Adapted from International Financial Markets, Amir Yaron of the Wharton School (Finance 219/719)
Part 1. Foundations of Int’l Financial Management

Chapter 2 Outline
-Balance of Payments Accounting
-Balance of Payments Accounts
—-The Current Account
—-The Capital Account
—-Statistical Discrepancy
—-Official Reserve Account
-The Balance of Payments Identity
-Balance of Payments Trends in Major Countries
-Summary

Chapter 2 Takeaways

-Balance of Payments (BOP) Accounting
Defined as a statistical record of a country’s transactions with the rest of the world over a certain period of time in the form of double-entry bookkeeping. It provides information about 1) demand and supply of its currency. 2) its potential as a business partner for the rest of the world – a surplus increases chances that it would accept imports. 3) the performance of the country in international competitivity – trade deficits => domestic industry lacks competitiveness.
-Balance of Payments Accounts
International trade as well as cross-border investments are recorded in the BOP.
—-The Current Account
Export and import of goods and services. Subdivided into 1) Merchandise trade (trade balance), 2) Services (invisible trade), 3) Factor Income (eg interest, dividends, other invome on investments), 4) Unilateral transfers (“unrequited payments”) e.g. foreign aid, reparations, grants, gifts. treated as goodwill in accounts . Since a deficit must be financed by borrowing from foreigners or drawing down on wealth, a deficit represents a reduction in net foreign wealth. J-curve effect: the initial deterioration and the eventual improvment of the trade balance following a depreciation, evidenced by a 1967 British devaluation. Research shows this occurs 40% of the time, and theory shows this happens only if imports and exports are inelastic (short run).
—-The Capital Account
Purchases and sales of assets like securities, real estate, businesses. Can be divided into 1) direct investment e.g. FDI – acquisitions, building factories 2) portfolio investment e.g. assets that do not involve a transfer of control, 3) other investment e.g. transactions in currency, bank deposits, trade credits, etc. 
—-Statistical Discrepancy
Differences arising from difference in methods used to record transactions.

The cumulative BOP including the current account, capital account, and statistical discrepancies = overall balance/official settlement balance. This indicates the gap that must be accommodated with the govt’s official reserves.
—-Official Reserve Account
All purchases and sales of international reserve assets such as gold, dollars, forex, and SDRs. To support gold, sell assets and “buy” dollars. World reserves – 63.8% is USD, 19.7% is Euro (2003 figures) 2% gold.
-The Balance of Payments Identity (BOPI)
BCA + BKA + BRA = 0 (C = current, K = capital, R = reserves)
With pure flexible exchange rate regime, no reserves are needed so BCA = -BKA is possible.
Identity not Causation: it is equally possible to argue that current account deficits lead to capital account surpluses as the other way around.
-Balance of Payments Trends in Major Countries
US has current deficits (up to $531b), capital surpluses. Largest debtor nation.
Japan has current surpluses, capital deficits. Lagest creditor nation.
UK current deficits, capital surpluses.
Germany current surpluses, capital deficits. Brief period of current deficits in 1991-2001 due to reunification.
China current surplus, capital surplus. Official reserves up to $610b in 2004.
-Summary
A country need not achieve BOP equilibrium every year. If a trade deficit is due to import demand for capital goods for economic development projects, the deficit can be self correcting in the long run because supply expansion can increase exports/decrease imports. However if the deficit is due to importing consumption goods, the situation will not correct by itself.

Adapted from International Financial Markets, Amir Yaron of the Wharton School (Finance 219/719)
Part 1. Foundations of Int’l Financial Management

Chapter 1 Outline
-Evolution of the Int’l Monetary System
—-Before 1875: Bimetallism
—-1875 – 1914: Classical Gold Standard
—-1915-1944: Interwar Period
—-1945-1972: Bretton Woods System
—-1973-Present: The Flexible Exchange Rate Regime
-Current Exchange Rate Arrangements
—-European Monetary System
-Mexican Peso Crisis
-Asian Currency Crisis
-Argentine Peso Crisis
-Fixed v Flexible Regimes
-Summary

