Macroeconomic Analysis

Investopedia.com ^ | 2009 | by Reem Heakal

[Son House]

What Is It?

Macroeconomics is the study of the behavior of the economy as a whole.

Macroeconomic analysis broadly focuses on three things: national output (measured by gross domestic product (GDP)), unemployment and inflation. (For background reading, see The Importance Of Inflation And GDP.)

National Output: GDP

Output, the most important concept of macroeconomics, refers to the total amount of goods and services a country produces, commonly known as the gross domestic product. The figure is like a snapshot of the economy at a certain point in time.

When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into account, as opposed to nominal GDP, which reflects only changes in prices. The nominal GDP figure will be higher if inflation goes up from year to year, so it is not necessarily indicative of higher output levels, only of higher prices.

The one drawback of the GDP is that because the information has to be collected after a specified time period has finished, a figure for the GDP today would have to be an estimate. GDP is nonetheless like a stepping stone into macroeconomic analysis. Once a series of figures is collected over a period of time, they can be compared, and economists and investors can begin to decipher the business cycles, which are made up of the alternating periods between economic recessions (slumps) and expansions (booms) that have occurred over time.

From there we can begin to look at the reasons why the cycles took place, which could be government policy, consumer behavior or international phenomena, among other things. Of course, these figures can be compared across economies as well. Hence, we can determine which foreign countries are economically strong or weak.

Based on what they learn from the past, analysts can then begin to forecast the future state of the economy. It is important to remember that what determines human behavior and ultimately the economy can never be forecasted completely.

Unemployment

The unemployment rate tells macroeconomists how many people from the available pool of labor (the labor force) are unable to find work. (For more about employment, see Surveying The Employment Report.)

Macroeconomists have come to agree that when the economy has witnessed growth from period to period, which is indicated in the GDP growth rate, unemployment levels tend to be low. This is because with rising (real) GDP levels, we know that output is higher, and, hence, more laborers are needed to keep up with the greater levels of production.

Inflation

The third main factor that macroeconomists look at is the inflation rate, or the rate at which prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and the GDP deflator. The CPI gives the current price of a selected basket of goods and services that is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. (For more on this, see The Consumer Price Index: A Friend To Investors and The Consumer Price Index Controversy.)

If nominal GDP is higher than real GDP, we can assume that the prices of goods and services has been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less than 1%. (If you'd like to learn more about inflation, check out All About Inflation.)

Demand and Disposable Income

What ultimately determines output is demand. Demand comes from consumers (for investment or savings - residential and business related), from the government (spending on goods and services of federal employees) and from imports and exports.

Demand alone, however, will not determine how much is produced. What consumers demand is not necessarily what they can afford to buy, so in order to determine demand, a consumer's disposable income must also be measured. This is the amount of money after taxes left for spending and/or investment.

In order to calculate disposable income, a worker's wages must be quantified as well. Salary is a function of two main components: the minimum salary for which employees will work and the amount employers are willing to pay in order to keep the worker in employment. Given that the demand and supply go hand in hand, the salary level will suffer in times of high unemployment, and it will prosper when unemployment levels are low.

Demand inherently will determine supply (production levels) and an equilibrium will be reached; however, in order to feed demand and supply, money is needed. The central bank (the Federal Reserve in the U.S.) prints all money that is in circulation in the economy. The sum of all individual demand determines how much money is needed in the economy. To determine this, economists look at the nominal GDP, which measures the aggregate level of transactions, to determine a suitable level of money supply.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy

A simple example of monetary policy is the central bank's open-market operations. (For more detail, see the Federal Reserve Tutorial.) When there is a need to increase cash in the economy, the central bank will buy government bonds (monetary expansion). These securities allow the central bank to inject the economy with an immediate supply of cash. In turn, interest rates, the cost to borrow money, will be reduced because the demand for the bonds will increase their price and push the interest rate down. In theory, more people and businesses will then buy and invest. Demand for goods and services will rise and, as a result, output will increase. In order to cope with increased levels of production, unemployment levels should fall and wages should rise.

