Economic Report

1
Economic Report

• Michael Brooks, Lauren Ewald, Janan Hatem, Tori
  Miller, Ryan Kaplan, Bejan Motamedi

2
Agenda

• Introduction
• Oil and Currency
• Interest Rates and the Fed
• Employment
• Consumer and Business Confidence
• Manufacturing and Elections
• Conclusion

3
Earnings and GDP

• Latest GDP estimates were 3 and they came in at
  2.8, which rallied the market.
• With GDP numbers in line with expectations there
  were not major changes to the inflation gauge,
  which is giving investors hope that the Fed may
  change their current policy of increasing rates
  at a measured pace.
• Earnings growth for the rest of year has been
  revised down with uncertainty and concerns of
  profit margins deteriorating

4

• SP 500 Index
• The valuation of the market is cheap with the SP
  500s P/E at 17x,
• the lowest in 7 years.
• The twelve month price target of the SP 500 is
  1200

5
Dow Jones Industrial Average This market has been
range bound since March, averaging gain or losses
of 1.5 daily, below the historical average of
1.8 and the 3 of the bull market
6
Nasdaq Composite
7
Yield on 10-year Bond
8
Oil

• High oil prices should slow global economic
  growth and create moderate inflationary
  pressures.
• Long-Term oil futures prices have also seen new
  highs.
• How long will oil prices continue to increase?

9

• Medium-term effects
• Concentration on cost reduction.
• Job cuts.
• Unused capacity.
• Loss of economic momentum.
• Long-term effects
• Shift of business capital stock towards energy
  related activities. (i.e. energy exploration,
  extraction, distribution)

10

• Oil prices negatively correlated with treasury
  yields.
• Provides a cushion for the equity market.
• sdf

11

• Higher oil prices have helped the US over the
  summer.
• But the resulting slow U.S. profit growth should
  limit private capital inflows which would
  otherwise further sustain the US.
• US expected to fall further in the near future.
• Expect a larger correction against the Asian
  currencies.
• Possible action from Asian central banks who
  might resist a plunge in the US.

12
INTEREST RATES
Interest rate activity over the past three
yearsthis summers increases marked the first
increase in over three years
13
The Past

• Interest rates were cut a total of thirteen times
  in response to the economic recession
• By implementing record low rates, the Fed
  encouraged mortgage refinancing, thus providing
  consumers with more money to pump into the
  struggling economy

14
June 30, 2004

• June witnessed the first short term rate increase
  in several years
• The rate was modestly increased from 1 to 1.25
• The increase was accompanied by an optimistic
  outlook from the fed that the economy was
  strengthening and that the worst was behind us

15
Second Quarter Financials

• To the dismay of economists and consumers, the
  second quarter financials were lower than
  anticipated
• Job growth was significantly lower than predicted
• Economic growth was slower than predicted
• Such results triggered speculation that the
  economy was not recovering as well or as fast as
  earlier guessed

16
Fed Response

• Despite disappointing numbers, the Fed continues
  to back their earlier statement that the economy
  is improving
• In their own words
• "In recent months, output growth has moderated
  and the pace of improvement in labor market
  conditions has slowed. This softness likely owes
  importantly to the substantial rise in energy
  prices. The economy nevertheless appears poised
  to resume a stronger pace of expansion going
  forward."

17
August 10, 2004

• Three weeks ago, the fed funds rate was increased
  another .25, hitting 1.5 after a unanimous vote
  for an increase
• Following the announcement of the increase, the
  Fed did not rule out the possibility of a similar
  increase as soon as September
• The move by the fed has been met with criticism
  and applause

18
Opposition and Applause

• Some believe that the recent increase and the
  alleged future hikes are an effort by the fed to
  conceal overly optimistic forecasts earlier this
  summer
• Other economists concur that the summer soft
  patch can be attributed to high oil prices and
  that the increase is a necessary measure to
  prevent stagflation

19
In the Coming Months

• The Fed is dedicated to maintaining a measured
  pace of short term rate increases
• Unless an unanticipated shock shakes the economy,
  expect to see the short term rates steadily
  increase by the same quarter percent over the
  coming months
• The Feds increases indicate growing confidence
  in economic recovery, and such confidence and
  actions should be reflected in stock prices