Chapter 1 Takeaways

-Evolution of the Int’l Monetary System
Defined as the institutional framework within which int’l payments are made, movements of capital are accommodated, and exchange rates determined.
—-Before 1875: Bimetallism
Free coinage of Gold and/or Silver in many countries incl US and UK, China, Germany. e.g. Official exchange rate btw Pound and franc determined by the actual gold content of the two currencies.
Gresham’s law: Since the exchange ratio between two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation. Bad money drives out good money. When gold was found in California and Australia, gold became overvalued in the official ratio.
—-1875 – 1914: Classical Gold Standard
3 conditions: 1) gold alone is assured of unrestricted coinage, 2) there is 2 way convertibility btw gold and nat’l currencies at a stable ratio, and 3) gold may be freely exported or imported. BoE started issuing gold redeemable notes in 1821. During this period London became the center of the int’l financial system.
Under the gold standard, misalignment of the exchange rate will be corrected by cross-border flows of gold. Int’l imbalances of payment will also be corrected automatically. Net export from A to B will be accompanied by a net flow of gold in the opposite direction, raising relative price levels in A, slowing exports from A and ensuring the intial net export from A will disappear. This is known as Hume’s price-specie-flow mechanism.
**There are still supporters of gold standard today – it controls inflation well. However the growth in supply of gold would restrict today’s growth in world trade and investment, causing deflation instead. Additionally, governments can leave the standard easily.
—-1915-1944: Interwar Period
econmic nationalism. halfhearted restoration of gold. bank failures. WW1 ended the standard -> hyperinflation in all countries that suspended the GS. Countries also depreciated their currencies to gain an edge in world export. US now int’l financial center, led return to GS in 1919. However it was not followed by any party – countries followed a sterilzation of gold policy in matching flows of gold with changes in domestic money and credit, giving themselves control of domestic economies. It was finally dropped after the 1929 Depression.
—-1945-1972: Bretton Woods System (BWS)
July 1944 – Bretton Woods system launched IMF and IBRD (World Bank). IMF set rules about the conduct of int’l monetary policies and enforced them. BWS designed to prevent recurrence of economic nationalism. Each country established a par value to the USD which was in turn fixed at $35/ounce of gold, with responsiblity to maintain their currencies within 1% of that par. Because the USD was an intermediary, countries could use that as an international means of payment on top of gold, solving the problem of deflationary effects from limited gold supply. However, Prof. Robert Triffin warned of its inbuilt collapse. To satisfy growing need for reserves, the US had to run BOP deficits continuously, eventually triggering a run on the dollar and causing the downfall of the system. The Triffin paradox concluded as predicted in the 1970s. Defensive measures included the Kennedy Interest Equalization Tax (increasing cost of foreign borrowing), the Fed’s Foreign Credit Restraint Program (limted amount US banks could lend for FDIs), IMF’s Special Drawing Rights (an artificil int’l reserve and payment currency), and finally the Smithsonian Agreement (last minute, short-lived attempt at revaluation that was not bold enough to stabilize the situation).
—-1973-Present: The Flexible Exchange Rate Regime
Ratified in 1976 in the Jamaica Agreement: 1) Flexible rates were declared acceptable to IMF, and central bank intervention allowed, 2) Gold was formally demonetized as an int’l reserve, 3) Non-oil exporting countries and LDCs given greater access to IMF funds. IMF continued to extend assistance under conditions of economic policy prescriptions.
Rates were more volatile – Dollar rose from 1980-84 due to high interest rates in the US from Reagan era deficit spending, and fell from 85-88 because of its trade deficit and also the 1985 Plaza Accord. Its fall was stopped by the Louvre Accord in 1987, marking the inception of the managed-float system of the G7 countries.
-Current Exchange Rate Arrangements
the IMF classifies 8 regimes: Exchange arrangements with no separate legal tender e.g. Eurozone, and Ecuador, Panama using USD, Currency board arrangements e.g. HK and Estonia’s fixes by legislative commitment, Other conventional fixed peg arrangement, e.g. peg to a currency or basket of currencies as in Morocco, Saudi Arabia, and Ukraine, Pegged exchange rates within horizontal bands, maintained within margins wider than 1%, e.g. Denmark, Slovenia, and Hungary, Crawling pegs currency is adjusted at a preannounced rate or with indicators like Bolivia, Costa Rica, and Tunisia, Exchange rates within crawling bands, like Belarus and Romania where the bands as well as the peg crawl, Managed floating with no preannounced path, eg Algeria, China, Czech Rep, India, Russia, Singapore, Thailand, Independent float e.g. Australia, Brazil, Canada, Korea, Mexico, UK, Japan, Switz, and US.
—-European Monetary System
launched March 1979, with the Exchange Rate Mechanism based on a “parity grid system”, a system of par values among currencies. In the 1991 Maastricht Treaty, the EMS irrevocably fixed rates and introduced the Euro in 1999. The agreement was to achieve a convergence of economies: 1) keep ratio of govt deficits to GDP below 3%, 2) keep debts below 60% GDP, 3) achieve price stability, 4) maintain currency within ERM ranges. Modelled after the successful Bundesbank, the European Central Bank was guaranteed to not have political pressure, aiming for an inflation rate of less than 2%. The national central banks formed the European System of Central Banks similar to the Federal Reserve US System, charged with duties: 1) define and implement monetary policy, 2)conduct forex operations, 3) hold and manage official eurozone reserves. Euro has been appreciating against USD since 2002 reflecting a slowdown in US and fewer European investments in the US. The benefits of union were lower transaction costs, elimination of exchange rate uncertainty, promoting corss-border trade and mergers and indirectly international competitiveness of EU companies, creating capital markets as deep and liquid as US markets - a 2004 study confirmed that cost of capital in eurozone was lower, adding 17% to firm values. The cost is loss of national monetary and exchange rate policy independence, important if the country is trade dependent. In theory this should be moderated by free capital and labor flows.
Will the Euro overtake the USD? it is comparable in population, GDP, and international trade share, as well as in bond markets.

Crises
-Mexican Peso Crisis
Dec 20, 1994 – President Zedillo devalued peso by 14% sparking a run of 40%, forcing the govt to float the peso. This spilled over to other Latin American and Asian markets as investors reduced holdings across the board. Clinton administration and IMF and BIS bailed out Mexico with a $53bln package, though the crisis stabilized just before. Investors had built up $45 bln of hot money in Mexico in the 3 years prior. 2 lessons: 1) it is essential to have a multinational safety net; political processes cannot cope with rapidly changing mkt conditions and 2) one cannot depend too much on foreign portfolio capital – should save domestically and depend on long term rather than short term investments. The G-7 endorsed a $50b bailout fund for countries in distress in the future.
-Asian Currency Crisis
July 2 1997 Thai baht was suddenly devalued, sparked further crises in Korea, Brazil and Russia. Far more serious than the preceding Mexican or European crises – corporations with foreign currency debt were driven to default. Economies went into a deep longlasting recession. Investors suffered large capital losses. Factors responsible: weak domestic financial system, free capital flows, contagion effects of changing market sentiment, and inconsistent economic policies. Lessons: liberalization of markets combined with a weak domestic system tends to create an environment susceptible to crises. Measures include strengthening system of financial sector regulation and supervision (e.g. Basel/Basle), prioritizing objective, not crony, lending, transparency, Tobin taxes. Countries also need to make choices about the “incompatible trinity”: only two out of the three of 1)fixed exchange rate, 2) free capital flows, and 3)independent monetary policy can be achieved at the same time.
-Argentine Peso Crisis
January 2002 – currency board arrangement also vulnerable to collapse, unless it is backed by political will and economic discipline. Factors – lack of financial discipline, labor market inflexibility, contagion from financial crises in Russia and Brazil. The govt encountered difficulty in raising debts, strong unions made it hard to lower costs, and the fixed rate disallowed the govt from restoring competitiveness thru depreciation. Argentina is still in default of over $100b in debt.
-Fixed v Flexible Regimes
For flexible: 1) easier external adjustments, 2) national policy autonomy. Against flexible: Uncertainty hampers trade and investment.
-Summary
A good int’l monetary system should provide 1) liquidity, 2) adjustment, and 3) confidence. it should provide the economy with sufficient monetary reserves to support the growth of int’l trade and investment. it should also provide an effective m echanism that restores the BOP equilibrium whenever it is distrubed. Last, it should offer a safeguard to prevent crises of confidence.

