Glossary

ADRs or American Depository Receipts represent foreign stocks that have been bought by a US bank and are then traded on US exchanges in USD. This grants US investors access to foreign company stock that might otherwise be unavailable on American exchanges. These certificates are traded in USD and therefore are exposed to exchange risk. ADRs may be subject to double taxation, both in foreign countries and in the US. A US income tax credit is typically granted for some or all the foreign taxes paid based on the investors’ tax situation. Finesse tracks country stock indices as ADRs because they automatically reflect what a US investor would be able to buy on a typical exchange, and the Exchange Rate is priced in, meaning returns are calculated after fluctuations in the Exchange Rate between the two countries.

The Finesse Bond Index measures the performance of a portfolio of government bonds of varying maturities with purchases staggered as follows: Short-term bonds have maturities of 1 year to 3 years: Six 1-year bonds are held; one bought every 2 months; six 2-year bonds bought every 4 months; and six 3-year bonds bought every 6 months. Intermediate bonds have maturities of 5, 7, or 10 years, with six 5-year bonds bought every 10 months; seven 7-year bonds bought every year; and ten 10-year bonds bought every year. The long-term Bond Index has ten 20-year bonds bought every 2 years, and ten 30-year bonds bought every 3 years. Bonds are valued and yields to maturity are recalculated every month based on changes in the country’s 30-day T-bill rate. Bond interest is assumed to be paid every month, and no deduction is made for bond commission expense. If a government bond yield is unavailable for a particular term, the bond yield is interpolated based on the closest bond terms.

The Bubble Index adds the average annual growth rate of six economic indicators over the prior three years and compares them to the 3-year period just prior to the 2008 financial crises to gage whether the current economy is headed toward an unsustainable bubble as occurred in 2008. The six indicators are the average 12 month % change in (1) the stock market; (2) real estate housing price index (or property prices or Housing Starts if a price index is not available); (3) personal consumption; (4) employment; (5), real GDP growth; and (6) total debt as a % of GDP.

Finesse calculates the business cycle with respect to the stock market in each country. The Finesse Business Cycle Index is based on the 12-month change in 6 indicators: the stock market price, real GDP, short term interest rates, consumer confidence, new orders for Durable Goods, and whether the Yield Curve is steepening, flattening or inverting.

The PE or Price-to-Earnings ratio divides a company’s stock price by the earnings reported by that company. The CAPE Ratio is a variant of this measure developed by Yale economist Robert Shiller and is typically applied to indices like the S&P500. The Cyclically Adjusted Price Earnings ratio divides the past 10 years’ average inflation-adjusted earnings by the current stock index value. The CAPE Ratio smooths out the impact of business cycles and other events and gives a better picture of a market’s sustainable earning power. Shiller found that the lower the CAPE Ratio, the larger the expected return over the next 20 years. It is criticized for being too pessimistic, and for undervaluing the earnings growth of new companies.

The Central Bank Balance Sheet indicates the amount of cash circulating in the economy and the amount of money available for loans. When its balance sheet is increasing, the Central Bank is trying to grow the economy by adding more liquidity that will lead to more loans and more economic activity. When its balance sheet is decreasing, the Central Bank is trying to moderate growth and slow spending. In the US, assets on the balance sheet are primarily US Treasury notes and bonds, and mortgage-backed securities such as mortgage loans guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Liabilities are commonly the amount of currency in circulation, bank reserves deposited by member banks into Federal accounts, and reverse repurchase agreements which represent overnight loans from member banks to the Central Bank.

Commodities impact financial markets because they are essential for producers and manufacturers. Commodity prices depend on supply and demand, and they vary by geographic factors such as drought or demand by importing countries. The spot price is what Commodities trade for today, but Commodities are typically traded according to futures prices, which is the price the commodity will sell for at a date in the future.

