1. Introduction
Economy and finance are complicated subjects.
Those are usually required a 3-year program of study in a university.
Governments are responsible to manage economy
creating jobs to people while central bank is taking care of setting interest rate influencing prime rate for
loans at banks as well as mortgage rate.
2. Finance
Finance in
many respects is an offshoot of economics. Finance describes the management,
creation, and study of money, banking, credit, investments, assets, and
liabilities that make up financial systems, as well as the study of those
financial instruments. Finance can be divided into three categories: public
finance, corporate finance, and personal finance.
Finance
typically focuses on the study of prices, interest rates, money flows, and the
financial markets. Thinking more broadly, finance tends to center around topics
that include the time value of money, rates of return, cost of capital, optimal
financial structures, and the quantification of risk.
Finance, as
in the case of corporate finance, involves managing assets, liabilities,
revenues, and debt for a business. Businesses obtain financing through a
variety of means, ranging from equity investments to credit arrangements. A
firm might take out a loan from a bank or arrange for a line of
credit—acquiring and managing debt properly can help a company expand and
ultimately become more profitable.
Source: Understanding
Finance vs. Economics (investopedia.com) -https://www.investopedia.com/articles/economics/11/difference-between-finance-and-economics.asp
3. Economy
Economics is
a social science that studies the production, consumption, and distribution of
goods and services, with the aim of explaining how economies work and how
people interact. Although labeled a "social science" and often treated
as one of the liberal arts, modern economics is in fact often very quantitative
and heavily math-oriented in practice. There are two main branches of
economics: macroeconomics and microeconomics.
Macroeconomics
is a branch of economics that studies how the aggregate economy behaves. In
macroeconomics, a variety of economy-wide phenomena are thoroughly examined,
such as inflation, national income, gross domestic product (GDP), and changes
in unemployment.
Microeconomics
is the study of economic tendencies, or what's likely to happen when
individuals make certain choices or when the factors of production change. Just
as macroeconomics focuses on how the aggregate economy behaves, microeconomics
focuses on the smaller factors that affect choices made by individuals and
companies.
Source: Understanding
Finance vs. Economics (investopedia.com) -https://www.investopedia.com/articles/economics/11/difference-between-finance-and-economics.asp
4. Economy
versus Finance
As a general
social science, the focus of economics is more on the big picture, or general
questions about human behavior around the allocation of real resources. The
focus of finance is more on the techniques and tools of managing money. Both
economic and finance also focus on how companies and investors evaluate risk
and return. Historically, economics has been more theoretical and finance more
practical, but in the last 20 years, the distinction has become much less
pronounced.
·
Economics
and finance are interrelated disciplines that inform each other, even if the
specifics are distinct.
·
Finance, as
a discipline, is derived from economics; it involves assessing money, banking,
credit, investments, and other aspects of the financial systems.
·
Finance can
be further broken down into three related but separate categories—public
finance, corporate finance, and personal finance.
·
Economics
looks at how goods and services are made, distributed, and used, as well as how
the economy overall functions, along with the people who drive economic
activity.
·
The two main
branches of economics are macroeconomics, which looks at the overall economy,
and microeconomics, which looks at specific factors within the economy.
Source: Understanding
Finance vs. Economics (investopedia.com) -https://www.investopedia.com/articles/economics/11/difference-between-finance-and-economics.asp
5.
Impact of economy on investment in stock
market
Economy and finance are complicated subjects. If you
wanted to understand those in details, you should follow the “source link” in
preceding sections to read OR you could go to university to study either
Economy or Finance.
We will focus on a few opportunities to purchase
stocks, which performances are influenced by economic factors including
recessions, good economy, or trouble times such as COVID-19 shut down.
Markets provide finance for companies so they can hire, invest and grow.
They provide money for the government to help it pay for new roads, schools and
hospitals. And they can help lower the costs you face buying food at the
supermarket, taking out a mortgage or saving for your retirement.
Source: What
are financial markets and why are they important? | Bank of England - https://www.bankofengland.co.uk/knowledgebank/what-are-financial-markets-and-why-are-they-important
5.1
Recession
A recession is a macroeconomic term that refers to a significant decline
in general economic activity in a designated region. It had been typically
recognized as two consecutive quarters of economic decline, as reflected by GDP
in conjunction with monthly indicators such as a rise in unemployment.