20
Inflation

• This summer reported surprisingly low levels of
  inflation
• The August 17 report indicates that the July CPI
  actually fell 0.1, an unexpected event given the
  0.3 increase in June
• The fall is mostly attributed to an unexpected
  fall in energy prices from June to July

21
Inflation Continued

• Experts believe that the inflation relief is only
  temporary
• The increase in oil prices are expected to have a
  major impact on inflation in the coming months
• Forecasts predict a CPI of 0.4 for August and
  September

22
Inflation CPIviewed as a negative. Food and
energy prices are increasing thus some of the
disposable income growth of 5 is being eroded by
higher inflation resulting in less real income.
If we see additional inflationary pressures the
Fed will have to counteract that by raising
interest rates, which will increase the cost to
borrow- this will hurt the housing and business
equipment markets
Currently 1.88 June 2005 1.93 Consensus 3Q
2.8 4Q 3.0 1Q 2.7 2Q 2.3
23
Overall

• While inflation is expected to play a bigger role
  in the coming months, the overall rate for the
  year remains under 2
• If the inflation rate remains under 2 for the
  year, it can be expected that the Fed will
  continue the measured pace of interest rate
  increases

24
Non Farm PayrollsWe expect 200,000 new jobs
created per month adding 1.2 million additional
jobs by the end of December. 2004 will have seen
approximately 2.2million new jobs created by year
end. We expect further improvement but not at
the fast acceleration we have seen. The addition
to non-farm payrolls will be a driver in consumer
confidence and disposable income. A positive
indicator.
Currently 131,301 (1.1 growth) June 2005 133,
830 (1.9 growth)
25
Unemployment RateAs non-farm payrolls increase
the unemployment rate decreases. Projected
unemployment is 5.2 at years end. This
translates to strong fundamentals for the
consumer with hiring increasing steadily, wages
increases, incomes increasing and consumer
confidence increasing. A positive indicator.
Currently 5.5 June 2005 4.8 Consensus 3Q
5.5 4Q 5.4 1Q 5.3 2Q 5.2
26
Consumer Statistics

• University of Michigan Survey
• Consumer Sentiment Fell to 95.90 from
  96.70(-.83)
• Consumer Expectations Fell to 88.20 from
  91.20(-3.29)
• Current Expectations Rose to 107.90 from
  150.20(2.57)

27
Conference Board Survey

• Consumer Confidence fell to 98.20from 105.70
  (-7.1)
• Current Situation fell to 100.7 from
  106.4(-5.36)
• Consumer Expectations fell to 96.6 from
  105.3(-8.26)

28
Economist Projection

• University of Michigan Survey
• Median Est. 94.00
• Average Est. 93.9
• High Est. 95.00
• Low Est. 89.00
• Conference Board Survey
• Median Est. 103.2
• Average Est. 103.1
• High Est. 106.1
• Low Est. 97.0

29
Business Confidence

• Conference Board Index of Business Confidence
• Business Confidence fell to 70 from 73 (-4.1)
• Current Business Situation Unchanged at 78
• Business Expectations fell to 68 from 72
  (-5.6)

30
Consumer Confidence There is a clear upward
trend in the past two years thanks to the
improved assessment of the labor market and
income growth. This translates to a positive
indicator for the consumer and is encouraging for
the household sector.
31
Disposable IncomeCurrently at about trend
growth- meaning that there is not a shortage of
income and in fact solid income growth is
occurring. The expectation is that it will
continue to improve as the labor market continues
to improve with longer hours and overall
increased wages. Overall a positive indicator.
Current Situation 8,672.9 (6.4 growth) June
2005 9,100.9 (4.9 growth)
32
Wilshire Index (proxy for Equity Wealth)Stock
prices are stuck in a range thanks to uncertainty
being at an all time high due to geopolitical
risks, the election, tax policy, interest rates,
and oil. The equity risk premium is at a new
high of 5.4. Earnings growth for the rest of
year has been revised down with uncertainty and
concerns of profit margins deteriorating-
Business balance sheets came out of the recession
in a better position then they went into it, now
with less debt on the books.
33
Manufacturing