On the other hand, when the central bank needs to absorb extra money in the economy, and push inflation levels down, it will sell its T-bills. This will result in higher interest rates (less borrowing, less spending and investment) and less demand, which will ultimately push down price level (inflation) but will also result in less real output.

Fiscal Policy

The government can also increase taxes or lower government spending in order to conduct a fiscal contraction. What this will do is lower real output because less government spending means less disposable income for consumers. And, because more of consumers' wages will go to taxes, demand as well as output will decrease.

A fiscal expansion by the government would mean that taxes are decreased or government spending is increased. Ether way, the result will be growth in real output because the government will stir demand with increased spending. In the meantime, a consumer with more disposable income will be willing to buy more. A government will tend to use a combination of both monetary and fiscal options when setting policies that deal with the macroeconomy.

Conclusion

The performance of the economy is important to all of us. We analyze the macroeconomy by primarily looking at national output, unemployment and inflation. Although it is consumers who ultimately determine the direction of the economy, governments also influence it through fiscal and monetary policy.

[Son House]

Yep, the state run media passes hype in the DOW numbers as a beginning to an economic recovery

[Son House]

Yep, and more importantly being we know this White House will not improve the private sector, the 111th Congress needs prompting to

a). Dump Pelosi,
b). Pass tax cuts for private sector/cut spending
c). Over-ride expected Presidential Veto

and sooner, rather then later, even according to their own Keynesian Economist

[ModelBreaker]

“There is only one way GDP has risen in Q3.....that is, if companies were building up inventories.”

I believe GDP equals C+I+G (consumption plus investment plus gvt spending) adjusted for inflation. Inventory build up would be part of investment.

But G has gone WAY up. My firm belief is that

C+I+Lots of G

is not equal to

C+I+Not Much G,

even if the two sum to the same number.

It’s been too long. But I don’t recall if the borrowing or money printing our overlords in Washington are doing reduces the I component, as it represents UnInvestment.

[ModelBreaker]

Nice chart. You can show many other measures that show what looks like an exponential asset bubble that started popping in 2002 and is still popping.

It is sobering to note that last March’s LOW in your chart is about the same as the HIGH in the 1929.

But charting dividend yields and price to earnings charts ratios will show about the same thing.

The only explanation I can think of (other than an asset bubble) is that a permanent change happened in the economy between the 1960’s and the 1990’s. I know computers came into widespread use then; but even so that implies that seven years ago the market had already valued stocks for future growth of the economy (because of computers) as if the private economy was going to be more than twice to three times the size it is today. I’m not really comfortable with that explanation. Looks more like a really big bubble that will continue to pop for a while.

[stig]

National Output: GDP

Output, the most important concept of macroeconomics, refers to the total amount of goods and services a country produces

A question for FR. How is this measured? Do we just look at number of units sold by American companies? Because I don't see how we could be losing manufacturing jobs and continue with increases in GDP coupled with rising unemployment.

Also (as an aside) has productivity really increased or are we counting in the fact that we no longer do anything here in the US. So ipso facto we automatically have less people here in the US moving the same goods and services?

[April Lexington]

You appear to dismiss poor education and indifference of students as an immutable fact. If so, no political measures would help. Our economic prospects depend on our values, and the latter are broken.

BINGO! If the people don't acre, then, they don't care what kind of system they live under. As long as the food is good, the beer is cold and the condoms fit...

[Son House]

I think they get near that idea in this article, these are intentional excepts, sometimes the opinions are distracting;

What Should GDP Mean To You?

http://www.forbes.com/2009/10/22/gdp-guidance-earnings-intelligent-investing-consumers.html

He suggests investors look at the GDP over three quarters to see a trend rather than just looking at it quarter by quarter.

Tom Higgins, chief economist at Payden & Rygel, an investment management firm, says that GDP is correlated to corporate profits. The GDP measures the production output, which is met by demand and leads to profits. Therefore, “the faster the growth in GDP, the faster companies will be able to raise revenues and get profits,” he says.

Government spending could also boost GDP.

