Download Economy/Market Analysis

Economy/Market Analysis
Chapter 13
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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
 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
 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)
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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
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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
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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
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Determinants of Stock Prices
Exogenous or predetermined variables
 Potential output of economy (Y*)
 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)
 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
 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
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Valuing the Market
To apply fundamental analysis to the market, estimates are needed of
 Stream of shareholder benefits
 Earnings or dividends
 Required return or earnings multiple
Steps in estimating earnings stream
 Estimate GDP, corporate sales, corporate earnings before taxes, and
finally corporate earnings after taxes
The earnings multiplier
 More volatile than earnings component and therefore more difficult to
predict
 Cannot simply extrapolate from past P/E ratios, because changes can and
do occur
 1928-95 average for S&P 500: 14
 1947-1998 average for S&P 500: 15
P/E ratios tend to be high when
 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:
 earnings estimate
 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
 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
 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
 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
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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
 Dividend yield, earnings yield
 dividend yield on S&P 500 Index declines below 3%, market in for
a downturn
 Economic indicators
 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:
 When are they signaling a change?
 How reliable is the signal?
 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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