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 14 Chapter Guide

Prelude

Economic Data and the Market

Principles of Market Reaction

Information Content of Data Releases

• Economic Growth and Stock Prices
  • The Employment Report
  • The Cycle of Announcements
• Inflation Reports
  • Core Inflation
  • Employment Costs
  • Impact on Financial Markets
• Central Bank Policy

CONCLUSION

—————————————–

Chapter 14 Chapter Takeaways

Prelude
-Anecdote on the impact of US employment statistics. Low employment in 1996 -> Bonds collapsed as traders expected higher rates. S&P futures fell. European markets sold off almost 2% – world equity markets lost $200 bilion, and world bond markets just as much. Main Street’s good news can be bad news on Wall Street, because interest rates, inflaiton, and the future direction of the Fed policy have a major impact as well as mere profits.

Economic Data and the Market
-Economic data not only frame the way traders view the economy but also impact traders’ expectations of how the central bank wil implement its monetary policy. Stronger economic growth or higher inflation increases theprobability that the central bank wil either tighten or stop easing monetary policy. ALl these data influence traders’ expectations about the future course of interest rates, the economy, and ultimately stock prices.

Principles of Market Reaction
-Markets do not respond to what is announced; they respond to the difference between what traders expect to happen and what actually happens. TO understand movements, one must identify the market expectation for the data released, often the consensus estimate.

Information Content of Data Releases
-Data are analyzed for implications on future growth, inflation, and central bank policy.
-Faster growth raises interest rates because: 1. stronger economic activity makes consumers confident, increasing loan demnd. Firms motivated to expand production, increasing demand for credit. 2. this growth might be inflationary especially at the end of an economic expansion, without corresponding growth in productivity.
-Central banks: the threat of inflation make it likely that the bank will tighten credit.
-Another important principle: the market reacts more strongly after several similar reports in the same direction, as there is a lot of noise in individual reports.

• Economic Growth and Stock Prices
  -Stronger-than-expected growth has 2 opposite implications for the market. A strong economy increases future earnings. But it also raises interest rates. Which effect is stronger depends on where the economy is in the business cycle. From research, a strong report increases stock prices in a recession as profits are considered more important. DUring expansions, the interest rate effect is usually stronger.
  • The Employment Report
    -Bureau of Labor Statistics – single most important data report. It does 2 different surveys, measuring employment and unemplyent. The payroll (also “establishment”) survey counts total jobs on payrolls. The household survey counts total number of people looking for jobs, determining the unemployment rate. Traders typically look at nonfarm payroll as farm employment is very volatie and not associated with cyclical economic trends. Because these are 2 different surveys, the rates can both rise for a few reasons. Economists downplay the importance of this figure because of that. Since 2005, Automatic Data Processing corp has released its ADP National Emplyment Report which provide hints at BLS data 2 days ahead.
  • The Cycle of Announcements
    -See pg 243 for monthly chart of announcements.
    -Purchasing managers index – a reading of 50 means half the managers report rising activity. A reading of 52 is a normally expanding economy. A 60 means a strong economy. Below 50 is a contracting manufacturing sector, and below 40 is almost always a sign of recession. A service sector index is also published two days after this.
    -There are many reports released before those with good correlations, like the Chicgo Purchasing Managers report, UMIch sentiment indicators, and COnference Board survey.
• Inflation Reports
  -The first inflation release is the Producer price Index. The next day – th Consumer Price index, the benchmark measure of inflation, also a link to many government and private contracts. However economists regard the PPI as more sensitive to early price trends as wholesale prices rise before retail.
  • Core Inflation
    - Excluding volatile food and energy sectors (which change due to weather and disruptions). Greenspan and Bernanke have supported the personal consumption expenditure deflator in calculating the consumption component of the GDP accounts.
  • Employment Costs
    -Labor costs – hourly wage rate. Since labor costs average nearly 2/3 of a firm production costs, increases in wage over increases in productivity increase costs and lead to inflation. the Employment index released quarterly also includes benefit costs so is more comprehensive. The Fed weighs this more and so do the markets.
  • Impact on Financial Markets
    -Lower than expected inflation lowers interest rates, boosts bond and stock prices. vice versa.
• Central Bank Policy
  -Chapter 13 showed that 4 of the top 5 largest one-day rallies were involved with monetary policy. Lowering short term rates and providing credit is almost always welcome.
  -Chapter 11 showed that over the past 50 years, tightening by the Fed was associated with poor returns over the next year while easing boosted the market.
  -The only case in which stocks react poorly is if the CB eases excessively so the market fears increase in inflaiton. If so, the investor would prefer to be in stocks than bonds as bonds are hurt more by unexpected inflation.

CONCLUSION
-The reactions of financial markets are not random and can be predicted. Strong growth raises rates but has an ambiguous effect on stock prices. Inflation is bad. Cenral Bank easing is good.
-The focus of traders constantly shift – in the 1970’s, inflation was prime. Volcker then shifted it to monetary supply. 1980’s when the dollar soared, trade stats were it.
-This chapter focused on the short run reaction of financial markets to economic data. Investing on the basis of these releases is a tricky game.

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 13 Chapter Guide

Prelude

WHAT MOVES THE MARKET?

1. UNCERTAINTY AND THE MARKET
2. DEMOCRATS AND REPUBLICANS
3. STOCKS AND WAR
   -The World Wars
   -Post 1945 Conflicts

CONCLUSION

—————————————–

Chapter 13 Chapter Takeaways

Prelude
-On 9/11, S&P futures plunged about 3 percent, indicating nearly $300b would have been wiped off of US stock values if markets had been opened. They were closed for the week but the German DAX fell over 9%. London also suffered. The Pound and the Euro rallied against the dollar with the US’ new vulnerability. When the NYSE opened on Sept 17, the Dow fell 7.13%, and closed the week down 14% from Sept 10.

WHAT MOVES THE MARKET?
-However, many moves arent accompanied by news at all. Since 1885, there have been 126 days when the DJIA changed by 5% or more. However only 30 of those can be explained with a world political/economic event (Data provided). Monetary policy is the biggest driver. The 22.6% one day fall on Oct 19, 1987 is not associated with any identifiable news event.
-Even when news has occurred, there can be sharp disagreement over what news caused the market change. On Nov 15 1991 when the Dow fell 4%, headlines in Investor’s BUsiness Daily read “Dow Plunges 120 in a Scary Stock Sell-off: Biotechs, Programs, Expiration, and Congress get the Blame”. the FT read “Wall Street Drops 120 Points on Concern at Russian Moves”.