For investors who want to determine where corporate profits are headed, look at how sustainable the growth drivers of GDP are.

If GDP is growing because of something more cyclical like inventory replenishment and government spending, those profits might not last too long. “You want to see GDP stability before you start overweighting consumer discretionary stocks,” Higgins says.

[ChessExpert]

“Although it is consumers who ultimately determine the direction of the economy, governments also influence it through fiscal and monetary policy.”

The author has a blind spot. There is no mention of investment and investors. In Keynesian economics, which is taught in all schools, aggregate demand = C + I + G, consumption, investment, government. The Chicago and Vienna schools of economics are also aware of investment. Leave out investment and investora, and you you just about get what we are getting now, capital flight and growing unemployment.

[Son House]

When they get to the part about ‘What Government can do’ be careful, they are not talking about the Bankrupt, Corrupt One

^
I kinda tried to address that in the first post because I could not find a date for that article, I think it was before the Stimulus bill, the part that really got me

=>
or lower government spending in order to conduct a fiscal contraction. What this will do is lower real output because less government spending means less disposable income for consumers.

^
less disposable income for Democrat constituents

[Forgiven_Sinner]

My comment: "Very interesting. Theoretically, the value (capitalization to GDP ratio) should be around 100%, not 50%. That says that historically, the stock market has been under invested."

Refering to this formula:

Your comment: "What's the theory here? Could you expand?"

Sure. The GDP of the stock market would be all the income of the all the stocks in the market for one year. The market capitalization would be all the prices of all the stocks times all the shares.

I thought market GDP might refer to the capitalization to the market's revenue, but the definitions I have seen don't seem to support that.

A ratio of 1:1 of Price to Earnings would be very low for the market. I think I must be misunderstanding the definition some way. I cannot see my error. Can you?

[TopQuark]

I think your analysis is exactly right --- up until the conclusion.

Think of a given stock market as a stock of a single company. The price of it today is the market capitalization. The earnings of the "company" that issued the "stock" is "the market GDP" (whether trailing or projected is not important at the moment, right?). The ratio, as you correctly pointed out is simply the market's P/E.

In theory, then, what should this P/E equal to? This is clearly an ill-posed question, because P/E of any stock reflects not only the current or next-period earnings but also (the current beliefs regarding) all future earnings (in periods 1,2,...infinity). That is why we see P/E values having a wide range of values: two companies with the same E are assigned by the market very different P's because people have widely different beliefs about the future of the two companies. We also see that P/E of a given stock changes over the course of a quarter, although the reported E stays the same: people change their beliefs depending on the news they acquire, and assign P accordingly.

It appears, therefore, that the "theory" cannot assign the value of P/E to the market just as it cannot do that for any stock of a real company: other factors (beliefs) must be taken into consideration by any theory that attempts to do so.

[ Consider the "market" in the formula to be the set of SP500. Then the formula yields a widely reported "P/E of the SP500." As you know, people often speculate on whether the market is under- or overvalued depending on the value of that P/E. This P/E, in line with the foregoing, is also oscillating --- from low teens, as far as I remember to 35 or so.]

Does all this make sense to you?

[Forgiven_Sinner]

Hi TopQuark,

Thanks for the reply. My main concern was the definition of “stock market GDP”. I knew what GDP was—all production of goods and services in the US. That doesn't map clearly to either profits or revenues.

You are correct that one cannot “assign” a P/E ratio to a stock, group of stocks, or the entire market. Rather, it is a consensus decision of the entire market that assigns it.

There still seems to be a contradiction between the observed P/E ratios of stocks (5-100 is the rough range) and the observed capitalization to “market GDP” ratio (50% to 150%). I would expect the group to follow the individual stocks. Since it varies so wildly, I think I still don't have the correct definition of “market GDP”.

[TopQuark]

"My main concern was the definition of “stock market GDP”. I knew what GDP was—all production of goods and services in the US."

I never questioned that you knew that, of course.

Application to "stock market" requires some care. For GDP, the universe is all producers of a nation, and the GDP itself is the sum total of output of all members of that universe.