Source: Recession Definition (investopedia.com)
- https://www.investopedia.com/terms/r/recession.asp
What is a recession? A common definition is two consecutive quarters of
decline in GDP, but this isn't necessary for the economy to be in a recession.
A recession just needs to be a contraction of the economy, featuring shrinking
production and consumption, higher unemployment, and (sometimes) lower price
levels.
Source: What
happens in a recession? | John Hancock Investment Mgmt (jhinvestments.com)
- https://www.jhinvestments.com/viewpoints/investing-basics/what-happens-in-a-recession
The common effects of a recession were higher rate of
unemployment, which lead to lower consumption of goods and services. Many
companies had produced excess of goods or services during economic boom time.
Some companies have invested in new goods or services, which were not needed by
consumers, thus they closed down business. Both excess or unnecessary goods and
services caused lay off of employees creating higher rate of unemployment
triggering a recession.
During a recession, most of companies’ earnings (EPS)
were going down causing investors to sell shares. All stock indices would be
dragged down quickly or slowly in downward trend called a bear market.
5.2
Great recession
The Great Recession was the sharp decline in economic activity during
the late 2000s. It is considered the most significant downturn since the Great
Depression. The term Great Recession applies to both the U.S. recession,
officially lasting from December 2007 to June 2009, and the ensuing global
recession in 2009. The economic slump began when the U.S. housing market went
from boom to bust, and large amounts of mortgage-backed securities (MBS's) and
derivatives lost significant value.
The Great Recession refers to the economic downturn from 2007 to 2009
after the bursting of the U.S. housing bubble and the global financial crisis.
The Great Recession was the most severe economic recession in the United
States since the Great Depression of the 1930s.
In response to the Great Recession, unprecedented fiscal, monetary, and
regulatory policy was unleashed by federal authorities, which some, but not
all, credit with the subsequent recovery.
GDP declined by 0.3% in 2008 and 2.8% in 2009 and
unemployment briefly reached 10%, did not reach depression status. However, the event is unquestionably
the worst economic downturn in the intervening years.
The term The Great Recession is a play on the term The Great Depression. The latter occurred during the
1930s and featured a gross domestic product (GDP) decline of more than 10% and
an unemployment rate that at one point reached 25%.
Source: The Great
Recession Definition (investopedia.com) - https://www.investopedia.com/terms/g/great-recession.asp
6.
Stagflation
This is the scenario of high inflation and slow
economy growth. This happens in the year 2022, when inflation rate passes +8%
and continues going up. Central banks are raising interest rate to bring
inflation rate back to their target of around +3%.
This time the inflation occurred because of supply
chain issues. There are many factory plants in China and other countries shut
down due to COVID-19 spread. Central banks had printed or given out lots of
money to local residents during the lock-down periods as well as setting
interest rate between 0% and +0.25%. Central banks have also bought assets or
bonds to stimulate economy with tremendous amount of money. People didn’t
travel or spend money during those lock-down periods, thus they have surplus cash
to spend in the period of reopening economy.
Surplus demands and shorted supply has pushed up
inflation rate.
The residential housing market is red hot because of
low interest rate during this period, i.e. house prices have been up +10% or
+20% for many months in a row.
Even with the current strong economy (June 2022), the
rising of interest rate would slow down economy and stall it. The housing
market would be corrected down because of rising mortgage rate, which was based
on the interest rate set by central banks, leading to higher mortgage payments
for mortgagees. Mortgagees may not able to keep up with rising mortgage payments,
so they may declare “foreclosure” or sell their property quickly at lower price
than the market price.
We would be experiencing a period of slowing economy
growth, but the interest rate keeps going up to bring down inflation, i.e.
recession + high interest rate. Usually central banks would buy bonds/assets
and lower interest rate during slow growth of economy.
Local banks are usually doing well during high
interest rate period, but it is not quite correct in this case with housing
market correction. As many mortgagees declared foreclosures, bank would suffer
loss on mortgage loans, i.e. lower income (EPS) reported in quarter earnings.
The benefits of collecting higher payments in loans with high interest rate may
not be able to offset loss of mortgage loans.
