Download Investments: Analysis and Management, Second Canadian

INVESTMENTS:
Analysis and Management
Third Canadian Edition
W. Sean Cleary
Charles P. Jones
Prepared by
Khalil Torabzadeh
University of Lethbridge
Chapter 15
Analysis of the Economy
and the Stock Market
Learning Objectives
• Describe the relationship between the stock
market and the economy.
• Analyze the determinants of stock market
values.
• Make basic forecasts of market changes.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Economy and the Stock Market
Top-Down Approach
• Analyze economy/stock market  industries
 individual companies

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Need to understand economic factors that
affect stock prices initially
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Economy and the Stock Market
• Direct relationship between the two
• Economic business cycle

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Recurring pattern of aggregate economic
expansion and contraction
Cycles have a common framework
•

trough  peak  trough
Can only be neatly categorized by length and
turning points in hindsight
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Economy and the Stock Market
Measures of Economic Activity
• GDP: The value of all goods & services
produced in a country within a given time period


GDP = C + I + G + (X - M)
Economic Growth – commonly measured as %
growth in ‘real’ GDP
• GNP: The value of all goods & services
produced by a country’s nationals, whether at
home or abroad
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Economy and the Stock Market
The Business Cycle
• Five major phases:
Expansion – stable inflation, increased corporate
profits and job starts
 Peak – demand exceeds economic activity, rising
interest rates, falling bond prices
 Recession – significant decline, lasting longer than
two months, and spread throughout entire economy
 Trough – falling demand and excess capital; drop in
prices and wages
 Recovery – GDP returns to previous peak; return to
purchasing items such as houses and cars

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Business Cycle
• Statistics Canada
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Monitors economic indicators
Dates business cycle when possible
Uses Composite Leading Indicator to predict
future economic conditions
Composite Leading Indicator
•
Index that combines ten leading indicators of
economic activity in order to assess the status of
the business cycle and predict future economic
conditions
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Business Cycle
Leading Indicators tend to change prior to
changes in economic activity. Examples
include:
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housing starts
manufacturers’ new orders
changes in profits
spot commodity prices
average hours worked per week
stock prices
money flows
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Business Cycle
GDP Growth (%)
Expansion
Peak
Recovery
Recession
Expansion
Trough
Time
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Figure 15-1 Real GDP per Capita and
Real Income Per Capita (1970-2005)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Statistics Canada’s Leading
Indicators
•
•
•
•
•
•
•
•
•
•
S&P/TSX Composite Index
Real Money Supply (M1)
US Composite Leading Index
New orders for durables
Shipments to inventory ratio (finished goods)
Average work week
Employment in business & services
Furniture & appliance sales
Sales of other retail durables
Housing spending index
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Coincident and Lagging Indicators
• Coincident Indicators: change at the same
time as changes in economic activity

e.g., GDP, industrial production, personal
income, retail sales
• Lagging Indicators: follow economic changes

e.g., business investment, unemployment rate,
labour costs, inventory levels, inflation
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Stock Market and Business Cycle
• Stock prices lead the economy

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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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the
Aggregate Economy
• Global economic factors
o
o
The state of US economy is a critical
factor for Canadian economy
70 to 80 percent of Canadian trade is
with the US.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the
Aggregate Economy
• Interest rates
The most important financial variables affecting
securities market
High interest rate tend to
o Raise the cost of capital to firms
o Discourage consumer spending
o Reduce disposable income available for net
investment
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the
Aggregate Economy
• Exchange rates
o Higher exchange rate tends to reduce trade balance
• Inflation
o
o
o
o
It erodes the standard of living
It reduces the real value of investment
It distorts signals to economy participants
It tends to raise interest rate, which may lead to
recessionary periods
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the
Aggregate Economy
• Unemployment
o High unemployment rate may lead to recessionary
periods
• Government policies
Governments influence general economic
conditions through
o Monetary policy (the use of interest rats)
o Fiscal policy (the use of government taxation)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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?

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Changes due to shifts in supply or demand
Actions of Bank of Canada important
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Understanding the Stock Market
• Market measured by index or average
• Most indexes designed for particular market
segment (e.g. blue chips)
• Most popular indexes
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S&P/TSX Composite Index
Dow Jones Industrial Average (DJIA)
S&P 500 Composite Stock Index
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Determinants of Stock Prices
• Exogenous or predetermined variables
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Potential output of economy (Y*)
•
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Productivity, resources, investment opportunities
Corporate tax rate (tx)
Government spending (G)
Nominal money supply (M)
•
Three policy variables subject to governmental
decisions
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Determinants of Stock Prices
• 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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Determinants of Stock Prices
• Corporate earnings and expected inflation affect
expected real earnings
• Interest rates and required rates of return also
affected by expected inflation
• Stock prices affected by earnings, rates

If economy is prospering, earnings and stock
prices will be expected to rise
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Determinants of 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 is not
linear

Determinants of interest rates also affect investor
expectations about future
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Valuing the Market
• To apply fundamental analysis to the market,
estimates are needed of
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Stream of shareholder benefits
•
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Earnings or dividends
Required return or earnings multiple
• Steps in estimating earnings stream
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Estimate GDP, corporate sales, corporate
earnings before taxes, and finally corporate
earnings after taxes
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Valuing the Market
• The earnings multiplier
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More volatile than earnings component
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Difficult to predict
Cannot simply extrapolate from past P/E ratios,
because changes can and do occur
1986–2003 average for S&P/TSX: 37.44
(ignoring 2001)
P/E ratios tend to be high when inflation and
interest rates are low
• Put earnings estimate and multiplier together
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Forecasting Changes in the Market
• Difficult to consistently forecast the stock
market, especially short term
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EMH states that future cannot be predicted
based on past information
Although market timing difficult, some
situations suggest strong action
• Investors tend to lose more by missing a bull
market than by dodging a bear market
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Using the Business Cycle
to Make Forecasts
• Leading relationship exists between stock
market prices and economy

Can the market be predicted by the stage of
the business cycle?
• Consider business cycle turning points well in
advance, before they occur

Stock total returns could be negative (positive)
when business cycle peaks (bottoms)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
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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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Using Key Variables to Make
Market Forecasts
• Best known market indicator is the
price/earnings ratio
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Other indicators: dividend yield, earnings yield
• Problems with key market indicators
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When are they signalling a change?
How reliable is the signal?
How quickly will the predicted change occur?
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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