A diversified stock portfolio analysis with economic indicators

Finance Portfolio

FedEx Corporation (NYSE: FDX)

Industry: Air delivery & freight services

Investment Style: Large Blend

Microsoft (Nasdaq: MSFT)

Industry: Application software

Investment Style: Large Growth

Target (NYSE: TGT)

Industry: Discount, variety stores

Investment Style: Large Blend

Johnson & Johnson (NYSE: JNJ)

Industry: Drug manufacturers

Investment Style: Large blend

Ford (NYSE: F)

Industry: Automobiles

Investment Style: Large Blend

Citigroup (NYSE: C)

Industry: Banking

Investment Style: Large Blend

Altria (NYSE: MO)

Industry: Cigarettes

Investment Style: Large Blend

Berkshire Hathaway (NYSE: BRK-B)

Industry: Property & casual insurance

Investment Style: Large Growth

Exxon Mobile (NYSE: XOM)

Industry: Oil & Gas

Investment Style: Large Growth

JetBlue (Nasdaq: JBLU)

Industry: Airlines

Investment Style: Large Growth

Portfolio, based on November 2 purchases, as of November 24th, 2009.

Economic Indicators

The leading economic indicators that I have chosen are the Dow Jones Industrial Average and the money supply growth rate (M2). The Dow Jones Industrial Average has been improving steadily since early March, when the index declined to just above 6500. The Dow now sits at 10,433, representing an improvement of 59.5% in that span. The Dow is considered a leading indicator because investors trade based on presumptions of future earnings. Therefore, the sharp rise in the Dow is indicative of investor sentiment that earnings will increase sharply in the coming months and years.

The M2 money supply is the amount of available money in the economy at a given point in time. M2 consists of funds readily available for spending (M1) plus savings deposits, time deposits under $100,000 and money market accounts for individuals. The money supply is considered a leading indicator because it hints at future spending patterns. In recent months, M2 has fluctuated (Federal Reserve, 2009). The seasonally-adjusted M2 is $8.359 trillion. This represents a slight upward trend in the past three months and is the highest level -- except for a spike in June 2009 in the past several years. This indicates that the economy is growing, and there is more money in the economy to continue that growth trajectory.

The coincident indicators I have selected are the gross domestic product and personal income. The gross domestic product (GDP) is an indicator of the value of the output of the nation, from within its borders. The real GDP of the United States increased in the third quarter by 2.8%. This comes on the heels of a second quarter GDP decline of 0.7% (Bureau of Economic Analysis, 2009). The medium-term trend, however, is towards a declining GDP. There is debate among economic experts as to whether the third quarter GDP increase represents a reversal of the trend, or is merely a blip caused by economic stimulus.

Personal income is another coincident indicator, and reflects the amount of money that consumers have to spend. Personal income decreased by $0.1 billion in September, or less than 0.1%. This continues a trend of flatlined personal income. The metric saw its last significant move in June, with a 1.1% decline coming on the heels of a 1.3% gain in May. This trend shows that the economy is stabilizing, but is not yet showing significant signs of improvement. It hints that the GDP increase in the third quarter may well be the result of stimulus, rather than long-term growth as the skeptics have suggested.

The lagging indicators that I have selected are the unemployment rate and the average prime rate charged by banks. The unemployment rate continues to decline. The rate for October 2009 was 10.2%, which represents an increase from 9.8% in September. The unemployment rate reflects the economic struggles at the beginning of the year. The current rate is the highest since April 1983 and is 5.3 percentage points higher than at the outset of the recession (Bureau of Labor Statistics, 2009). This rate is to be expected. Unemployment is mirroring the economic slowdown. It is not expected that there will be significant improvement in the unemployment rate for another six to nine months.

The second lagging indicator is the prime mortgage rate charged by banks. Banks seek to have a competitive edge over the competition, which keeps rates lower than the U.S. prime rate for longer periods of time. The bank rate has been dropping for the past several months and is expected to drop for several more. Analysts predict that by spring the bank mortgage rates will begin to increase again (Financial Forecast Center, 2009). What this indicates is that mortgage rates are following the pattern of the economy as a whole. Furthermore, significant change is not expected until spring, which as with unemployment rate expectations supports the idea that recovery has begun this fall.