• Manufacturing continued to grow throughout the
  summer months at a historic rate. The latest ISM
  index of goods producing companies reading was
  62.0, up from 61.1 in June
• The 62.0 reading, 2 points above 60, extends the
  number of consecutive months of the ISM index
  being above 60 to 9 months. This is the longest
  period of growth above an ISM reading 60 since a
  12-month stretch from July 1972 to June 1973
• 2 Important Statistics to note
• New Orders increased up from 60.0 in June to 64.7
  in July
• Prices paid for good produced decreased from 81.0
  in June to 77.0

34
Industrial Production

• Federal Reserve stated overall output of U.S.
  factories, mines and utilities rose .4 while
  capacity utilization increased to 77.1 up from
  the revised 76.9 number from June
• Factory production rose .6 in July, up from
  Junes .2 drop
• Factory efficiency increased as well Factories
  operated at 76.3 of full capacity, comparable
  only to April 2001 number of 76.6

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Presidential Election Trade Deficit
Vs. Tax Cuts

• Main Concern The Ballooning Trade Deficit
  Current-Account deficit has quintupled to 542
  billion between 1995-2003a record of near 5 of
  total GDP
• Dollar crisis Weakening of dollar USAs
  Goods Relatively Cheap

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Tax Cut Benefits Economic Growth

• After-tax incomes are up 11 since December 2000.
  The reason In 2003 Americans kept more of their
  incomes than in any year since 1965.
• Quick Tax Relief Stats

40
Presidential Election

• The Equity Market has preformed 8 better after
  the incumbent candidate wins
• SP 500 EPS growth has been 7.7 the year
  following incumbent party win vs. 1.3 in time of
  a loss

41
Election Year Gains

• The Dow Has Been Up Eight of the Past 10
  Presidential Election Years
• Year Winner Gain
• 1964 Lyndon Johnson 14.6
• 1968 Richard Nixon 4.3
• 1972 Richard Nixon 14.6
• 1976 Jimmy Carter 17.9
• 1980 Ronald Reagan 14.9
• 1984 Ronald Reagan -3.7
• 1988 George H.W. Bush 11.8
• 1992 Bill Clinton 4.2
• 1996 Bill Clinton 26.0
• 2000 George W. Bush -6.2
• Average 9.8
• Source USA TODAY research

42

• The massive tax cuts engineered by the president
  last year, coupled with the lowest interest rates
  in 45 years and the Bush administration's
  decision not to prop up the sliding dollar, have
  sparked an economic renaissance at an opportune
  time for the president.

43

• The median gain (meaning half were below and half
  above) when an incumbent Republican wins a second
  terms is 14.6 vs. 8 for all elections
• Note Any change in expectations (A Bush
  Victory) will add serious volatility and price
  instability into the market
• One more thing to consider InvesTech Research
  says more bear markets have started over the
  nine-month period surrounding an election than
  any other time. So even if 2004 is a good year
  for stocks, 2005 could be tougher.

44
Housing Prices
The median sales price is the sales price of the
house which falls on the middle point of the
total number of houses sold.
45
New Home Sales
46
Household Net Worth (tr)
Household Debt to Income Ratio
47

• Household balance sheets are heavily in debt.
  There is concern over the ability of households
  to repay their debt, up 30 in the last three
  years, approximately 3 trillion dollars. The
  highly leveraged household is more vulnerable to
  shocks such as unemployment, inflation and rising
  interest rates which will directly impact
  consumer spending.
• Price appreciation in the housing market is
  expected to slow. Fifty percent of the mortgages
  outstanding have coupons of 5.5 or less, now
  they are 6.25- there is no rate incentive to
  refinance. In the low interest rate environment
  households were being refinanced, which allowed
  consumers added spending. However, this trend is
  not expected to continue.
• Mortgage debt is 75 of all household debt.
• Sales of new homes in the United States fell 6.4
  percent in July to a seasonally adjusted
  annualized rate of 1.13 million
• the National Association of Realtors reported a
  2.9 percent drop in sales of existing homes.
• Prices in the housing market are expected to
  flatten over the next year. This is not to say
  money cannot be made in the housing sector over
  the long term, but over the short term a great
  deal of growth is not expected.

