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Unit 7: Fundamental Analysis 1: Economic Analysis

7.2.2 Investment-making Process Notes

Each of the sectors show sings of stagnation and degradation in the economy. This, we can
examine and understand by studying historical performance of various sectors of the economy
in the past, their performances at present and then forming the expectation about their
performances in the future. It is through this systematic process that one would be able to realise
various relevant investment opportunities whenever these arise. Sectoral analysis, therefore, is
carried out along with overall economy analysis as the rate of growth in overall economy often
differs from the rate within various segments/sectors.
Rationale of the above type of analysis depends on economic considerations too. The way
people in general, their income and the way they spend these earnings would in ultimate
analysis decide which industry or bunch of industries would grow in the future. Such spending
affects corporate profits, dividends and prices of the shares at the many would grow in the
future. A research study conducted by King (1966) reinforces the need of economic and industry
analysis in this context. According to him on an average, over half the variation in stock returns
is attributed to market prices that affect all the market indices. Over and above this, industry
specific factors account for approximately 10 to 15 per cent of the variation of stock returns. Thus,
taken together, two-third of the variation of stock prices/returns reported to market and industry
related factors. King’s study, despite the limitations of its period of its publication and use of
US-specific data, highlights the importance of economic and industry analyses in making
investment decisions. To neglect this analysis while deciding where to invest would be at one’s
peril.
It must be clear by this now that analysis of historical performance of the economy is a starting
point; albeit an important step. But, for the analyst to decide whether to invest or not, expected
future performance of the overall economy along with its various segments is most relevant.
Thus, all efforts should be made to forecast the performance of the economy so that the decision
to invest or to disinvest the securities can be a beneficial one. Decisions can be made in the most
haphazard manner. Interestingly, this calls for using the same indicators that describe how the
economy has shaped up in the past and how it is likely to take shape in the future as compared
to the current state of affairs.

Notes A healthy outlook about the economy goes a long way in boosting the investment
climate in general and investment in securities in particular.

7.2.3 Economic Forecasting

Still, it must be properly understood at this stage that economic forecasting is a must for making
investment decision. It has been mentioned earlier too, that the fortunes of specific industries
and the firm depends upon how the economy looks like in the future, both short-term and long-
term. Accordingly, forecasting techniques can also be divided and categories: Short-term
forecasting techniques are dealt with in detail; these terms should be clearly understood. Short-
term refers to a period up to three years. Sometimes, it can also refer to a much shorter period,
as a quarter or a few quarters. Intermediate period refers to a period of three to five years.
Long-term refers to the forecast made for more than five years. This may mean a period of ten
years or more.

Techniques used
Economic indicators

Diffusion index

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