There are two issues of concern for financial ratios and their interaction

with economic activity. These two issues are the interaction of cyclical and

secular (longer-term) patterns and the role of broader economic change that

alters the financial ratios.

First, the patterns of many financial ratios have a cyclical component

tied to the business cycle, as well as a secular component that reflects a

longrun pattern. Therefore, it is important to distinguish cyclical and secular

patterns with each financial ratio. In examining the behavior of any ratio

across time, the role of time series analysis comes into play. As analysts

look at the behavior of any series over time, they want to judge whether

the movements in the series suggest cyclical motion around a series that

has no trend (stationary) or cyclical motion around a changing trend (non-

stationary),as the statistical properties and therefore the degree of confidence

in their modeling will be different in each instance.

Second, the patterns in financial ratios may reflect a more generalized

pattern of economic change; therefore, each financial ratio is not an independent

indicator of the financial or economic health of an institution. Putting

two ratios in a model to forecast behavior when both ratios may reflect

a third, unaccounted-for, economic factor may lead to statistical problems

in estimation that are discussed later. Ratios are indicators of some other

factor—efficiency, liquidity, leverage, market value, which are the true in-

terests of the analyst. And yet while different ratios may both be inputs to

a model, they may also be the dependent variable of other economic

factors. The correlations for the financial

ratios show a statistically significant value in relationship to a number of

economic drivers. For example, the P/E ratio is highly correlated to growth

and inflation. Taking another cut at the data, the 10-year Treasury rate is

negatively linked to the P/E ratio, as would be expected. The dollar is

positively correlated with the price/earnings ratio as well, and this would be

expected as both would be linked to a growing economy.

Financial ratios provide the basis for many investor decisions. These ratios

also provide guidance to leaders who want to monitor the progress of their

own institutions. Each ratio is linked to economic factors, particularly the

economic cycle, which will influence how decision makers interpret any

change in the observed values of the ratio. Ratios are endogenous to the

economic cycle, impacted by a number of economic factors and yet also

showasecularpatternovertime.Inmodelsthatestimatechangesinfinancial

ratios, such as the P/E ratio, over time, there is a challenge to choosing the

independent variables that influence the behavior of any financial ratio. The

focus in this chapter is on the five economic factors of growth, inflation,

interest rates, the dollar, and profits.

The principles for information also apply here. The role of financial

ratios is to provide information to decision makers —helping them forecast

important turns in factors such as liquidity, leverage, operating efficiency,

and market valuation of how well firm management is doing. A change in a

critical financial ratio is a signal of change in the economic landscape, and

that will lead decision makers to reevaluate the implications for whatever

purpose they are using their ratio.

The information decision makers derive from the patterns of the financial

ratios that they study introduced,unfortunately,into an imperfectly specified

decision-making process. In real world decision-making patterns, analysts focus

on a few plausible outcomes and assign a probability to each. In some cases,

they search for only a limited number of equities or bonds, perhaps for a limited

number of countries. Analysts are limited in time and so they often proscribe the

number of outcomes they examine.

This reflects their judgment and, in some cases, their judgment can be very

unrealistic about the range of options. During the Great Recession of 2007

to 2009, assumptions about liquidity, marketability of financial assets, and

therealmarketvalueofrealassetssuchashomeswerequiteunrealisticatthe

start of the recession. Moreover, the damage of the recession was far greater

than policy makers at the time anticipated. Information provides data for

assessment and revision of the probabilities of various outcomes—it does

not provide certainty. Analysts draw upon their experience to suggest what

their initial assumptions will be on the models they build and the changes

and feedback they anticipate.

Drawing upon their experience and their initial read of the data,

analysts will assign their expected probabilities to possible outcomes. These

outcomes, such as estimates of the feedback effects of any given change

in the framework, cover a range of possibilities. For example, analysts

estimate the feedback from any change in oil prices upon a company’s earnings,

given the analysts’ reading of its history. In other cases, analysts, and

investors in general, will assign probabilities to the range of possible out-

comes for the P/E ratio and earnings per share given any change in oil prices,

regulations, or tax rates. As you might suspect, these probabilities are highly

subjective at times and often reflect certain biases such as the anchoring bias

in decision making, which we will discuss further.

Finally, analysts make choices that reflect the values they bring to the

whole process. Their values influence their view on the feedback of any

change, their choices in response to the feedback, and the construction of

a new framework to go forward. Since the Great Recession, investors and

business leaders have clearly chosen to be more conservative in their spending.