Stocks and Their Economic Indicators

FedEx Corporation

FedEx is considered to be an economic bellweather. The company has a broad customer base including both businesses and consumers. FedEx is engaged in the logistics business, with its core business being the overnight courier business. FedEx also has a ground shipping business and a variety of smaller businesses that allow the company to be an all-round logistics supplier.

FedEx is subject to high fuel prices, which cut into its profit margins. The company has high fixed costs for its stations and airplanes, although they rely on airplane leases and casual labor to give them some degree of flexibility. The company was founded in the early 1970s and has grown rapidly to become an international firm, operating in all corners of the world. The company also faces intense competition from UPS. Overall, analysts are impressed with the quality of FedEx's operations and the strength of its brand, but are lukewarm about its financial prospects in a rising fuel cost environment and sluggish economy.

FedEx has performed roughly in line with its expectations. The company's stock price has improved over the course of the fall, in line with the indicators of economic performance. The improvement in the economy comes with expectations of FedEx having a strong peak season (November-December) with renewed consumer spending and economic growth.

JetBlue

JetBlue is a regional discount airline that operates hubs around the east coast, as well as its first hub at Long Beach International Airport in California. The airline began in 1999 and has focused on capturing the low-cost market by differentiating itself from other low cost carriers. To that end, JetBlue offers a wider range of amenities on its flights that do most of its competitors.

As with FedEx, JetBlue's performance is highly correlated with that of the economy as a whole, since the economy is a key determinant of air travel. The cost of jet fuel is another key input, and fluctuations in that commodity can impact JetBlue's ability to offer competitive pricing profitably.

It would be expected that JetBlue's stock would improve with the recent upswing in the economy, and this has proven to be the case. The company's stock has risen gradually over the past several months, with investors being tentatively willing to support JetBlue. The company's stock has declined slightly in recent months, but as with FedEx, JetBlue's fortunes rest on a busy holiday season.

Microsoft

Microsoft is primarily engaged in the software business. The company was founded in 1975 and grew rapidly from there. It went public in 1986, and hit big when its Windows operating system became the dominant platform for personal computers. The company has continued to expand its business beyond its core software offerings, by investing in online content and in the video game console industry. Microsoft is a highly profitable company, with strong margins driven by its near monopoly pricing power.

Microsoft's business is largely tied to the state of the broad economy. A substantial portion of its revenue base in corporate, in particular with respect to its software business. As such, Microsoft's business is tied largely to the GDP. In light of this, the company would be expected to have shown healthy gains in the past few months as the GDP has improved and the Dow Jones, of which Microsoft is a component, has improved as well. Indeed, Microsoft has seen a steady gain in its stock price over the past several months in response to this improvement in business conditions.

Target

Target is a discount retailer. Although the company has a long history dating to the beginning of the 20th century, the company has only engaged in the discount retailing segment in recent decades. Despite being one of the largest and most successful American companies, Target nonetheless is a distant second to Wal-Mart in its business. Competition is fierce, as the segment also competes against traditional department stores and against warehouse clubs such as Costco.

Discount stores have a negative correlation to the state of the economy. Many consumers "trade down" to discount stores during difficult economic times in order to stretch their shopping dollars. Both Wal-Mart and even the perennial industry dog K-Mart have seen upturns in business over the course of the recession. Target should, therefore, be subject to a similar phenomenon. It is not that economic improvement is bad for the company, but the slumping economy should not have hurt Target much. Target's chart, however, shows that the company has tracked the market and GDP fairly closely, indicating that perhaps it does not trade the way a discount retailer should.

Johnson & Johnson

JNJ is a pharmaceutical and consumer products company. It competes in pharmaceuticals, consumer products in the health and beauty segment and in medical devices. The company was founded in 1886 and today is a multinational conglomerate with operations in 57 countries and with approximately 250 subsidiaries.

To a certain extent, JNJ's product line is price inelastic. Pharmaceutical demand is tied to overall consumer demand and the state of the economy, but not to the same extent that many other consumer products are. As a result, JNJ would be expected to have less significant swings in its stock price relative to the GDP, other macroeconomic indicators, or the Dow Jones. The stock, however, has traded roughly in line with the market over the past year, hitting its lows in early March and gradually climbing back up.