The global Competitiveness index GCI has been compiled by Columbia University economists in NY since the 1970s and is based on these factors: laws and courts protecting company and worker rights; transportation, electricity, communications, and information Infrastructure; predictable inflation rates; sustainable budgets and debt levels; health and education systems; protecting basic worker rights; bank and financial regulations and soundness; business regulations and the cost to start a business; tariffs; research and development and patent applications; and the size of the country’s domestic and export markets. In response to the COVID pandemic, the GCI revised its Competitiveness index in 2020 to measure a country’s readiness to respond to societal weaknesses exposed in the COVID pandemic and to transform to 4IR, the 4th Industrial Revolution dominated by the internet and communications as contrasted with the earlier coal, oil and electricity revolutions. The new index measures a country’s exposure to populism; declining financial incentives in energy, emissions and social services; progress in eldercare and childcare; unemployment relief beyond simple furloughs where workers keep their jobs but lose pay; ease of finding skilled workers; incentives for alternative energy; and broadening access to electricity, information, and communication technology.

Core Inflation measures the change in the costs of goods and services not including changes in very volatile sectors like food and energy. Each country determines which sectors are to be included in the Core Inflation measures. For example, food and energy are dependent on supply and demand and can cause short term price changes such as from drought that distort long term inflation changes. Core Inflation is often calculated using the Consumer Price Index CPI and the Personal Consumption Expenditures Index PCE. These are indices that are constructed from monthly changes in the prices of a pre-selected basket of goods and services and removes items that have the largest price changes due to their distorting effect. Economies grow when GDP and wages increase more than the Core Inflation rate.

A currency crisis is defined as an extreme drop in the real Exchange Rate and in foreign reserves at least 3 standard deviations below average. Warning signs include a drop in the stock market and exports, a high ratio of M2 broad money compared to foreign reserves (often because the country spreads its foreign exchange reserves to purchase and prop up its domestic currency), a rise in the ratio of short-term government debt to foreign reserves, and a drop in industrial output and GDP. See Reinhart et al, Assessing Financial Vulnerability, An Early Warning System for Emerging Markets, Institute for International Economics, 2000.

Hedge fund Bridgewater Associates founder Ray Dalio breaks down debt cycles into 5 phases: (1) the early phase typically lasting 2 years, often described as the Goldilocks period when the economy is neither too hot nor cold; (2) the bubble, lasting 3 years when the economy grows faster than is sustainable; (3) the market top, typically lasting about 12 months; (4) the depression when the country reduces its excess debt for about 3 years; and (5), normalization, taking 3 years or longer, as the economy recovers and returns to normal. Dalio describes 48 big debt crises in the world since 1918, 21 from established economies, which typically borrow in their own currency and respond to debt crises by lowering interest rates and deflating their own currency, and 27 from emerging markets that typically borrow in foreign currencies such as the US dollar and respond by inflating their own currency: Dalio, Big Debt Crises, 2018, Part 3, p.3.

Durable Goods orders reflect new orders placed with domestic manufacturers for delivery of factory hard goods (Durable Goods) in the near term or future. Businesses and consumers generally place orders for Durable Goods when they are confident the economy is improving. An increase in Durable Goods orders signifies an economy trending upwards. Durable Goods are expensive items that last three years or more. As a result, companies purchase them infrequently. They include machinery and equipment, such as computer equipment and industrial machinery.

The proportion of a country’s working age population that is employed. Note that countries often vary in their working age range. “Employed” persons typically include everyone who is employed, or works in their own business, or works without pay in a family business. Countries may also have different standards regarding how many hours worked constitutes “employed” status. There may be significant variation between any two countries. The “Phillips Curve” compares employment with inflation, suggesting that high employment would cause inflation to increase. Governments that consider this a worthwhile tradeoff adopted expansionist policies, figuring that higher inflation was justified if it increased employment. The Phillips Curve has lost favor in recent years as the relationship between unemployment and inflation is less robust, but countries still use it in economic policy decisions.

Equity Risk Premium = 1/PE ratio minus the 10yr Bond Yield. Also known as the Stock Risk Premium, it measures the expected additional return an investor earns by holding the riskier stock market rather than government bonds. Finesse calculates it by subtracting the 10-year government bond% yield from the current stock market earnings % yield. The stock market earnings % yield is the inverse of the price-earnings PE ratio (i.e., 1/PE). The PE rises as the stock market becomes over-valued. This causes the earnings yield and the Equity Risk Premium to drop, making the bond yield more attractive. So, the Equity Risk Premium rises as the stock market value decreases or as bond yields decrease, and the higher the premium, the better. The Equity Risk Premium can also be based on historic stock market returns or by polling stock analysts, but Aswath Damodaran, NYU School of Business, suggests these are unreliable and that the current implied premium based on the current PE ratio has a higher correlation with actual stock market returns over 1, 5, and 10 years out. See Table 26, pg. 128 of his paper “Equity Risk Premium: Determinants, Estimation, and Implications – the 2021 Edition,” updated March 21, 2021. He cautions that it is important that the same method be used consistently over time and across countries as Finesse does with the formula described above.

