This is Bernie Keating's sixth book after finishing other careers spanning 60 years: Naval officer - Korean War Teaching Assistant, U.C., Berkeley Multi-national company executive Management consultant Rancher in Sierra Mountains

RATIONAL MARKET ECONOMICS

A Compass for the Beginning InvestorBy Bernie Keating

AuthorHouse

Copyright © 2011 Bernie Keating
All right reserved.
ISBN: 978-1-4634-0163-4

Contents

PREFACE.................................................ixONE: WHY ECONOMICS?.....................................1TWO: PARAMETERS OF THE ECONOMY..........................3THREE: WHERE DO WE START?...............................8FOUR: CORPORATE EARNINGS................................10FIVE: INFLATION.........................................12SIX: INTEREST RATES.....................................16SEVEN: LIQUIDITY........................................21EIGHT: DOLLAR EXCHANGE RATE.............................25NINE: GROWTH DOMESTIC PRODUCT...........................29TEN: THE BUSINESS CYCLE.................................33ELEVEN: PSYCHOLOGY IN THE ECONOMY.......................41TWELVE: UNEMPLOYMENT....................................44THIRTEEN: U. S. FISCAL POLICY...........................47FOURTEEN: THE U. S. MONETARY POLICY.....................52FIFTEEN: WHERE AND HOW TO INVEST........................57SIXTEEN: DERIVATIVES, HEDGING, ETC......................63SEVENTEEN: 2007 FINANCIAL MELTDOWN......................69EIGHTEEN : BOOKKEEPING AND RECORDS......................78NINETEEN: PRINCIPLES FOR INVESTING......................82TWENTY: SUMMARY.........................................85APPENDICE:..............................................88ENDNOTES................................................93

Chapter One

WHY ECONOMICS?

Some knowledge of economics is necessary. Investing is a skirmish fought on the battlefield of the economy; so we need to look at the arena where it is fought. Economics is a Greek word relating to "management of a household," and it starts in the gut of the individual with how people react to the events in their lives. This notion did not exist several centuries ago before people had "connected the dots," and realized how things in their lives – the needs and resources -were interrelated.

An Englishman, Adam Smith, became the first economist when he published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776, the same year that Thomas Jefferson wrote our Declaration of Independence. No one had realized until then how the fragments of social activity fit together in a cohesive whole. Smith accomplished that and the result was a blueprint for a new social science called economics, which analyzes the products, distribution, and consumption of goods and services. It explains how things interact throughout society not only in business, finance, and government; but also in crime, education, the family, health, law, politics, religion, social institutions, war, and science.

Economics is generally dealt with on two levels: macroeconomics and microeconomics. Macroeconomics looks at the big picture and deals with the performance, structure, behavior and decision-making of the entire economy. Microeconomics comes from the Greek word meaning "small," and focuses on the details. It looks at the allocation of limited resources in markets where goods or services are being bought or sold. The reason we look at both macro - and micro - economics is because these will have considerable impact on how our investments will fare in the stock market.

There are two opposing philosophies of how much control should be maintained over the economy: Free Market, and Keynesian.

Free Market relies on minimal economic intervention and regulation by the state, except to enforce private contracts and the ownership of property. Keynesian advocates monetary policies by the central bank and fiscal policies by the government to stabilize the business cycle. 2 While these two opposing philosophies may seem somewhat academic, we realized during the 2007 financial meltdown their differences can create great impact in the economy and in the stock market.

One of the yardsticks used to measure the economy is the Gross Domestic Product (GDP). It is the market value of all goods and services produced within a country in a given period of time. All countries like to maintain their GDP in a positive direction. The United States administrations have a goal to maintain it stabilized within the 2% to 4% annual growth rate. When the GDP growth rate is below zero for two consecutive quarters, an economy is considered to be in recession. It seldom climbs above the 5% annual growth rate in the United States, but the GDP of a number of emerging foreign countries such as China often climb up to a 10% annual growth rate because they have started from a lower base.

Economies are seldom entirely stable but fluctuate over several months or years, involving shifts between periods of relatively rapid growth (expansion or boom) and periods of relative stagnation or decline (contraction or recession). These are referred to as the business cycles. A successful investor should understand the things that cause the instability.

An investor must understand what is going on in the economy. If the economic parameters are weak, how will that affect their investments, or what if the economy is booming? Is this the time to buy, sell or hold their cards close to the vest? As in all professional disciplines, an investor must learn the basics of the trade.

