THE BASIC CONCEPT ECONOMY
The performance of an investment is influenced by the economy.  The effects of inflation or deflation may hinder with anticipated returns.  Thus, the direction of the economy must be considered when formulating an investment strategy.

THE BUSINESS CYCLE
The business cycle represents a repetitive succession of changes in economic activity.  The business cycle has four phases: expansion (also called recovery), peak, recession (also called contraction), and trough.

EXPANSION
In the expansion phase, business activity is growing, production and demand are increasing, and employment is expanding. Businesses and consumers normally borrow money to expand, which causes interest rates to rise.

INFLATION
As the cycle moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During inflationary times, there is too much money chasing a limited amount of goods. Therefore, businesses are able to charge more for their items causing prices to rise. This, in turn, reduces the purchasing power of the consumer. As prices rise, demand slackens which causes economic activity to decrease. The cycle then enters the recessionary phase.

DEFLATION
As business activity contracts, employers lay off workers (unemployment increases) and demand slackens. Usually, this cause prices to fall creating deflation. The cycle enters the trough. Deflation is the persistent and appreciable fall in the general level of prices. Eventually, lower prices will stimulate demand and the economy moves into the next cycles, expansion.

GROSS NATIONAL PRODUCT
One of the most significant measures of economic activity is the Gross National Product (GNP). GNP is the total value of goods and services produced by the entire U.S. economy. Components of the GNP include consumer spending, investments, government spending, and net exports.

The government reports GNP quarterly. There are two types of GNP. "Normal GNP" reflects the total dollars spent on goods and services for the quarter. "Real GNP" adjusts the nominal GNP for the effects of inflation. Real GNP is measured in constant dollars (money adjusted for inflation) and is the best method for comparing GNP over time.

A recession occurs when Real GNP (Gross National Product adjusted for inflation) has declined for two successive quarters.

BUSINESS CYCLE INDICATORS
Economists use three types of indicators that provide monthly data on the movement of the economy as the business cycle enters different phases. The three types are leading, coincident, and lagging indicators.

LEADING ECONOMIC INDICATORS
Leading economic indicators precede the upward and downward movements of the business cycle. They may also be used to predict the near term activity of the economy. The U.S. Government complies an index of eleven leading economic indicators. This index is released monthly and is adjusted for inflation. The components of the index are:

COINCIDENT ECONOMIC INDICATORS
Coincident indicators usually mirror the movements of the business cycle. The makeup of the coincident economic indicators include four components:

LAGGING ECONOMIC INDICATORS
The index of lagging indicators represents items that change after the economy has moved through the various stages of the business cycle. The index of lagging indicators confirms the economic condition portrayed by the leading and coincident indexes. Lagging indicators includes:

THE EFFECT OF THE BUSINESS CYCLE ON FINANCIAL MARKET
As the economy moves through the different phases of the business cycle, the bond and equity markets react to these changes. Investors view these changes and take corresponding action, attempting to take advantage of changes in the economy.

In the bond markets, prices of bonds move inversely to interest rates (yields). As interest rates increase, bondholders sustain losses as the prices of their bonds fall. If interest rates fall, bondholders will benefit from rising prices.

Changes in the business cycle also affect the equities markets. Interest rate sensitive stocks, such as those issued by utilities, react to changes in interest rates. Since utility companies are highly leveraged, it becomes more expensive for these companies to raise money when interest rates increase. Interest charges increase, causing a drain on earnings, resulting in a decline in prices of these securities.

Cyclical stocks are those stocks that move with the business cycle. If the economy is in a period of prosperity, these companies prosper. However, as the economy falters, cyclical stocks decline. The common stock of a machine tool company would be an example of a cyclical stock. As the economy expands, new orders for machinery increase and machine tool companies prosper. Other examples of cyclical stocks would be basic industries (rubber, steel, etc.), construction firms, and manufacturers of durable good.

The stocks of defensive companies react less to changes in the business cycle than cyclical stocks. These would include stocks of utilities, tobacco, beer, candy, and food companies. The basic premise is that people still need basic services to exist. Thus, these companies are the last to be negatively affected as the economic moves through difficult periods.

MONETARY POLICY
Monetary policy attempts to control the supply of money and credit in the economy. This will affect interest rates causing an increase or decrease in economic activity. The primary focus of monetary policy is the control of inflation.

THE FEDERAL RESERVE SYSTEM
The Federal Reserve System implements monetary policy in the U.S. An Act of Congress established the Federal Reserve System, the nation’s central bank, in 1913. The Act divided the country into 12 Federal Reserve districts. Responsibility for coordinating the activities of the district banks lies with the Federal Reserve Board of Governors in Washington, D.C. The board has seven members appointed by the President and confirmed by the Senate.

MAJOR TOOLS OF THE FEDERAL RESERVE BOARD
Since money is primarily created by the commercial banking system, the FRB must control the banking system to implement monetary policy decisions. The Fed has various tools at its disposal through which it may implement its monetary policy. These tools are:

EFFECTS OF THE FEDERAL RESERVE BOARD'S ACTIVITIES
As with any product, when the supply increases, the price of that product will decrease. If the supply contracts, the price will increase. The "price of money" is the interest rate that lenders charge borrowers. Thus, as FRB changes the supply of money, the "price of money" (interest rates) must also change. As interest rate changes, the FRB will adjust its monetary policy in order to influence the various sectors of the economy.
In summary, Federal Reserve Board activities tend to cause the following:

Activity Effect on Money	Effect on Money Supply Credit  Availability	Impact on General Interest  Rate Levels
Raise bank reserve requirements	Decrease	Raise
Raise the discount rage	Decrease	Raise
Raise margin requirements	Decrease	Raise
Sell government securities in the open market	Decrease	Raise
Lower bank reserve requirements	Increase	Lower
Lower the discount rate	Increase	Lower
Lower margin Requirements	Increase	Lower
Buy government securities in the open market	Increase	Lower

Terminology Used in Fundamental Analysis:

Term	Definition
Trade Deficit	When the merchant export value is smaller than import value, the outflow of currency results.
Balance of Payment	A statement in which all the revenues and expenditures of country are recorded.
Gross National Product	This figure reflects the growth and the economic situation of a country.
Unemployment Rate	A rate showing the percentage of the unemployed workers within the total population.
Non-Farm Payroll	This figure reflects the health of the commercial and industrial sector of an economy. The size of this figure is positively related to the growth rate of an economy.
Industrial production	It shows the industrial output of an economy. The higher the figure, the better the economy.
Factory Orders	The amount of orders received by manufacturers. The higher the figure, the better the economy.
Business Inventory	Unsold output. When this figure is high, an economy is slow and the currency of this country would be weakened.
Capital Utilization	This figure is high when an economy is strong. A high figure is beneficial to the currency of a country.
Leading Indicator	It can be used to predict the health of an economy. A high figure reflects high inflationary pressure. The following indices are related to inflation.

The following indices are related to inflation:

Federal Fund Rate - The inter-bank rate for borrowing or lending reserve to meet margin requirement.