The Exchange Rate pair represents 1 unit of the domestic currency (the “base currency”) purchasing an amount of the foreign currency or (the “quote currency”). Because the USD is considered the world’s reserve currency, and it is currently the most traded currency, our analysis uses the USD as the as the quote currency in any currency pair. Take note that in trading FOREX, traders have standardized pairs that may be opposite. For example, a common trading pair is USDCAD (Canadian dollar). Finesse inverts the pair to be CADUSD so that we know how much USD a single CAD would be worth at a given time. Hence, this standardizes all our foreign currency analysis in USD. Exchange Rates are affected by (1) the country’s inflation rate (higher inflation devalues the currency); (2) central bank interest rates (higher rates cause investors to purchase the currency and the country’s bonds thereby increasing the currency’s value, and vice versa); (3) stock market (investors buy the currency to invest in the rising stock market, and vice versa); and (4) the current account (investors purchase the foreign currency to buy its exports, or the country’s consumers sell the currency to pay for imported goods). Exchange Rates can be fixed (ex. gold standard) by the country or more commonly float (fiat) so that they are based on currency demand. A country can have only 2 of 3 of the following: A fixed Exchange Rate, free capital movement, and independent monetary policy according to the Mundell Fleming Model.

Fiat Money is a type of currency that is not backed by a commodity, such as gold or silver, but is backed by the country’s full faith and credit. It is typically designated by the government to be legal tender. Legal tender includes coins and currency, generally anything recognized by law as a means to settle a public or private debt or to meet a financial obligation including tax payments, contracts, and legal fines or damages. The national currency is legal tender in practically every country. A country can try to maintain a fixed Exchange Rate by varying its interest rate, buying or selling its currency on the open market, or by imposing capital constraints to prevent investors from withdrawing capital. The Mundell-Fleming model posits the country can pursue only 2 of these 3 at any one time.

The Forward Currency rate is a rate that a currency will trade for at a future date and is determined by the short-term interest rates in the 2 countries whose Exchange Rate is being determined. Traders use these interest rates to calculate the price at which a currency will be traded on a future date. It is a derivative contract of the underlying currency which suggests the direction of a currency in the future. French academic Peir Sercu suggests that fundamental indicators are poor predictors of future Exchange Rates and that the forward rate is the best predictor of future Exchange Rates because it efficiently captures market sentiment; International Finance, 2009, p. 385, 428. Foreign currency investors sell their domestic currency to purchase foreign currency, so they incur interest expenses at the domestic rate on the currency they sell and receive interest on the foreign currency they hold.

Fundamental Analysis is a method of determining a country’s economy based on interest rates, inflation, production, employment, GDP, housing, etc., or a company’s value by examining its financial statements, health, competitors and markets. Fundamental investors search for companies whose stock prices are below their intrinsic value, expecting profits when the market reprices them until they reach their intrinsic value. In bottom up analysis investors start with the company and compare its prospects to the industry and overall economy, while top down investors start with the overall economy and work down to specific industries or companies. Contrast to Technical Analysis which focuses on stock trends and price levels and investors’ emotional responses to price movements. Investors commonly combine both fundamental and Technical Analysis.

Finesse tracks Gasoline Prices as an average price paid at the pump in $USD/ Liter. Gas prices often reflect changes in the geopolitical climate, environmental climate, economic conditions, and ultimately supply vs. demand. When oil rises over 50% in a year, recessions often occur in the US, as happened in the 1970’s and after the 2008 financial crisis.