48
Psychology

• The risk premium in the equity market is at a
  high of 5.8 compared to the average of 3.8
  thanks to geopolitical risks, uncertainty
  surrounding the election, and increased terror
  alerts. There is an inverse correlation between
  the risk premium and performance.
• In the post 9/11 world investors are less likely
  to be surprised by disappointing news. A prime
  example was on Monday August 2nd 2004. The
  market closed up 39.45 points despite the
  increased terror threat with specific targets
  being the financial markets and intuitions.

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Key Items of Impact to Watch

• Presidential Election
• Geopolitical Situation
• Iraq
• Terrorism
• Psychology
• Federal Reserve
• Interest Rates
• Employment
• Economic Growth
• Price of Oil

50

• Growth
• The economy is expected to settle down to a
  sustainable growth rate of about 3.5-3.75 in
  real terms.
• Employment
• Currently unemployment is 5.5 equating to
  roughly a million unemployed workers resulting in
  underutilized resources. The expectation is for
  roughly 200,000 jobs to be added per month with
  the unemployment rate at 5.2 at years end,
  however in June there were disappointing numbers
  in non farm employment with an addition of only
  32,000 jobs.
• Market Performance
• In the short run the market will continue to go
  sideways until there are resolutions to some of
  the geopolitical and political risks. Until then
  the risk premium will remain high.
• Interest Rates and Market Performance
• The SP MidCap 400 tends to outperform the SP500
  during monetary easing cycles- reverse is true
  during monetary tightening cycles. Large-cap
  stocks are currently favored. There is a
  forecast of a 100 basis point rise in this year
  as well as next year.
• Fundamentals within household sector
• In terms of fundamentals, things are good with an
  improving labor market, increasing levels of
  consumer confidence, increasing household incomes
  and increasing consumer spending.
• Fundamentals for the business sector
• Business spending is likely to increase,
  especially in the equipment and software areas
  due to the tax structure and bonus depreciation
  allowances that must be spent by the end of the
  year,
• coupled with strong balance sheets and a
  stronger economy which is creating demand for
  replacement investments.

51
Conclusion Time to be Bullish

• Expect a Fall Rally
• Valuation Cheap (17x)
• Light volume Signal of Bottom
• Market historically performs well year of
  presidential election
• Fed moves are anticipated and measured removing
  uncertainty

52

• Sectors
• Stocks that do the best when the Fed tightens
  are companies with earnings rising the fastest-
  lately those have been technology, supplies of
  basic materials and industrial equipment.
• Technical Analysis and Fundamental Analysis both
  suggest that Industrials and Materials are the
  best sectors to be invested in.
• Technical Analysis
• Industrials and Materials both in uptrend with
  positive momentum. Specifically positive on
  Chemical, steel, oil, equipment, metals/mining,
  tires and rubber, fertilizers, metals and glass,
  gasses, paper and forest, aluminum, gold
• The Telecom sector is looking more promising,
  specifically the RBOCs (Tony Butler and Steve
  Levy- ex. SBC and VZ)
• Technology and Telecommunication services
  earnings growth over revenue growth. Biggest
  surprises are Telecommunication Services (11.3)
  and Materials (9.1)
• Technical analysis team expects mean reversion
  with technology and healthcare in the short-term.
  
• Technical Analysis Industry Group Technical
  Rankings
• Strongest Steel, Consumer Electronics,
  Motorcycle Manufacturers, Oil and Gas Exploration
  and Production, Tires and Rubber
• Weakest Airlines, Reinsurance, Semiconductor
  Equipment, Electronic Manufacturing Services,
  Investment Banking and Brokerage
• Fundamentals
• Overweight Industrials and Materials- believe
  that the sector will be improving for the next
  year
• Industrial believe industrial recovery is early
  in cycle
• Materials coal, copper, paper forest (favored)
• Underweight Consumer Staples, Energy and Utility
• Utilities pending on rate cases- not a lot of
  upside historically
• Energy drivers- geopolitical, supply/demand,
  believe supply will incrase? prices down
• Consumer Staples 1. economic activity 2. not bad
  but not as good as they were before- taxes have
  taken affect, mortgage refinancing subsided, not
  as much liquidity