Chapter Two

PARAMETERS OF THE ECONOMY

The economy is a complex social phenomenon with many dimensions, and some of these measure important parameters of the stock market. These are:

Corporate Earnings Interest Rates Inflation Liquidity $ Exchange rate

An investor who keeps focus on these economic parameters will be in a better position to predict the future course of the market, or at least be able to react more intelligently to events as they arise. There are also many secondary factors that affect the market, but they do this mostly through the influence that they exert on these primary parameters. Here is an overview:

CORPORATE EARNINGS: Investors buy stock to gain part ownership of a corporation so they can share in its earnings, or in growth that will lead to future earnings. The price they are willing to pay for stock is based on current earnings and their perception of future earnings, compared to what they could make from other investments.

INTEREST RATES: Interest rates and the stock market have a tendency to move in opposite directions because of two reasons:

1. Interest bearing investments are competitors of equity stocks for available investor's dollars. 2. Interest rates are used by the Federal Reserve as a tool to fuel or to retard the economic growth rate, and this has a major impact on corporate earnings.

The net effect is that the stock market normally reacts to changes in interest rates faster and more sharply than most other factors.

Which of these interest rates are the most important to watch: prime rate set by commercial banks, discount rate or federal funds rate set by the Federal Reserve, or T bill rates determined by bids in the open market? Also, how does the Federal Reserve Bank go about the control of interest rates?

INFLATION: The Federal Reserve considers inflation one of the greatest threats to our economy; so they place high priority on its control. One of the tools they use is interest rates. As inflation increases, interest rates are raised by the Federal Reserve as a means to cause inflation to be decreased.

LIQUIDITY: Liquidity means how much money supply and other liquid assets exist that are readily available to the economy. It involves both how much is available and how fluid it is to flow into various investments. When liquidity is too low, the economy and the stock market suffer. When liquidity is high and investor's pockets are full of money, they tend to buy stock; so the markets often rise.

U.S.DOLLAR EXCHANGE RATE: Until recent years it made little difference to the investor how much a U. S. dollar was worth compared to the Euro or other foreign currencies. That has changed in recent decades because we now deal with a global economy. How important is exchange rate to the U. S. Stock Market? In the view of Federal Reserve Chief Paul Volcker, exchange rate adjustments were a major contributing cause to the sudden market crash that occurred in October 1987.

These five primary economic parameters are interrelated. As one of them goes up or down it may cause another parameter to move in parallel or in the opposite direction. For example: if the Federal Reserve issued new currency to buy back government bonds, which could fuel a rise in inflation; then to head-off this rise, the Federal Reserve may increase the federal funds interest rate, which would have the effect of bringing inflation back down again. Seldom are all five parameters stable or in lock step.

SOME ECONOMIC AND MARKET LANGUAGE:

It is difficult to discuss the stock market without using common jargon. Some of this provides benchmarks to relate today's market for comparison with other time periods, other U.S. stock market indices, or with other indices in the global market. Let's review some of the terms the investor will encounter:

S&P 500 INDEX: One of the principle benchmarks for the U.S. Stock Market is the S&P 500 Index. This Index is a composite based on the value of the 500 largest corporations in America. These corporations contain 70% of the U.S. equity market's value and capture 60% of the daily trading volume; so it has a close correlation with the broad stock market, and is normally the most representative of the overall market trend.

The S&P 500 Index is based on Return on Investment (ROI), a measure of profit that is discussed later. The change in this Index over a period of time reflects not only the change in stock price, which is the capital gain, but also the dividends that are paid during the period; therefore, the change in the S & P 500 Index represents the Return on Investment for this large segment of the stock market. For example; if the price of stock increased by 7% during the year and there was a 3% increase in value due to dividends, then the S&P 500 Index increased in value by 10%, and we could hazard a guess that the U.S. Stock Market had a total return on investment of about 10%.

OTHER STOCK MARKET INDICES: There are other indexes in common usage. The Dow Jones Industrial Average is based on 30 large corporations that have been chosen by the Dow Jones Company, the former owner of the Wall Street Journal. The NASDAQ Index is based on a cross section of small companies whose stock is sold over-the-counter as identified by the National Association of Securities Dealers.

RETURN ON INVESTMENT (ROI): Return on Investment (ROI) is the total earning the investor receives for his stock, which includes capital gain (or loss) plus dividends and interest. For example; if you invest $10,000 in a thousand shares of stock at $10/share; and in one year it has increased in value by $2,000 dollars to $12/share and it paid a dividend of $1,000, your Return on Investment is $3,000, or 30%. The ROI is the bottom line that most investors are interested in.