A country can tolerate growing debt if GDP is growing faster than debt because its growing income can pay its growing debt. The obvious warning sign is when debt grows faster than GDP. Negative consequences of this are (1) a country might not be able to repay debt; (2) cash must be added to the system to pay for these debts which increases inflation or deflates the currency or both; (3) taxes must be levied to pay for debt, which is difficult on an economy and can slow growth.

A country can tolerate growing debt if its net long-term bond interest rate is kept below its GDP Growth Rate, what former World Bank Chief Economist Carmen Reinhart calls “financial repression”. Otherwise, a country will end up paying bond holders at a rate higher than GDP with negative consequences to the country’s balance sheet.

Government Spending refers to public expenditure on goods and services and is a major component of the GDP. Government spending policies on budgets, taxation and increasing public expenditure on public works are effective tools in influencing economic growth. Countries vary widely in how much they tolerate deficit spending, and nearly every country’s public debt has increased since 2000. A low ratio of Debt / GDP indicates the economy produces enough goods and services to repay the debt without incurring further debt. The Euro Convergence Criteria requires Euro Countries to keep Public Debt below 60% of GDP. According to Reinhart and Rogoff (Growth in a time of Debt, 2010, pg. 11, NBER Work Paper 15639), when the gross debt of the public sector exceeds 90% of GDP, median real GDP growth is 1% lower in the coming decade and the average growth rate is lower still. There is little evidence that countries can grow their economy enough to lower the debt to a manageable percentage of GDP. Instead, countries typically must adopt austere fiscal policies (increase taxes, decrease expenditures), restructure and roll over their debt, increase inflation so that debt is repaid with inflated currency, or hold interest rates low to reduce interest cost. A country that can “monetize” the debt by printing more money to pay for it but this will cause inflation. In emerging economies, an external Debt/ GDP ratio above 30-35% signals heightened risk of a credit crisis; Reinhart, C., Rogoff K., This Time is Different, 2009, p. 25.

Housing Starts report the number of privately owned new houses (technical housing units) on which construction has been started in a given period. Housing permits are an advance measure that indicates when housing building permits are approved. Data is typically divided into three types: single-family houses, townhouses or small condos, and apartment buildings with five or more units. Each apartment unit is considered a single start, so, the construction of a 30-unit apartment building is counted as 30 Housing Starts. It is considered an important leading economic indicator where an increase in housing is often an early indicator that the country is pulling out from a recession. Housing incentives like low interest rates can cause overbuilt housing, which can lead to economic crises as occurred in the US in 1989 and 2008, and in China starting in 2020.

Income inequality is measured according to the share of wealth owned by the top 10%, based on data compiled by the World Inequality Lab managed by Lucas Chancel, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. Finesse ranks countries based on this disparity, with the highest wealth inequality receiving the lowest rank, and the lowest wealth inequality receiving the highest rank. The World Inequality Lab obtains data from public data sources including tax records, national income accounts, and wealth surveys. Critics counter that this excludes the underground cash economy, which is inherently challenging due to its secretive nature. Piketty’s work is more focused on identifying long-term trends and he believes the underground economy would not fundamentally alter his conclusion that income and wealth inequality have been increasing. His solution is to enact an annual wealth tax starting at 1% of assets including net real estate equity (assessed property value less mortgage) and publicly traded stocks, bonds, and cash accounts.

Infrastructure measures a country’s spending on Infrastructure including roads, airports, communications, and computer technology. It includes both public and private spending. Data compiled by the World Band and International Monetary Fund can vary widely, particularly for developing countries.

Innovation measures how readily a country’s economy adopts new technologies. The index measures inputs which focus on how well the business environment fosters Innovation, and outputs which demonstrate how much Innovation is occurring, such as the number of patent applications or research articles published. Inputs include contract and patent protection; creditor protection measured by their asset recovery rate in bankruptcy proceedings; education levels, including the country’s 15-year-old students’ scores in reading, mathematics and science; transportation, electricity and communication Infrastructure; R&D as a percent of GDP; availability of business credit; and unique factors such as the percentage of females employed with advanced degrees, a measure of how sophisticated the economy is. Outputs include 3-year increase in labor productivity; the percent of total trade spent on computer software, intellectual property and high-tech exports; net foreign direct investment; the value of the 5,000 most valuable brands as a percent of GDP; national feature films produced and other creative goods as a percent of total exports; and unique factors including the number of annual Wikipedia edits. The Global Innovation Index is produced by the World Economic Forum, known for its annual winter forum in Davos, is a non-governmental organization founded in 1971 in Geneva Switzerland to promote European business interests to the world.