Similarly, the universe of "stock market" is a set of companies with given stocks --- SP500, for instance. The GDP of that stock market is the sum total of earning in that universe.

"You are correct that one cannot “assign” a P/E ratio to a stock, group of stocks, or the entire market. Rather, it is a consensus decision of the entire market that assigns it."

I am sorry I did not make that clear, but it is not the consensus issue. Even one decision-maker cannot assign the same price P given E, because his decision (P) is affected also by factors other than E, namely, ALL FUTURE EARNINS of the company (hence dividends, which are the cash flows received by the decision-maker that owns the stock). You probably know the formula for the valuation of the stock based on its dividend: it is the result of summation over all FUTURE periods, from 1 to infinity. [Of course, since we don't know the future, what enters the formula is the d-maker's BELIEFS about the future or, as practitioners refer to it, estimates of the earnings and dividends.

"There still seems to be a contradiction between the observed P/E ratios of stocks (5-100 is the rough range) and the observed capitalization to “market GDP” ratio (50% to 150%). I would expect the group to follow the individual stocks.

The opposite should be true. The larger the sample, the closer the observed value to the average over the sample. So if you measure something --- whatever it is --- and it varies over the range 5-100, you can be almost sure that the observed value for the entire sample is closer to the average. Formally, this is expressed by various versions of The Central Limit Theorem (it does have assumptions, and one has to make sure that those assumptions hold, but the intuition expressed by the Theorem is correct in most business situations). "I still don't have the correct definition of “market GDP”."

Your definition is the same as used by all analysts and S&P. When they report "P/E for the SP500 index," they take the total (sum) capitalization of the 500 stocks and divided by the sum of earning of those companies (trailing or projected). There is nothing wrong with that definition or that computation. It is the intuition that leads one to expect the ration to be close to 1 that lacks support.

[Forgiven_Sinner]

Thanks for the interesting discussion. I'm afraid I haven't always been clear with you. Let me rectify that.

"Similarly, the universe of "stock market" is a set of companies with given stocks --- SP500, for instance. The GDP of that stock market is the sum total of earning in that universe."

Thanks for clarifying the term.

I said: "You are correct that one cannot “assign” a P/E ratio to a stock, group of stocks, or the entire market. Rather, it is a consensus decision of the entire market that assigns it."

You said: "I am sorry I did not make that clear, but it is not the consensus issue. Even one decision-maker cannot assign the same price P given E, because his decision (P) is affected also by factors other than E, namely, ALL FUTURE EARNINS of the company (hence dividends, which are the cash flows received by the decision-maker that owns the stock). You probably know the formula for the valuation of the stock based on its dividend: it is the result of summation over all FUTURE periods, from 1 to infinity. [Of course, since we don't know the future, what enters the formula is the d-maker's BELIEFS about the future or, as practitioners refer to it, estimates of the earnings and dividends."

Yes, the valuation of the stock price based upon future earning is not a question in my mind. I was not clear enough by what I meant by "consensus". By this, I mean the MARKET consensus on the stock price. That then gives the consensus on the appropriate P/E ratio.

I said: "There still seems to be a contradiction between the observed P/E ratios of stocks (5-100 is the rough range) and the observed capitalization to “market GDP” ratio (50% to 150%). I would expect the group to follow the individual stocks."

You said: "The opposite should be true. The larger the sample, the closer the observed value to the average over the sample. So if you measure something --- whatever it is --- and it varies over the range 5-100, you can be almost sure that the observed value for the entire sample is closer to the average. Formally, this is expressed by various versions of The Central Limit Theorem (it does have assumptions, and one has to make sure that those assumptions hold, but the intuition expressed by the Theorem is correct in most business situations)."

I am familiar with the central limit theorem. My point was, (which I did not make explicit) the stocks at the low end of the P/E range were at 5, but the historic stock market cap to earnings ratio is is at .5--how can that be? If the low end of the sample is 5, surely the average will be higher for the entire market? Why is the ratio so low, given the P/E ranges?