1. UNCERTAINTY AND THE MARKET
   -The markets hate uncertainty. Eg post Sept 11: How big a hit would the $600b tourist industry take?. Presidents are one source. Eisenhower’s heart attack – 6.54% decline. JFK – 2.9% decline before NYSE shutdown for 2 days, and 4.5% increased when LBJ took over.
2. DEMOCRATS AND REPUBLICANS
   -The markets prefer republicans to democrats. However the stock market has actualy done better under Democrats than Republicans. The greatest bear market occurred under Herbert Hoover (R), and the greatest bom under FDR (D). Yet since 1888, the market fell avg 0.5% following a Democratic victory, but rose 0.7% following a Republican victory, though this effect has muted since WW2.
   -The returns in a third year of a presidential term are clearly the best. The fourth is not.
   -Since 1888, the market has fared better in nominal terms under Democrats than Republicans, but since inflation has been lower when Republicans held ofice, real stock returns have been slightly higher under Republicans than Democrats, though this has not been true the past 60 years when the market performed far better under Democrats on real and nominal terms.
3. STOCKS AND WAR
   -Since 1885, the US economy has been involved in a war about 1/5th of its time. Inflation averaged 6% during wartime and less than 2% during peacetime while stocks perform nominally equally.
   -Stocks have actually been more volatile during peacetime than during war. Theory indictes that war should be profoundly negative on stock prices due to government interventions.
   -The World Wars
   – The market rose nearly 100% during early WW1, then fell 40% when the US became involved and rallied when it ended. WW1 was far more volatile than WW2. When Austria-Hungary declared war on Serbia on July 28 1914, the markets remained closed until December 12. Illegal trading continued outside NYSE with prices 15-20% below the July close. But Traders soon realised that the US would benefit from the rise in demand for munitions and raw materials, and when the NYSE reopened the Dow rose 5% higher. 1915 is the best single year increase in the Dow, up 82%. Stocks fell 10% when the US entered the war on APril 16 1917.
   –Traders learnt this lesson in WW2 – When Great Britain declared war on Germany on Sept 3 1939, a buying panic caused the Dow to gain 7%. This faded as FDR imposed an excess profits tax on corporations during wartime. On Pearl Harbor, the Dow was down 25% from its 1939 high and after PH it fell 3.5%. By the time Germany surrendered in May 7 1945 the Dow were 20% above the prewar level. The detonation of the atomic bomb over Hiroshima caused stocks to surge 1.7%.

   -Post 1945 Conflicts
   –The Korean War – Jun 25, 1950, the Dow fell 4.65%, > Pearl Harbor fall because it took markets by surprised. The Vietnam War – the Dow climbed 18% over the first 1.5 years, but fell 30% when the Fed moved to curb inflation in the following months. Markets then recovered, but when Nixon sent troops into Cambodia, the market fell again. The 1991 Gulf War – Oct 11, Dow slumped 18% with oil price news and a US recession. After the US joined the Gulf War on Jan 17, stocks soared 4.4% on Jan 18, Dow ending 18% higher on Feb 28 when the war ended. War on Terrorism – Dow down 16% by Sept 21 but rebounded on the Afghanistani offensive. Because of the success of the Afghanistani war and aggresive Fed policies, the Dow rose 26.3% FROM sEPT 21 TO dEC 28. From the end of March 2003, the first month of the Iraq invasion thru June 2007, the annual return on the market was an extremely srong 17.5% per year.

CONCLUSION
-When investigating the causes of major market movements, it is sobering to realize that less than one in four can be linked to a news event of major economic or political import. This confirms the unpredictability of the market and the difficulty in forecasting market moves. Those who sold in panic at the outbreak of World War 1 missed out on 1915, the best year ever in the stock market. But those who bought at the onset of WW2, believing there would be a replay of WW1 gains, were disappointed because of the government’s determination to cap wartime profits. World events may shock the market in the short run, but thankfully they have proven unable to dent the long-term returns that have become characteristic of stocks over the long run.

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 12 Chapter Guide

Prelude

WHO CALLS THE BUSINESS CYCLE?

STOCK RETURNS AROUND BUSINES CYCLE TURNING POINTS

GAINS THROUGH TIMING THE BUSINESS CYCLE

HOW HARD IS IT TO PREDICT THE BUSINESS CYCLE?

CONCLUSION

—————————————–

Chapter 12 Chapter Takeaways

Prelude
-Anecdote. Lesson: Markets and the economy are often out of sync. Many investors dismiss economic forecasts. HOWEVER: the market still responds powerfully to economic changes.
-Altho a market decline might not be followed by a recession, stocks almost always fall prior to a recession and rally on an impending recovery. If you can predict the business cycle, you can beat the buy-and-hold strategy. Wall Street loves this not because they are successful at it but because of the potential gains.

WHO CALLS THE BUSINESS CYCLE?
-The dating of business cycles is done by NBER, a private body founded in 1920 which keeps data back to 1854.
-Common definition of a recession = 2 quarters of negative econ. growth. However NBER actually uses 4 facotrs: employment, industrial production, real personal income, and real manufacturing/trade sales.
-Over the past 2 centuries, the 46 recessions have an average length of 19 months while expansions average 34 months. Since WW2, there have been 10 recessions, avg 10 mths, and expansions avg 66 months.
-NBER takes care not to make mistakes in calling the peaks and troughs, sometimes collecting data til 20 months after the fact.

STOCK RETURNS AROUND BUSINESS CYCLE TURNING POINTS
- Out of 46 recessions, 42 have been preceded by declines of 8% or more.
- Analysing the 10 post WW2 recessions, returns peaked anywhere from 0 to 13 months before a recession beginning.
- However, as Paul Samuelson noted, “The Stock market has predicted nine out of the last five recessions!” – lots of false alarms. False alarms have increased since WW2.
- Chapter 16 will discuss the 1987 stock crash and explain why it did not lead to an economic downturn, tho its decline of 35.1% is the largest in 200 years of stock returns data.
- The average lead time between a market upturn and an economic recovery has been 4.8 months, as compared to the average 5.7 months that peaks in market precede peaks in the business cycle.
- 2000 to 2002 bear market: Some controversy as to if there were 1 or 2 bear markets. Economic data supports 2.
- By the time the economy has reached the end of the recession, the stock market has risen 22.4% on average, so an investor waiting for tangible evidence that the cycle has hit bottom has missed a substantial rise.