The Market Cap to Gross National Income GNI ratio is the “best single measure of where valuations stand at any given moment” according to Warren Buffett. It compares the total value of the country’s stock market to its annual GDP after adding investment income earned abroad and subtracting investment income paid to foreign investors (that forms Gross National Income or GNI). Like the CAPE Ratio, it can be a predictor of future long-term returns based on a fundamental valuation. When valuations are high, the stock market’s long-term return is likely to be lower.

Momentum is the rate of acceleration of a securities price – that is, the speed at which the price is changing. Momentum trading is a strategy where traders work with volatility to find buying and selling opportunities within a trend, typically short term.

The monetary and fiscal tightening gauge is based on government spending and central bank policies regarding the availability of cash and the interest rate target. Policies are expansionary when government spending increases as a percent of GDP (including increased deficit spending), and when the central bank increases the money supply or lowers interest rates. Policies are contractionary when the government decreases spending as a percent of GDP, and when the central bank reduces the money supply or raises interest rates. Finesse constructs a monetary tightening gage with the following three indicators: (1) the 12-month change in Money Supply as a % of GDP, with higher values indicating expansion and lower values indicating tightening; (2) the 12-month change in government spending, with increasing deficit spending indicating expansion, and a budget surplus indicating contraction; and (3) the 12-month change in the short-term interest rate, with decreasing rates indicating expansion, and increasing rates indicating contraction. In the graph, Lower numbers indicate tightening, and higher numbers reflect looser monetary conditions.

Money supply measures the amount of cash in the economy, with designations ranging from M0 to M3 where each successive number includes the lower number designations (i.e., M1 includes M0, and M2 includes M1 & M0, etc.). M0 includes bank reserves, both required and excess, plus cash and coins in circulation. M1 includes money in checking accounts (demand deposits) and travelers checks. M2 includes savings accounts, money market accounts, and CDs under $100,000. M3 includes CDs over $100,000. Economist Milton Friedman asserts money supply is directly tied to inflation, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (The Counter-Revolution in Monetary Theory, 1970). Not all economists agree.

Nominal values in economics refer to the unadjusted rate or current price, without taking inflation or other factors into account. Compare to Real (Inflation-Adjusted) values, where adjustments are made for inflation to the change in the general price level over time.

A “consumer economy” is driven by consumer spending. Personal consumption accounts for about 70% of GDP in developed countries. Services account for 60% of total consumption, followed by 30% of non-Durable Goods like groceries and gasoline, and 10% Durable Goods that last 3 years or more. Economies can be ranked by absolute consumer spending, or by consumption’s % share of total GNP (Gross National Product). In 1960, US consumption accounted for 62% of GDP, rising to 71% by 2013.

The Projected Stock Return equals the dividend % yield plus 100% of the past 2.5-year average GDP % growth rate, plus the Market Cap to GNI % discount (or minus the Market Cap to GNI premium). The GDP growth rate is reduced to its 2.5-year average because the dividend yield already captures part of the country's GDP growth. To the extent the Market Cap to GNI ratio is above average (indicating the stock market is over-valued), this premium is subtracted from the Projected Stock Return. Conversely, to the extent the Market Cap to GNI ratio is below average (indicating the stock market is under-valued), this discount is added to the Projected Stock Return.

Real values subtract the inflation rate from the growth rate. They are more important than nominal values for various economic measures, such as gross domestic product (GDP) and personal incomes, because they help ascertain the extent to which increases over time are driven by actual growth as opposed to what is driven by inflation. Readers should assure themselves that any comparison is comparing real with real, or nominal with nominal values.