You can see why I said "I still don't have the correct definition of “market GDP”."

"Your definition is the same as used by all analysts and S&P. When they report "P/E for the SP500 index," they take the total (sum) capitalization of the 500 stocks and divided by the sum of earning of those companies (trailing or projected). "

This sample of the SP500 shows a P/E ranging from 5-45 over 130 years:

Given this large sample, how can the market capitalization ration be historically under 1?

[TopQuark]

"the historic stock market cap to earnings ratio is is at .5"

Could you please given me a reference where this number is derived?

[Forgiven_Sinner]

I said: "the historic stock market cap to earnings ratio is is at .5"

You said: "Could you please given me a reference where this number is derived?"

Sure. Post 10 has:

[TopQuark]

I think I understand now where the disconnect lies. The chart uses the capitalization of PUBLICly traded companies and divides it by the GDP of the entire nation. Well, in a nation, only a portion of the companies that contribute to GDP are public. Think of all the laudromats, fast food franchises, small hotels and motels you drive by. They all contribute to the GDP but PRIVATEly owned.

The ration on on the chart is therefore NOT a P/E ratio. To arrive at such, they should divide not by the GDP of U.S. but by the sum of all the earnings of NYSE+NASDAQ.

Make sense?

[Forgiven_Sinner]

Thank you for your patience in clarifying that. Now I have to rethink my understanding of that chart. What it says is that market capitalization dramatically increased from ‘82 until the collapse of the dot com bubble in 2000. It still has not returned to its mean of 60%. The question I have is, has the mean moved? What has changed between ‘82 and now?

Candidate ideas: 1) the Reagan tax cuts; 2) the increased productivity due to PC’s; 3) the beginning of IRA’s (increased demand for market securities);

Any ideas?

[TopQuark]

" The question I have is, has the mean moved?"

I has certainly moved. If you add to a sample (marketcap values) values that are predominantly large (1982-1999) --- more precisely greater than the mean --- the new mean will be larger.

"What has changed between ‘82 and now? You are essentially asking the question, what makes bull markets?

"Candidate ideas: 1) the Reagan tax cuts; "

That certainly had a role from 1982 to mid 1980s.

"2) the increased productivity due to PC’s;"

At the time, this was one of the factors credited with the 1990s boom.

"3) the beginning of IRA’s (increased demand for market securities);"

You are probably correct here, too. Whether its effect was large is unclear to me. What funds paid for the IRAs? If people purchased securities with cash they would otherwise invest in mutual fund, then the effect is zero, since the funds would invest in securities anyway. If they bought securities with funds that they would otherwise spend on consumption goods, then the effect should be there. I just don't know data to have any intuition here.

Another difficult question is, of course, whether your list is exhaustive. As one identifies smaller factors, it becomes progressively difficult to identify their respective effects.

[Forgiven_Sinner]

I said: “ The question I have is, has the mean moved?”

You said” I has certainly moved. If you add to a sample (marketcap values) values that are predominantly large (1982-1999) -— more precisely greater than the mean -— the new mean will be larger.

“What has changed between ‘82 and now? You are essentially asking the question, what makes bull markets?”

Actually no. What I really mean, has the mean ratio permanently moved from 60% to 80-100%, through bull and bear markets? Is the time period from 1980-2010 merely an aberration that will return to the 60% mean, or has there been a permanent change in our nation's financial structure?

The Reagan tax cut effects continued until the 1990 budget when taxes were increased, causing the recession. Less obvious effects were deregulation of energy markets, which lowered the price of oil.

The IRA law passed in the 80’s definitely moved money from consumption to savings in bonds and stocks. For the first time, middle class people had a tax shelter for their income. This created an increased demand in stocks. This was extensively commented upon throughout the 90’s.

Perhaps the greatest act that President Clinton did was the 1994 NAFTA agreement which caused booms in the US, Mexico, and Canada. That agreement negated the effect of his tax increase.

Combined with the 1994 Republican takeover of Congress and a reduction in Federal spending, the 90’s were good for business and labor.