RATIONAL MARKET ECONOMICS

AuthorHouse

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

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

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...