The Real Effective Exchange Rate measures the strength of a country’s Exchange Rate against a basket of currencies that are weighted by the amount of trading the country has with its major trading partners. Differing weights are assigned to imports and exports, and the weights are adjusted every 3 years to account for changes in the country’s particular mix of imports and exports (i.e., if computers previously accounted for 5% of a country’s imports but now make up 10%, the country’s import mix will change). The real effective Exchange Rate adjusts the nominal Exchange Rate by the appropriate foreign price level and deflates it by the home country price level. Effective Exchange Rates are useful for gauging whether a currency has appreciated overall relative to trading partners. They are volatile over short periods of time and a poor guide for comparing standards of living across countries. For that purpose, Purchasing Power Parity measures are more appropriate.

Joseph Ellis (Ahead of the curve, 2005, p. 109) considered this as the most significant leading economic indicator of stock market performance. He considers unemployment a lagging indicator because employers typically delay hiring until after the economy improves and similarly delay laying off employees until after it starts deteriorating. Wage price growth is a good predictor of consumer spending, the major driver of advanced economies, because most consumer cash comes from wages. It surpasses consumer sentiment, which Ellis believes has little predictive value, and the “wealth effect” of higher stock and home values, because they are “back burner” assets that consumers generally don’t spend.

Retail Sales Growth is calculated by interviewing retailers by phone each month about their inventory turnover, focusing on food and liquor; household goods including furniture, electronic goods, hardware and gardening; clothing and footwear; department stores; restaurants; and specialty retailers selling books, drugs, and recreation equipment. Figures are real (inflation-adjusted) and seasonally adjusted to account for calendar year variations, such as the difference in weekly sales that would occur if Christmas fell on a Sunday and was preceded by 6 days of sales or fell on a Thursday and preceded by only 3 days of sales.

The Taylor Interest Rate is a monetary policy targeting rule proposed by economist John B. Taylor in 1992. The formula to derive a target interest rate is calculated using the Nominal Federal Funds Rate, the Rate of Inflation, and the deviation between the current real GDP and potential GDP if the country were operating at full capacity, also known as the GDP Output Gap. The OECD calculates the GDP Output Gap for select countries; if it is unavailable, the country’s Employment Rate is substituted. The Taylor rule adds the amount by which a country’s inflation exceeds 2% to an assumed equilibrium federal funds rate of 2% in determining the short-term interest rate, so as inflation increases, so does the Taylor Interest Rate.

The unEmployment Rate is the percentage of workers who are actively looking for work but cannot obtain it, calculated by dividing the number of unemployed persons by the number employed in the labor force. Countries may vary in what age range they use to determine whether workers are part of the employment cohort (i.e., whether they exclude workers under age 16 or after they reach age 66 for instance). Classical economists believe unemployment results from unions and bureaucratic regulations such as minimum wage laws and payroll taxes. John Maynard Keynes believed unemployment resulted from a dearth of money in the economy and recommended public spending and expansionist monetary policies to increase employment. The unEmployment Rate understates actual unemployment because it does not include people not looking for work (4% of the US workforce in 1950 vs. 11% in 2018), or under-employed persons. In the US the underEmployment Rate is called the “U-6” unEmployment Rate, reaching 17.1% in May 2010 compared to the official 9.9% unEmployment Rate.

Technical Analysis is a method that determines moments to buy or sell an investment based on functions of security price and volume. Investors using Technical Analysis search for statistical trends based on historical performance such as whether a stock is above or below its 6-month moving average. Technical Analysis captures the psychological aspects of the market in the review of past patterns, whereas Fundamental Analysis fails to factor in investor psychology, believing that fundamentals will rule in the long term and short-term psychological blips will correct themselves. Technical analysts might also use charting techniques to determine support, resistance, and trend reversal in charts like a candlestick chart. Investors commonly combine both fundamental and Technical Analysis.

The Yield Curve is represented as a line plotted across yields from different bonds of the same credit rating with different maturity dates. This forms three modes for the Yield Curve; normal, where bonds with longer maturity dates have higher yields than bonds with shorter maturity rates; inverted, where short term bond yields are higher than long term bond yields; and flat, where short term bond yields are roughly the same as long term bond yields. Finesse measures the slope of this curve by subtracting the short-term bond yield (1yr or less) from the 10-year bond yield rate. Long term rates are generally higher to compensate lenders for future risk including inflation. Central banks raise short term rates to slow inflation and cool the economy. If short term rates exceed long term rates, the Yield Curve inverts (turns negative) which often precedes a recession and a stock market drop.