GAINS THROUGH TIMING THE BUSINESS CYCLE
-Switching returns are defined as the returns to an investor who switches from stocks to bills a given number of months before (or after, if predictions ar enot accurate) a business cycle peak and switches back to stocks a given number of months before/after a trough. Buy and hold returns are the returns from holding the market thru the entire business cycle. Excess returns are defined as switching returns minus the returns from the buy-hold strategy.
-Results: it is more important to forecast troughs of the business cycle than it is peaks. Additionally, the maximum excess return of 4.8% per year is obtained by investing in bills 4 months before the busines cycle peaks and in stocks 4 months before the business cycle troughs.
- The long term impact of these gains can be impressive. Successfully predicting the above wil more than triple your wealth compared to buy and hold.

HOW HARD IS IT TO PREDICT THE BUSINESS CYCLE?
-The record is poor. Presidential economic advisors have called recessions 6 years ahead of time.
-Eggert and Moore compiled a summary of a panel of forecasts called Blue Chip Economic Indicators – anecdotes about BCEI was years off target during 1979-82.
-Much data to show how bad forecasters are.

CONCLUSION
-Stock values are based on corporate earnings, and the business cycle isa prime determinant of changes in these earnings. The gains of being able to predict the turning points of the economic cycle are enormous, yet doing so with any precision has eluded all economists. Despite the growing body of economic statistics, predictions are not getting much better over time.
-The worst course an investor can take is to follow the prevailing sentiment about economic activity. The reason is that it will lead the investor to buy at high prices when times are good and everyone is optimistic, and sell at the low when the recession nears its trough and pessimism prevails.
-The lessons to investors are clear. Beating the stock market by analyzing real economic activity requires a degree of prescience that forecasters do not yet have. Turning points are rareloy identified (by forecasters) until several months after the peak or trough has been reached. Byu then it is far too lat eto act in the market.

Stocks for the Long Run
Part 3: HOW THE ECONMIC ENVIRONMENT IMPACTS STOCKS

Chapter 11 Chapter Guide

• MONEY AND PRICES
• THE GOLD STANDARD
• THE ESTABLISHMENT OF THE FED
• THE FALL OF THE GOLD STANDARD
• POSTDEVALUATION MONETARY POLICY
• POSTGOLD MONETARY POLICY
• THE FED AND MONEY CREATION

HOW THE FED’S ACTIONS AFFECT INTEREST RATES

STOCKS AS HEDGES AGAINST INFLATION

WHY STOCKS FAIL AS A SHORT TERM INFLATION HEDGE

• Higher Interest Rates
• Nonneutral Inflation: SUpply-side effects
• Taxes on Corporate Earnings
• Inflationary Biases in Interest Costs
• Capital Gains Taxes

CONCLUSION

—————————————–

Chapter 11 Chapter Takeaways

Prelude: The lessons from history: liquidity and easy credit feed the stock market, and the ability of the central banks to provide liquidity at will is a critical plus for stock values (referring to reactions to the GOld Standard in UK and US before the depression)

• MONEY AND PRICES
  -In the last 60 years there has never been a year where the CPI declined. What changed? control of the money supply has shifted from gold to the government. With this shift, a new system. The key? Money Supply. see your favorite economics text of choice for more details.
• THE GOLD STANDARD
  -Adherence to the Gold Standard was why the world experienced no overall inflation during the 19th and early 20th Century. However this meant the central bank had no control over money supply during economic or financial crises or in economic growth.
  -Interesting fact: When the governemnt issued non-gold-backed money during the Civil War, the notes were caled greenbacks because the only backing was the green ink printed on the notes. Yet just 20 years afterward, the govt redeemed each of those notes in gold, completely reversing the inflation of the Civil War period.
• THE ESTABLISHMENT OF THE FED
  -Liquidity crises caused by the gold standard led to the Federal Reserve Act of 1913 to provide liquidity to enable depositors to withdraw deposits without forcing banks to liquidate loans and other assets. Yet the Fed was never given guidance on how to determine the right quantity of money.
• THE FALL OF THE GOLD STANDARD
  -In 1929, the Fed failed to provide extra reserves in the face of several bank panics. this caused a widespread, further panic spreading to continental Europe. the gold standards were eventually suspended, rallying confidence in stocks but killing bonds because of inflationary expectations.
• POSTDEVALUATION MONETARY POLICY
  -Bretton Woods: the US governement promised to exchange all dollars for gold held by foreign central banks at the fixed rate of $35 per ounce as long as those countries fixed their currency to the dollar. This backing was removed in 1968 and central banks arbitraged gold prices between market rates and the US $35 price, depleting US reserves from $30billion to $11 billion. President Nixon closed the gold window in 1971 with his New Economic Policy and the link between gold and money was finally broken.
• POSTGOLD MONETARY POLICY
  -The first oil shock from 1973 to 1974 coincided with the relaxaiton on monetary expansion, causing inflaiton. Congress mandated Fed presentations to Congress with the Humphrey-Hawkins Act. In 1979 Paul Volcker announced that the Fed would no longer set interst rates, it would exercise control over the suply of money without regard to interest rate movements. This meant higher interest rates necessary to tame inflation. Inflation had become the world public enemy number 1.
• THE FED AND MONEY CREATION
  -Changing the money supply is straight forward: open market operations.

HOW THE FED’S ACTIONS AFFECT INTEREST RATES
-Fed funds rate: when the Fed buys govt securities, it affects the amount of reserves in the banking system. Banks trade these among themselves in the federal funds market, and the interest rate of these funds is caled the Fed funds rate.
-although the FF rate is an overnight rate, it is an anchor to all short term interest rates. Including the prime rate, th ebenchmark for most consumer and commercial lending.
-Changes in fed funds rates have been a very good predictor of future stock prices: folowing increases in the rate, subsequent returns on stocks in the following 12 months are significantly less than average, and vic versa. (data from 1955-1990s) Yet, Since 2000, the opposite has applied. In June 1999, the Fed raised rates but the market only started to fall in Sept 2001. In 2004, the fed increased rates 17 times but stocks continued to rise through 2006.
-possible reasons to the above: investors have good predictive abilities? Siegel does not have a good answer, but has the data to show the significant disconnect.