Ford Motor Company

Ford was founded in 1903 and soon became the dominant automobile manufacturer in the United States. The company has always remained in the top three. Ford was, at the time, revolutionary for its approach to employees and to production management. Over time, Ford has been superceded by competitors such as General Motors and Toyota, but has always remained prominent. Ford still dominates the light truck market with its F-series. The company has struggled in recent years, a function of legacy costs and poor brand image.

The state of the economy has contributed to Ford's problems, but is certainly not the total cause of the company's struggles. Ford, with its historical emphasis on non-fuel-efficient vehicles, is susceptible to price movements of fuel, in addition to fluctuations in the general economy. The economic downturn had a strong negative impact on the company, but this impact forced Ford to make dramatic strategic moves. The result is that Ford has traded roughly in line with economic indicators over the course of this year. The company has seen its stock rise at a much faster rate than the Dow Jones or the broader economy, which would not have reasonably been predicted.

Citigroup

Citigroup is a major banking institution. It was founded in 1812 and is therefore one of the oldest firms on the New York Stock Exchange. Citigroup operates a nationwide network of retail banks, but also engages in corporate banking, investment banking and global wealth management. Citigroup has suffered greatly as a result of its "toxic assets," and has needed federal assistance in recent years in order to survive. As a result, Citigroup was removed from the Dow Jones Industrial Average.

As with most banks, Citigroup trades in part on the basis of interest rates. With interest rates at rock bottom, Citigroup's low cost of capital should allow it to make significant profits on its operations. However, the company has struggled as a result of bad assets on its books, relating to subprime mortgages and collateralized debt obligations. Citigroup, therefore, is not expected to trade in line with the GDP, but more in line with interest rates. Indeed, the company's stock has flatlined in recent months and trades today only slightly higher than it did in early April.

Altria

The former Phillip Morris is a cigarette manufacturer. The company formerly owned a stake in Miller Brewing, but has recently focused on its core cigarette business. This business has a low degree of price elasticity, and may even be seen as benefiting from economic downturn.

Altria is most heavily affected by cigarette tax rates, which can be set at all levels of government. Cigarette taxes have been on a long-term upward trend. The company has traded roughly in line with the broad market and the GDP, indicating that the company is more directly tied to the general economy than was perhaps believed.

Berkshire Hathaway B

Berkshire Hathaway is a conglomerate, with a number of different businesses. The main driver for Berkshire, however, is its insurance arm, Geico and General Re. Berkshire purchased Geico in 1996 and has built the brand into an insurance powerhouse since that time. General Re was added in 1998. Among Berkshire's other brands are Dairy Queen, Benjamin Moore and Fruit of the Loom.

The insurance segment of Berkshire's business is loosely affected by interest rates, but the conglomerate overall is more affected by the state off the economy, since it has a high degree of diversification. This is reflected in Berkshire's stock performance, which has traded broadly in line with the market but has flatlined in recent months in sympathy with prevailing interest rates.

Exxon Mobile

Exxon Mobile is an oil and gas multinational, engaged in both the exploration and extraction phase and the retail phase. The company has its roots in Standard Oil, founded in 1870 -- both Exxon and Mobile were descended from Standard. Since combining in 1999, Exxon Mobile has become the world's largest company by market cap. The company, however, remains much smaller than many state-owned oil enterprises and only holds a 3% market share.

Exxon Mobile can be expected to trade primarily in line with prevailing oil prices. Over the past year, crude oil prices have roughly tracked the broad economy, hitting a bottom in March and rising steadily since then. While XOM bottomed in March, it is had a less steady rise and has largely been rangebound for several months, thus performing below expectations.

Technical Analysis

JNJ is currently trading above its 50-day moving average, which is just below $61. It is trading well above its 200-day moving average, which is $57. As such, JNJ is likely overvalued based on technical analysis.

FedEx is trading above its 50-day moving average of around $78 per share; and well above its 200-day moving average of $61.50 per share. This indicates FedEx may be overvalued.

Microsoft is trading well above its 50-day ($27) and 200-day ($22.80) moving averages, indicating that it is perhaps overvalued.

