Economy/Market Analysis



Economy/Market Analysis

Chapter 13

Top-down Approach

Analyze economy-stock market first then industries and finally individual companies

Need to understand economic factors that affect stock prices

Need to understand the current and the future state of the economy to understand what is likely to happen to the market

Given the economy-market relationship then

4 Use valuation models applied to the overall market and consider how to forecast market changes

Stock market’s likely direction is of extreme importance to investors

Economy and the Stock Market

Direct relationship between the two

Economic business cycle

Recurring pattern of aggregate economic expansion and contraction

Cycles have a common framework

Trough (the beginning) - peak - trough (the ending)

• Since WWII—cycles have lasted on the average 50 months

• Current expansion is the longest peacetime expansion since March 1991 ----102 months (August 1999) and still going but may be changing

4 Can only be neatly categorized by length and turning points in hindsight

• Composite Indexes of General Economic Activities

▪ Leading

• Increase—expansion in next 3-12 months

• Decrease-immediate downturn

• Confirmation by first the coincident and then by the lagging indicators—if not reconsider

▪ Coincident

▪ Lagging

Stock Market and Business Cycle

Stock prices lead the economy

Historically, the most sensitive indicator

Stock prices consistently turn before the economy

How reliable is the relationship?

The ability of the market to predict recoveries is much better than its ability to predict recessions

• Expansions typically end for one of the following reasons:

• Overheating of the economy with rising inflation (Fed comes in to control)

• External shock—such as sharp rise in oril prices or a financial crash following a break in an speculative bubble

Stock Market and the Bond Market

• With the introduction of mortgage-backed securities and derivatives, increase of federal debt in the 80’s, sharp swings in inflation during the 70’s—bond volatility has increased

• Bond market can provide daily signals of what bond traders and investors think of the economy (react by increasing or decreasing prices (interest rates) ).

• React to daily information about the economy and the stock martket

Macroeconomic Forecasts of the Economy

How good are available forecasts?

Prominent forecasters have similar predictions and differences in accuracy are very small

Investors can use any such forecasts

Does monetary activity forecast economic activity?

Changes due to shifts in supply or demand

• Omitting period 1979-1982—money supply is still useful in forecasting economic activity

• Alternative measure of money MZM --stable relationship with nominal GDP

o Defined as M2 + savings deposits, small time deposits, and retail money market funds

Actions of Federal Reserve important

• Influence of the Chairman of the Fed

Understanding the Stock Market

Market measured by index or average

Most indexes designed for particular market segment (ex. blue chips)

Most popular indexes

Dow-Jones Industrial Average

S&P 500 Composite Stock Index

Favored by most institutional investors and money managers

Uses of Market Measures

Shows how stocks in general are doing at any time

Gives a feel for the market

Shows where in the cycle the market is and sheds light on the future

Aids investors in evaluating downside

Helps judge overall performance

Used to calculate betas

Determinants of Stock Prices

Exogenous or predetermined variables

Potential output of economy (Y*)

1 Productivity, resources, investment opportunities

Corporate tax rate (tx)

• Government spending (G)

• Nominal money supply (M)

G and M affect stock prices by

Affecting total aggregate spending (Y), which together with the tax rate (tx) affects corporate earnings

Total aggregate spending, together with economy’s potential output (Y*) and past changes in prices, determine current changes in the price level (P)

4 Total spending and price level determine changes in real output

expected inflation affects expected real earnings of corporations

Interest rates and required rates of return also affected by expected inflation

Three policy variables subject to governmental decisions

• Fiscal policy

• Monetary policy

• Corporate tax rate

• Potential output of the economy affects:

• Total spending

• Price level

• Real money

• Total spending, price level, and real money affect:

• Corporate earnings

2 Interest rates

Ultimate determinant of stock prices are expected corporate earnings and interest rates

• If economy is prospering, earnings and stock prices will be expected to rise

Determinants of Stock Prices—Interest Rates and Stock Prices

From constant growth version of Dividend Discount Model

P0 =D1/(k-g)

Inverse relationship between interest rates (required rates of return) and stock prices

Interest rates and P/E ratios are inversely related

Inverse relationship between interest rates (required rates of return) and stock prices is not linear

Determinants of interest rates also affect investor expectations about future

Valuing the Market

To apply fundamental analysis to the market, estimates are needed of

1 Stream of shareholder benefits

1 Earnings or dividends

2 Required return or earnings multiple

Steps in estimating earnings stream

1 Estimate GDP, corporate sales, corporate earnings before taxes, and finally corporate earnings after taxes

The earnings multiplier

1 More volatile than earnings component and therefore more difficult to predict

2 Cannot simply extrapolate from past P/E ratios, because changes can and do occur

3 1928-95 average for S&P 500: 14

▪ 1947-1998 average for S&P 500: 15

P/E ratios tend to be high when

5 inflation and interest rates are low

• earnings are growing and the trend appears sustainable

To value the market, must anlyze both factors that determine value:

5 earnings estimate

6 and multiplier together

Forecasting Changes in the Market

Difficult to consistently forecast the stock market, especially short term

EMH states that future cannot be predicted based on past information

Although market timing difficult, some situations suggest strong action

2 Investors tend to lose more by missing a bull market than by dodging a bear market

Using the Business Cycle to Make Forecasts

Leading relationship exists between stock market prices and economy

• Stock prices decline in recessions

• Market turns down some months before the economic downturn

Can the market be predicted by the stage of the business cycle?

Consider business cycle turning points well in advance, before they occur

1 Stock total returns could be negative (positive) when business cycle peaks (bottoms)

• Using the business cycle to make market forecasts:

If investors can recognize the bottoming of the economy before it occurs, a market rise can be predicted

1 Switch into stocks, out of cash

As economy recovers, stock prices may level off or even decline

Based on past, the market P/E usually rises just before the end of the slump

Using Key Variables to Make Market Forecasts

Best known market indicator is the price/earnings ratio

• Last 30-years the P/E for S&P 500 Index has ranged from 7 to 22

Other indicators widely watched

2 Dividend yield, earnings yield

▪ dividend yield on S&P 500 Index declines below 3%, market in for a downturn

3 Economic indicators

4 Interest rates

• Treasury 30-year maturity bond

▪ Direction of commodity prices

▪ Unit labor costs

• Above 3% signals a potential problem

Problems with key market indicators:

6 When are they signaling a change?

7 How reliable is the signal?

8 How quickly will the predicted change occur?

Conclusions

Market forecasts are not easy, and are subject to error

Investors should count on the unexpected occurring

Intelligent and useful forecasts of the market can be made at certain times, at least as to the likely direction of the market

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