STOCKS AS HEDGES AGAINST INFLATION
-The ability of an asset such as stocks to maintin its purchasing power during periods of inflation makes equities an inflation hedge.
-As noted in CHapter 7, many investors stayed with stocks in the 1950s despite seeing the dividend yield on equities fal below the interest rate on long term bonds.
-Figures show neither stocks nor bonds nor bills are good short term hedges against inflaiton. But real returns on stocks are virtually unaffected over long horizons.

WHY STOCKS FAIL AS A SHORT TERM INFLATION HEDGE

• Higher Interest Rates
  -Theory: Inflation could increase interest rates on bonds, and higher interest rates on bonds depres stock prices. Verdict: Incorrect. Higher inflation also means high future cashflows available to stockholders. Future cashflows will also rise with the rise in price levels.
• Nonneutral Inflation: SUpply-side effects
  -Theory: Earnings cannot keep up with inflation i.e bcause restriction in OPEC oil supplies increased energy costs faster than firms could raise prices of their own outputs. Also Inflation has been closely linked to government budget deficits and spending – it is a sign that the govt has too large a role in the economy, meaning lower growth/profits.
• Taxes on Corporate Earnings
  -Corporate profits and capital gains.
  -Depreciation is based on historical costs – during inflation, depreciation allowances are understated since allowances for rising cost of replacing capital are not reportaed. thus Taxable earnings are overstated.
  -Also, in inflation, the gap between inventory prices and selling prices widens, producing inflationary profits for the firm which does not represent a real increase in earning power.
• Inflationary Biases in Interest Costs
  -Ther is a downward bias in earnings due to interest costs. Firms funded with debt are affected. Nominal interest costs rise but real interst costs remain unchanged, overstating the real interest cost to the firm and depressing corporate profits.
• Capital Gains Taxes
  -CG Taxes are paid on the difference between cost and sale price of assets with no adjustment for the impact of inflation. This reduces real returns in inflaitonary times.

CONCLUSION

Before WW2, persistent inflation worldwide was nonexistent. During the Great Depression, the gold standard was thrown out and control passed to central banks. Banks now came to fear inflation and not deflation. The message of this chapter is that stocks are not goodhedges against increased inflation in the short run. No financial asset is. However, they are very good hedges in the long run, while bonds are not. Still, inflation is not good for equity holders.

Stocks for the Long Run
Part 2: Valuation, Style Investing, and Global Markets.

Chapter 10 Chapter Guide

The World’s Population, Production, and Equity Capital

CYCLES IN FOREIGN MARKETS

• The Japanese Market Bubble
• The Emerging Market Bubble
• The New Millenium and the Tech Bubble

DIVERSIFICATION IN WORLD MARKETS

• Principles of Diversification
• “Efficient” Portfolios: Formal Analysis
• Should You Hedge Foreign Exchange Risk?
• Sector Diversification
• Sector Allocation around the World
• Private and Public Capital

THE WORLD IN 2050

CONCLUSION

APPENDIX: The Largest Non US-Based Companies

—————————————–
Chapter 10 Chapter Takeaways

The World’s Population, Production, and Equity Capital
-The Developed world contains less than 15% of the world’s population but it produces over 50% of the world’s goods and headquarters over 93% of the world’s equity capital. For now.

CYCLES IN FOREIGN MARKETS
-In the past (70’s to date), Strong US markets were often coupled with weak foreign markets, vice versa. So a well-diversified world portfolio is important.

• The Japanese Market Bubble
  -Japanese stocks averaged >10% p.a. above US returns over the 1970’s and 80’s. by the end of 1989, the American stock market was no longer the world’s largest. Japanese investors justified PE ratios above 300 by coming up with entirely new ways of valuing stocks. The Nikkei went from 39,000 in Dec 1989 to below 8,000 in 2002.
• The Emerging Market Bubble
  -Emphasis shifted to booms in India, Indonesia, and China, as Taiwan, South Korea, and Thailand had put up ogod performances. Latin America also was impressive in Argentina, Brazil, and Mexico. However the 1997 collapse saw contagion spreading beyond the Pacific Basin to Latin America, Eastern Europe, and Russia. Indonesian, Thai, Russian, Phiippines, and South Korea markets fell more than 80%. Singapore and HK fell 70%. (in USD terms). This indicated that it made more sense to invest back in the US.
• The New Millenium and the Tech Bubble
  -The last 3 years of the 20th century saw strong gains in all stock markets. Yet a few months into 2000 all of the developed countries markets fell by at least 50% (for US, from March 2000 to Oct 2002). European and Jap had 60% and 63% declines respectively. Following 9/11, stocks in US and EU again hit all time highs, yet dollar based investors saw their international stocks far outperform their domestic holdings because the USD fell 33% from 2001 to 2004. (in a reversal of the Emerging Mkt Bubble)