While Target is trading well above its 200-day moving average, it has presently dipped below its 50-day moving average of around $49 per share. This dip is the first in the past three months, and likely indicates a good time to buy.

For the first time in months, Ford is tracking above its 50-day moving average. Ford stock is therefore likely to fall in the near future.

Citigroup's stock is currently trading below its 50-day moving average, but remains above the 200 day moving average. The 50-day average is trending downward and the stock price upward, so in the short-term at least Citigroup looks like a mild buy.

Altria has broken its technical ceiling and currently trades well above both of its moving averages. As such, Altria looks set to come down in price over the near-term.

Berkshire Hathaway B. broke through its technical ceiling on November 2nd, but appears to be sloping downward back to the 50-day moving average. It is likely therefore that the stock will decrease in value over the short-term.

Exxon Mobile has broken through both of its technical ceilings in early October. At present, the 50-day moving average shows a strong upward trend, but so does the stock price. Still, staying above the average for that long hints that Exxon may be set to fall soon.

JetBlue at the beginning of the month traded below both moving averages. It remains below the 50-day average. That average is declining, while the stock is rising (slowly), which indicates that it is likely to continue to rise near-term and break through the 50-day average.

Markowitz Risk

The Dow Jones Industrial Average has returned 6.58%. My portfolio, given the weightings on the first of November and the betas of the companies involved, should have returned 7.59%. Therefore, the actual returns were not only significantly smaller than the expected returns, but they were substantially different as well. This indicates that the portfolio was not well-diversified according to Markowitz. This portfolio's main theoretical advantage over the one that Markowitz would recommend is that it should return better than the market. Given that the market is expected to increase over the coming months, a riskier than average portfolio may be recommended for many investors looking to capture those strong market gains.

This portfolio is recommended for investors who are willing to take on a higher risk, but mainly wish to hold blue chip stocks. A value investor in particular, may find appeal in companies such as Ford and Citigroup that have very strong franchises but have seen their stocks beaten down over the past few years as a result of turmoil and significant government intervention in their industries. This portfolio is suitable for most of the people I surveyed, as most were students with high levels of risk tolerance and long time horizons.

The risk free asset selection I have made is a the five-year Treasury note. This bond expires on November 15, 2014. It has a coupon of 4.25% and currently trades at $110.12, giving it a yield to maturity of 2.271%. My average respondent was a student, with a long time horizon and high risk tolerance. On average, none of them needed the money right away. As such, I would not allocated any of their portfolios to this bond. They need long-term growth, not safety or income.

If any of them held the bond, its value would likely decrease if interest rates increased. However, since an interest rate increase is not expected in the near future, the bond value will likely hold steady. If rates moved against this bond, the best way to immunize this would be to invest in a business that benefits from higher rates, for example insurance companies like Berkshire Hathaway would provide immunization against rising bond rates.

Returns

I did not experience excess returns. The returns on the portfolio were 6.89%, versus an expected return of 7.59%. My portfolio, therefore, underperformed by 0.7 percentage points. The contribution of security selection to relative performance was significant. Many stocks have low betas, so the portfolio's success was predicated on a large run-up in the two high beta stocks, Ford and Citigroup. While Ford performed as expected, delivering 16.23% improvement, Citigroup did not. That company's stock only improved 5.51%, much worse than its risk level would indicate. My portfolio, in essence, was undermined by one dramatically underperforming stock.

Asset allocation would not have impacted the performance of my portfolio. Aside from Citigroup, the portfolio performed roughly to expectations. Because interest rates held flat, using fixed income instruments to lower the total risk would not have had much impact, since they would have returned to expectations.

Works Cited:

Yahoo! Finance, various pages. (2009). Retrieved November 25, 2009 from http://finance.yahoo.com

Federal Reserve. (2009). Money Stock Measures. Federal Reserve. Retrieved November 25, 2009 from http://www.federalreserve.gov/releases/h6/Current/

Bureau of Economic Analysis. (2009). National Economic Accounts. BEA. Retrieved November 25, 2009 from http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Bureau of Labor Statistics. (2009). Employment Situation Summary. BLS. Retrieved November 25, 2009 from http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Financial Forecast Center. (2009). 30-year mortgage rate forecast. FFC. Retrieved November 25, 2009 from http://forecasts.org/fha.htm