Stock markets would poorly perform during stagflation
period.
The above notes were written in June 2022, it’s August 2022 with some updates. The
GDP has been shrunk for 2 consecutive quarters (Q1 and Q2) in USA. The
unemployment rate was around 3.5% and many companies have delivered good
quarter earnings. The US interest rates have been up around 2.25% and 2.5%. The
Canada’s interest rate is 2.5%. According to definition of recession, USA is in
recession, but unemployment rate was low and quarter earnings of many
corporations were good. This is not a traditional recession, and central banks
keep raising interest rates. The current inflation rate is 7.6% for Canada and
8.52% for USA, i.e. very high inflation rate. Central banks target annual
inflation rate between 2% - 3%.
7.
Stock selection based on economic events
One of famous quotes from Warren Buffet, who is the
legendary investor and in the top 10 of wealthiest people on earth, is “be greedy when people are fearful, and be
fearful when people are greedy.”
An economy cycle is usually 10 years. During the peak,
companies have produced surplus of products creating over stock inventory, i.e.
high in supply. However people or consumers couldn’t use or buy all of those
products, i.e. low in demand. This would cause a recession or down-turn of
economy.
Usually during a recession, central banks would buy
bonds/assets and lower its interest rate, which is the base of prime rates set
by many local banks. The mortgage rates would also base on prime rate. It is
common that a central bank increased its rate by 0.25%, and then the prime rate
and mortgage rate would increase by 0.25% each.
With the lower interest rate, people would afford to
borrow money and buy more products, which pull the economy forward. Governments
would also borrow money to advance many road constructions, infrastructure
project, or public service’s projects. The economy would expand or accelerate with
higher Gross Domestic Product (GDP) above the target (around 3%), which prompt
central banks to increase interest rates again to slow it down. The economy
cycle is then repeated.
The economy cycle is currently getting shorter,
because manufacturing plants use robots, which increase productivity.
During the period before recession declared, stock
markets don’t perform well, i.e. share price keeps sliding down in a bear
market. The earning per share (EPS) is lower or higher Price/Share (PE). Investors are fearful. This is an
opportunity time purchase stocks at lowest price range. When the economy is
at its peak, stock price would be at its peak or keep moving upward. Investors are greedy. This is not a good
time to purchase stocks, because stocks may be over priced and due to a
correction.
As we can see that we should reserve cash to purchase
stocks during a bear market or recession. In order to do so, we should sell
some of our holding stocks during “fantastic days” of stock market or peak
period. It is easy to say “buy low and sell high”, but we should trim or sell
some of our shares when a stock’s PE multiple becomes very high.
During a recession, investors used to buy stocks in
the following sectors due to its steady incomes and revenues. Those companies
should have enough cash and low debts, because interest rates used to be high
or on the rise.
·
Power utility
·
Telecom operators
·
Etc.
During the rise of interest rate (inflation rate ->
interest rate -> mortgage rate) to fight against inflation or slowing down
over heated economy, investors used to buy stocks in the following sectors as
well as parking cash in US dollars.
·
Banks
·
Insurance
·
Etc.
During the period to stimulate economy during a recession,
the central bank would lower its key interest rate and buy asset or print
money. Stock price would go up quickly or create inflation. Investors used to
buy gold to hedge against inflation. Currently they don’t buy gold, but they play
with bit coins and cryptocurrency, which are hoax or useless financial
instruments. Stay away from those. Gold investment is still good if share
prices reasonable. We consider it as a good mineral for jewelries and special
conductor.
We should also consider seasonal stocks. Those stocks
perform well for a certain period of a year. For example, oil stocks are
usually peak during summer or driving seasons in USA. Natural gas stocks
perform well during winter or heating season in northern regions of USA and
Canada. Many seasonal stocks are considered as trading stocks, i.e. buy at low
price during off-seasons; and sell during high seasons with good EPS causing
higher share prices. If we looked at its stock chart, it behaves like a sine
wave.
It is common that stock market is in advance
prediction of economy states. For example, stock markets or indices touched its
bottom 6 months before a recession announced; or their peaks before interest
rates start to rise.
Author: Vinh Nguyen at canvinh@gmail.com written on August 28, 2022.
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