YIELD: is the earnings produced, but normally does not factor in the capital gains. In the above example, the investor receives a $1,000 dividend, which is the yield. What is the point of ignoring the capital gain and using the term yield? Many investors are primarily interested in the dividends that come from a fixed capital investment and are not in the business of trading stock. For debt instruments such as Treasury Notes, Bonds, and Money Market the two terms, ROI and yield, become interchangeable; here the annual yield produced in the form of interest is the same as the ROI. Because these terms are commonly misused, you can never be certain what is meant until you do the calculation yourself.

PRICE TO EARNINGS RATIO (P/E): An important number investors look at is the ratio between the price of a stock and its earnings, expressed as the Price/Earnings ratio (P/E). Many investors look at this number for an individual company to decide if the earnings adequately reflect support for the price of a share of that company's stock, while other investors look at the number for the S&P 500 Index to gage the earnings for the overall market. The earnings are normally based on the earnings of the past year, but sometimes other time periods are substituted such as the projected earnings for the forecasted next year, so using the number calls for some investigation.

The average P/E for the S&P 500 Index over the past 50 years was 15.5. This means that the price paid for an average share of stock in an S&P 500 Index fund was 15.5 times its earning over the past year.

SUMMARY:

The five principle parameters of the economy that affect the stock market are:

Corporate earnings Interest Rates Inflation Liquidity $ Exchange rate

An investor need to become familiar with common stock market terms, such as:

S&P 500 Index: a principle measure of the U.S. Stock Market.

Other stock indices: Dow Jones Industrial Average and NASDAQ (ROI) Rate of Return: total earnings from investment in stock. Yield: earnings that exclude capital gains. (P/E) Price Earnings Ratio: the ratio of the price of stock with earnings for the past year.

Chapter Three

WHERE DO WE START?

While there are many kinds of investments, I will narrow my focus to the ownership of equity (corporate stock) that is bought and sold on the U.S. Stock Exchange. A purchase of equity could be accomplished as simply as a buyer handing cash to secure a purchase and the seller handing over the stock certificate, but today it is normally accomplished on a stock exchange. Our American Stock Exchange started a couple hundred years ago under a tree in New York City where men engaged in a bartering process. The tree has since been replaced by the New York Stock Exchange on Wall Street and it may eventually be replaced by computers using the internet or other modern alternatives. The bartering process has always been a dog-eat-dog operation - read Shakespeare's Merchant of Venice for a look at the market of six hundred years ago on the Rialto Bridge in Venice when Shylock wanted his pound of flesh for an unpaid debt.

Every person offering something for sale is looking for someone who wants to buy. They are each trying to out-do the other, and it remains the same process today even though it may have become impersonal and more complex. Since its earliest beginnings, the stock market has struggled with borderline corruption, insider information, minimal regulations, what information is ethical to share with whom, and how these things can be controlled. Additionally, all investments are subject to the jeopardy of risk compared with reward or potential return. A higher potential return normally is the result of assuming a greater risk. These problems cannot be totally eliminated; so that presents additional peril for a naive investor. Buyer beware!

We must always remember that the stock market is a bartering process where every transaction involves a buyer and a seller who each act on the basis of their own self-serving needs. We must remind ourselves of this when we begin to think the market is based on logic or some scientific laws. Perhaps one scientific principle I could cite as a former physicist is that the stock market is always in a state of unstable equilibrium. One of the roles of a "specialist" on the floor of the New York Stock Exchange is to "create a market," thereby establishing non-equilibrium to stimulate the bartering process.

When I was an executive in Owens-Illinois Inc. with good information about the future of my own company, I invested in its stock. After I retired, I was no longer comfortable with what little information I still had about company performance; so I stopped investing in the company. Gradually I learned that I do not have sufficient access to information about any company to gamble a substantial part of my portfolio on one. But I do have some degree of expertise and information about the overall Stock Market; so my equity investments today are almost entirely with an Index Fund.

In the following five chapters, we will take a closer look at each of the primary parameters of the economy that affect the stock market.

Chapter Four

CORPORATE EARNINGS

Investors buy stock because they want the corporate earnings plus any growth in the value of the stock. My own investment focus is on the broad stock market; so instead of buying stock in individual companies, I buy shares in an S&P 500 Index fund that is a composite of the 500 largest companies.

Chart # 1 gives a graph of the index for the past several decades together with the earnings per share (adjusted 10 times so they fit on the same chart). The chart provides a picture of the relationship between corporate earnings and the S&P 500 Index.

As seen on the chart, the Index was relatively flat for several decades as a result of poor corporate earnings. Then in about 1985 the earnings began to improve, which led to a climb in the blue line of the Index. In fact, the Index rose at a faster rate than supported by the increase in earnings as the result of investors speculating on future earnings. Another factor, the Price/Earnings ratio (discussed in the endnotes), now comes into play in determining the price of stock.

(Continues...)

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