DIVERSIFICATION IN WORLD MARKETS

• Principles of Diversification
  -We do not invest in emerging countries because they are growing faster and therefore will provide beter returns. Chapter 8’s research disproved that. The reason of doing so is to diversify the portfolio and reduce risk. If two countries have zero correlation, a 50-50 allocation will reduce risk by 1/3 compared to the risk of investing in a single country. However countries have become increasingly correlated over time.
• “Efficient” Portfolios: Formal Analysis
  -We identify two forms of risk: local risk, fluctuations in local stock markets themselves, and exchange-rate risk: fluctuations in exchange rates. Table shows Domestic risk ranging from 16-28% and Exchange risk ranging from 5-12.7%.
  -Based on historical data, the best portfolio has a 37.8% foreign stock allocation. Ignoring foreign exchange risk, which is justified for an institution, the optimal portfolio allocation rises to 52.6%.
  -The more correlated foreign and US markets are, the less attractive US stocks are.
• Should You Hedge Foreign Exchange Risk?
  -using Currency hedging (entering into a currency contract that offests unexpected changes in the price of foreign currency relative to the dollar). But for investors with long-term horizons, hedging currency risk in foreign stock markets is not important. Currency hedges may actually increase the volatility of dollar returns as real assets typically adjust to compensate long-term investors for exchange rate risks.
• Sector Diversification
  -However, the returns betwen internationl industrial sectors are becoming less correlated. This is because the business cycle has become moderated, so shifts in sector demands rather than changes in the overall economy become the primary sources of changes in the firm’s profitability.
  -Siegel believes a sector approach to international investing will eventually supplant a country approach, envisioning a future of international incorporations where firms have no headquarter countries.
• Sector Allocation around the World
  -The financial sector is the largest sector in every region of the world. Banks are critical to economic growth.
  -In consumer discretionary sector, Japan has the highest weight because of Toyota Motors, Sony, Honda, and Matsushita. DaimlerChrysler in Europe. Comcast, Time Warner, HD in the US.
  -Consumer staples: US largest, with Europe a close second. P&G, Altria, WalMart. Nestle, Unilever, British Am. Tobacco. Japan has virtually no presence.
  -Energy: large everywhere but Japan which has little energy resources. XOM, Chevron, ConocoPhillips, BP Total, ENI. PetroChina, GazProm.
  -Healthcare: largest share of US firms, smallest share in emerging mkts: Pfizer, J&J, Merck. Europe: GSK, AstraZeneca, ROche, Novartis. Japan: Takeda Pharma.
  -Industrial: largest in Japan, smallest in emerging mkts. Japan: Mitsubishi/Mitsui, Europe: Siemens. US: GE.
  -IT: largest in emerging mkts, cos of Samsung and Taiwan Semicon. Excluding S. Korea and Taiwan, India has 80% of remaining mkt value led by Infosys and Wipro.
  -Telecom: Largest in emerging mkts: Chunghwa Telecom of Taiwan, American Movil of Mexico, and China Mobile. Vodafone in Europe. ATT and Verizon in the US.
  -Utility: 3.5% of US market share led by Exelon Corp, to 7% in europe led by Enel of Italy and Electricite de France.
• Private and Public Capital
  -XOM may be the largest company by market value and largest reserve of oil and gas in the world but it is only the 14th largest if one includes govt-owned companies. Aramco and Iran’s NIOC have far more and have been valued at about $1 trillion each. Much wealth is still owned by governments around the world, especially in land, natural resources, roads, dams, schools, and parks. Growth of the world’s capital stock will come partialy from the privatization of many government owned assets.

THE WORLD IN 2050
-The US’ share of world output will shrink from 19 to 12 percent
-West Europe: 19 to 9%.
-Japan: 6 to 2%
-China will have 23%.
-India: 15%.
-But China’s population is projected to be about 3.5x that of the US, and per capita income 0.5 our level.
-This brings Chinese and Indian output back to historical averages in the 17th and 18th centuries.
-The developed world has over 90% of world stock market value now -> will shrink to slightly more than 1/3.

CONCLUSION
-The inexorable trend toward integration of the world’s economies and markets will certainly continue in this new millennium. No country will be able to dominate every market, and industry leaders are apt to emerge from any place on the globe. The globalization of the world conomy means that the strength of management, product lines, and marketing will be far more important fctors in achieving success than where the firm is domiciled. Sticking only to US equities is a risky strategy for investors, in part because US market share will shrink to less than 18%  of the world market by 2050.

APPENDIX: The Largest Non US-Based Companies

1. PetroChina
2. OAO Gazprom
3. Royal Dutch SHell
4. BP
5. China Mobile
6. Toyota Motor Corporation
7. Industrial and Commercial Bank of China
8. HSBC
9. Total
10. Electricite de France

Stocks for the Long Run
Part 2: Valuation, Style Investing, and Global Markets.

Chapter 9

Security Analysis cannot presume to lay down general rules as to the “proper value” of any given common stock… The prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. – Benjamin Graham and David Dodd, 1940

Stocks that Outperform the Market
-What criteria can investors use to choose stocks with superior returns? Earnings, dividends cash flows, book values, capitalization, and past performance have been put forward.
-Yet if markets are efficient, this information cannot improve returns. The CAPM shows the correct measure of a stock’s risk is the correlation of its return with the overall market, known as beta.
-Unfortunately, beta was not successful in explaining the differences in returns among individual stocks. a 1992 Journal of Finance article showed that the size of stocks and the valuation of stocks are fare more important in determining a stock’s return than its beta.

Small and Large-cap stocks
-Rolf Banz at UChicago found in 1981 that small stocks systematically outperformed large stocks, even after adjusting for risk as defined within the framework of the capital asset pricing model.
-Evidence: from 1926 to 2006, small stocks performed 6.27% above what would have been predicted by the CAPM.
-However this performance wasn’t a constant. Small stocks never overtook large stocks between 1926 to 1959. From 1960 to 1974, small stocks only averaged 0.5% more than large stocks. Between 1975 and 1983, small stocks averaged 35.3% while large stocks were at 15.7%. After 1983 til 1999, small stocks again underperformed. they then enjoyed 7.2% compared to large stocks <1% from 2000 to 2006.
-Causes: the Employee Retirement Income Security Act in 1975 made it easier for pension funds to diversify into small stocks. The 2000-06 bubble followed the collapse of large cap tech stocks.
-What ever the reasons, small cap stocks not in a big index like the S&P 500 makeup about 20% of total US market value. The caveat is that the small stock premium is not a constant.

