost of inflation versus unemployment as well as the economy relative to vulnerability to these potential problems at any particular time. And again, this is why what the Federal Reserve tackles on a monthly basis. Another important factor that basically drives everything else including inflation or inflation drives it. It's the interest rate. Like what's what happened if you have high interest rate? Well, if you have high interest rate, you're going to reduce the present value of the future cash flow. What does that mean? It means you're going to have a less attractive investments. What does that mean? It means from a numerical perspective, let's assume you are looking for a future cash flow of $1,000. What you do with the future cash, let's assume you're gonna, you're gonna invest. This is for two years. So what's gonna happen, you're gonna discount it at one plus I raised to the second power because it's one plus two years. So what's gonna happen is this when this I when this interest rate goes up, it's going to make the investments less attractive, less attractive. Why? Because now you're taking more risk. You're gonna, you're taking more risk because it's risk comes with return. And you could, for example, use figures. Let's use just simple figures. Let's assume we're looking at an investment for one year. Let's just keep it simple. 10% interest rate. Let me just go, go ahead. So let's go ahead, take $1,000. We're going to talk about this later on when we do equity evaluation divided by 1.1. Sorry, let's go back. Clear this 1000. My fat fingers. Not really, I don't have fat fingers, but I don't know what's going on. Let me clear this. That's not clearing. Okay, let's start 1000 divided by 1.1 of the interest rate is 10%. The present value of the payment is $909. Let's take the $1,000 and illustrate. Let's make the interest rate 1.2. Let's go back here. Okay, $1,000 divided by 1.2. The present value is 833, $833. To compensate for higher return, to compensate for higher return, you're going to pay less for the investment. Why? Because you're earning 20%. That's risk. You want to pay less for it now. If you want to earn 20%, it makes it a little bit less attractive. For this reason, interest rate, real interest rate are the key determinant of business investment expenditure. 100%, 100%. And we're going to talk about interest rate much more in the next recording. And think about the demand for housing and high-priced consumer durables such as automobile, which are commonly financed, are also sensitive to interest rate because interest rate affects interest payment. And there's a rule in real estate. I'm sure you heard of it, maybe not. Every time the interest rate is increased by 1%, home prices go down by 10%, or the demand, either the prices or the demand goes down. What does that mean from a macro perspective? When you have 10% less people buying homes, we have less, 10% less home selling. It means people are not buying TVs, refrigerators, furniture, computers. We don't have home formation. We have less home formation. What is that affected by? By the interest rate. So as interest rate goes up, everything costs more. As everything costs more, you spend less. Same thing with the investment. Investment becomes riskier because the alternative, if you have high interest rate, is to put your money somewhere safe rather than risk it. Budget deficit, that's also important. What's budget deficit? Is the difference between spending and revenue. And basically, if you have more revenue, if you have more taxes and revenues than spending, you have a surplus. But if you have more spending than revenues, you have a deficit. So any budgetary fall, when you have a deficit, you must offset it by either borrowing. You have to borrow money or to raise taxes. When you raise taxes, guess what? You're going to have less revenues for companies because taxes, it's a cost of operating the business. Then your earning is lower. If your earning is lower, your earnings per share is lower. If your earnings per share is lower, the stock price is lower. If the stock price is lower, it affects everything else and so on and so forth. So budget deficit simply put, they are not good. Why? Because they can't force up interest rate because the government needs to finance their shortfall. How do they finance their shortfall? They borrow money. When they borrow money, they bid up the interest rate. They are competing for money and as a result, interest rate would go up because they have to compete with other private companies because also private companies need money. And the government, generally speaking, they don't produce the government they basically spend. In other words, they don't produce goods and services for the purpose of profit. They produce it for the sole service of the citizen versus companies. If they borrow money, they're going to make more of it than if the government did borrow the money. So what's happening is economies generally believe excessive government borrowing will crowd out private borrowing by forcing interest rate higher. And when interest rates are higher, it becomes costlier for companies. It becomes costlier. It becomes riskier because interest rate is higher. When you want to make an investment, now to recoup your money, you have to earn a high interest rate. It becomes much, much riskier. Again, in these days, that's not the case. Although we have a we have a deficit. The government is borrowing. Everything is working great. Some mystery that's going on, you know, due to inflation, we don't know. We don't technology, technology scalability, but there's something is helping our economy. Sentiment that's very extremely important consumers and producer optimism or pessimism pessimism. Basically, sentiment drives everything. If the look if people are pessimists, immediately they will stop spending. The stock market will drop. You'll have less demand for goods companies would lay off employees and this cycle would feed itself and you have more pessimism and optimism. Optimism is will have the opposite effect. So optimism and pessimism is extremely important. The sentiment you have to know that there's this this the sentiment is measured on a regular basis. We have the consumer sentiment index. And if the sentiment is good, everything else supposed to be good. If consumer have confidence in their future income level, they will become more willing to spend on big, big ticket items. Those companies that are manufacturing those big ticket items, hire employees and they pay them in the cycle would keep on going. So businesses will increase production and inventory level if they anticipate higher demand for their product. In this way, believes influence how much consumption and investment will be pursued and affect the aggregate demands for goods and services. And believe it or not, I would say sentiment drives everything else that we talked about everything else. Because suddenly, let's assume just for the sake of illustration. You know, you know, the, this is October the 10th, we're having the election coming up and the president just was infected with with the coronavirus. If the president was not doing well, then what happened? Everybody was going to be scared that look, if the president couldn't make it, it's a real issue. It's a real problem. More people will be, will have pessimism. Then they will, they will, they will drop their spending. They become more careful than this vicious cycle will take, take, take off basically. But the opposite will happen if the president came out, you know, unscratched, everything is good. But now we have the election coming in the next what less than a month. Actually, if the results are clear, November the 3rd, everything is good. You know, whether the president won the current president or Biden ones and, you know, the president said, okay, I'm done. I served my four years. It's Biden's turn. Everything is good. Then people will be optimist. But if there was any disagreement about the presidency results, then guess what? People's going to be more careful because we're going to have more uncertainty. So that's why sentiment is extremely important because at the end of the day, consumer drives the economy. Our economy is driven by consumer. So we have to look at what's influencing the consumer sentiment. In the next session, I would look specifically at interest rate because I believe it's extremely important. But as always, I'm going to remind you if you like this recording, please share it, put it in playlist. Don't forget to visit my website for head lectures dot com. And most importantly, stay safe. And if you can vote, go out and vote.