VALUATION
-Value stocks offer higher returns than growth stocks
–Relating the price of a stock relative to some fundamental metric of the firm’s worth like dividends, cash flows, etc., stocks whose prices are low relative to these fundamentals are called value or cyclical stocks, while those with high prices are called growth stocks. Value stocks generally occur in industries like oil, motor, finance, and utilities. Growth stocks are generally tech, consumer, and healthcare names which are more resistant to the business cycle and have high profit growth.
-Dividend Yields
–Graham and Dodd stated in 1940 that a dollar of earnings is worth more to the stockholder if paid in dividends than when carried to surplus.
–Ramaswamy and Litzenberger in 1978 found that dividend yield and subsequent returns were significantly correlated.
–O’Shaughnessy in 2003 found that the 50 highest dividend yielding large caps stocks had a 1.7% higher return than the market from 1951 to 1994
–Siegel’s research confirms this and shows the highest dividend yielders also had a beta below unity. The lowest dividend yielding stocks not only had the lowest return (1.68% underperform) but also the highest beta.
-Other dividend Yield strategies
–A well known alternative strategy is “Dogs of the Dow” chosen from the high yielding stocks of the DJIA: one of the most successful strategies of all time. The strategy calls for investors to buy the 10 highest yielding stocks (typically out of favor) in the DJIA and to hold them for the subsequent year and then repeat the process each december. This returned 14.08% p.a. over the past 50 years. This could be extended to a Dogs of the S&P strategy which returned a 15.71%. each was between 3 and 4% above their respective benchmarks.
–The worst year for both strategies was 1999 when large cap tech stocks reached their bubble peak, underperforming the indices by 16-17%. During the later stages of a bull market, value based strategies will underperform cap weighted strategies as growth stocks catch the eye of investors. However the performance of these strategies during bear markets more than redeems them, even gaining in down markets.
-Price to earnings ratios
–Sanjoy Basu (70’s) and Nicholson (60’s) discovered stocks with low PE ratios have significantly higher returns than high PE’s, even after accounting for risk. A portfolio of the 20% highest PE stocks had a return of 8.9 percent and the the 20% lowest had a return of 14.3%
-Price to book ratios
–Research by Dennis Stattman, and then Fama and French supported this. However there are significant problems with this today. During 1987 thru 2006, book value underperformed either dividend yields, PE ratios, or cash flows in explaining returns. this is because firms increasingly have values in intellectual property.

COMBINING size and valuation criteria
– Analyzing data from 1958-2006, the smallest value stocks returned 19.59% per year while the smallest growth stocks returned 5.97%. This difference narrows with larger stocks, where value returned 13.17% vs growth’s 9.87%.
-Initial public offerings; the disappointing overall returns on new small-cap growth companies
– Some of the most hotly sought after small stocks are initial public offerings.
– Examining the buy and hold returns of the 8606 IPOs issued since 1968-2001. 79% of them were losers, 50% underperformed the market by more than 10% per year. The performance of the mostly technology IPOs issued in the late 1990s were disastrous.
-The nature of growth and value stocks
When choosing growth and value stocks, investors should keep in mind that these designations are not inherent in the product the firm produces or the industry that the firm is in. Over time many firms and even industries are alternately characterized as value or growth as their market price fluctuates.
-Explanations of size and valuation effects

– The noisy market hypothesis

Conclusion

Stocks for the Long Run
Part 2: Valuation, Style Investing, and Global Markets.
Chapter 8

-What are the most important macrotrends in the economy that influence future stock market returns?
-Economic growth
-Stability of the overall economy
-reduction in transactions costs
-change in taxes on stock market income
-most importantly: the hundreds of millions of baby boomers planning to finance their retirement by selling their financial assets.
-the chapter comes to the conclusion that the long-term future of equity returns looks bright if the US keeps its capital markets open to the rest of the world.

-GDP Growth and Stock Returns.
-Suprising result: Plotting real GDP growth vs stock market returns of 16 developed markets and 25 developing markets shows GDP growth is negatively correlated with stock market returns. Why?
-Economic growth positively influences aggregate earnings and dividends, not per share earnings and dividends, which is part of stock market performance.
-Economic growth spurs technological improvement and investment which is funded by debt (adding interest cost) or equity (diluting earnings)
-While this may be mitigated by available capacity, history shows us that capital formation has grown in proportion with GDP – a 10% rise in GDP ultimately leads to a 10% rise in the capital stock.

-The low growth of real earnings per share caused economists to predict low future real returns for the stock market. But Siegel shows that they ignored the impact of the lower dividend-payout ratio on earnings growth. If Stock price P = dividend / (return-growth of future dividends), a lower dividend that causes a more than proportional increase in future dividend growth will still increase price.

Factors that raise valuation ratios
-We have established that historical returns on equity has been around 7%p.a. with an average PE ratio of 15. There may have been recent structural changes to this ratio.
-2 Changes to the expected rate of the return on equities
–Reduction in taxes on equity return (Chapter 5)
–Reduction in transactions costs. Research from Columbia’s Charles Jones reveals that fees paid to brokers as well as the bid-ask spread shows the average one-way cost to buy/sell a stock has dropped from over 1% of value as late as 1975 (before deregulation of brokerage fees) to under 0.18% today. Benefits: less costly to diversify, and, overall, stocks increase in liquidity and therefore in value.
-2 Change to the equity risk premium
–Historically, this has been around 3.5%. However, research has shown that increased knowledge of superior stock returns would cause a decrease in the equity risk premium. Studies show today’s historical premium to be as low as 1%.
–More stable economy: THere has been a major reduction in economic volatility over time since 1929. This trend has been called “The Great Moderation”, attributed to better monetary policy, a larger service sector, better inventory/production control helped by the information revolution.
-The lower the equity premium, the higher will be the valuation of stocks relative to economic fundamentals. This may also mean the average historical PE may not be appropriate any longer. One might justify ratios in the low 20s for the equity market.

The Age Wave
-Over the next 2 decades, nearly a quarter billion Americans, Europeans, and Japanese will leave the labor force. “Demography is the future that has already happened.”
-Though we know Social Security and Medicare will be threatened, private pensions will also be threatened. The assets of wealth can be transformed to goods and services only if they are sold to those willing to defer their consumption. if there is a shortage of savers in the future, retirees will have insufficient assets.
-Because of our aging population, it is most likely future increases in the age of retirement will exceed the increase in life expecatncy and cause an absolute reduction in the number of years in retirement.
-There is a solution that can help aging economies. the developing world is much younger: this is the “Global Solution” to the age wave – a graph shows that trade with a developing world that is growting at 8% will bring the retirement age down to below 60. The developing world has the capability of simultaneously providing us with goods and acquiring our assets.
-Why would developing countries wish to acquire American capital? we saw that the best returns are rarely found in countries that grow the fastest. Other reasons: US brand names, innovation, higher education.
-Conclusion: our nonreceptiveness to international capital has caused movement to London as the world’s financial capital. Resisting globalizing trends will lower our future returns and living standards.

We have been too long in the updates, because of other commitments. In the meantime please enjoy http://financial-education.com/ . Fliteracy will return at the end of May with more of Stocks for the Long Run and other good stuff.

-Swyx