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Chapter 13 ECONOMY/MARKET ANALYSIS Multiple Choice Questions Taking a Global Perspective 1. The general trend worldwide is to: a. b. c. d. close economies and deregulate industries. limit economies and regulate industries. open economies and deregulate industries. There is no general trend worldwide. (c, easy) 2. By 2002, the euro: a. b. c. d. fell against the dollar. replaced the dollar as the most important currency. gained significantly against the dollar. was replaced by the British pound. (c, easy) Assessing the Economy 3. The beginning and ending of a business cycle is also known as a: a. b. c. d. cycle. trough. peak. contraction. (b, easy) 4. On average, contractions since World War II last: a. b. c. d. slightly less than 6 months. slightly less than one year. slightly less than 18 months. slightly less than two years. (b, moderate) Chapter Thirteen Economy/Market Analysis 163 5. The National Bureau of Economic Research is: a. b. c. d. a division of the Department of Commerce. the largest association of professional economic forecasters. a private nonprofit organization. a division of the Federal Reserve. (c, moderate) 6. Which of the following is not one of the components of GDP? a. b. c. d. investment spending government spending net exports financial transactions (d, moderate) 7. The largest component of GDP is: a. b. c. d. consumption government spending net exports investment spending (a, easy) 8. Indexes of general economic activity are considered all except: a. b. c. d. lagging emerging leading coincident (b, moderate) 9. Which of the following is considered a lagging indicator? a. b. c. d. duration of unemployment stock prices money supply interest rate spread (c, moderate) Chapter Thirteen Economy/Market Analysis 164 10. The federal agency most involved with the money supply and interest rates is a. b. c. d. the Treasury Department the Federal Reserve the Department of Commerce the U. S. Mint (b, easy) 11. Which of the following statements concerning the stock market and the economy is true? a. b. c. d. The stock market generally leads the economy. The stock market generally follows the economy. The stock market has an inverse relationship with the economy. The stock market has little relationship with the economy. (a, moderate) 12. One explanation for stock prices leading the economy involves: a. b. c. d. a political change, such as a change in administration. investors switching from domestic to international stocks. an investor change in the required return. insider trading based on nonpublic information. (c, difficult) 13. When speculation pushes asset prices to unsustainable highs, this is known as a: a. b. c. d. crash. contraction. recession. bubble. (d, easy) Chapter Thirteen Economy/Market Analysis 165 14. Stock investors pay attention to the bond market because: a. b. it is more stable than the stock market. it can provide daily signals whereas stock market data is weekly, monthly or quarterly. it is a more accurate measure of overall economic activity. it is privy to more government information, especially from the Federal Reserve. c. d. (b, moderate) 15. Which of the following is included in MZM? a. b. c. d. M3 retail money market mutual funds wholesale money market mutual funds All are included in MZM. (b, moderate) 16. Generally, when interest rates fall, bond prices a. b. c. d. rise. fall. remain unchanged. rise or fall depending on the expected inflation premium. (a, easy) 17. An alternative money measure than includes M2, savings deposits, small time deposits and retail money market mutual funds is: a. b. c. d. M3. MBM. MZM L (c, moderate) 18. A steepening yield curve indicates: a. b. c. d. the economy is accelerating. economic activity is slowing down. a pending recession. rising inflation. (c, easy) Chapter Thirteen Economy/Market Analysis 166 19. _______ is a publication that compiles consensus economic forecasts. a. b. c. d. The Wall Street Journal's Economic Letter The Conference Board's Economic Forecast Blue Chip Economic Indicators The Kiplinger Letter (c, moderate) Understanding The Stock Market 20. In order to value the market with the P/E model, it is necessary to analyze a. b. c. d. earnings forecasts. P/E ratios. earnings forecasts and P/E ratios. earnings forecasts, P/E ratios, and the required rate of returns. (c, easy) 21. In the recent past, operating EPS for the S&P 500: a. b. c. d. grew faster than GDP growth. grew slower than GDP growth. grew the same as GDP growth. showed no relationship to GDP. (a, moderate) 22. Which of the following market indexes is favored by most institutional investors and money managers? a. b. c. d. DJIA S&P 500 Wilshire 5000 NYSE Index (b, moderate) Chapter Thirteen Economy/Market Analysis 167 23. Current stock prices reflect: a. b. c. d. investors' confidence in the current economy. investors' confidence in the current administration. investors' expectations of the future. investors' attitudes about the past market. (c, moderate) 24. If someone was to tell you that "the market" was up by two percent, they generally mean that __________ up by two percent. a. b. c. d. the level of a stock price index was retail prices of goods went productivity was costs were (a, easy) 25. Which of the following statements regarding the uses of market indicators is FALSE? a. Historical records of market indicators are used to determine unsystematic risk. Historical records of market averages are used for gauging market trends. The historical returns on market indices are used in computing betas. Market averages and indices are useful to investors in evaluating portfolio performance. b. c. d. (a, difficult) 26. Assume that the dividend payout ratio on the S&P 100 will be 40 percent when the rate on long-term government bonds falls to 9 percent. Investors being more risk averse demand an equity risk premium of eight percent. If the growth rate of dividends is expected to be 10 percent, what will be the price of the market index if the earnings expectation is $30? a. b. c. d. $384.00 $213.44 $266.56 $171.43 Solution: (d, difficult) Chapter Thirteen Economy/Market Analysis 168 D1 = k= P0= = 0.40($30) = $12 0.09 + 0.08 = 0.17 D1/(k – g) 12/(0.17 - 0.10) = $171.43 27. P/E ratios are generally depressed when interest rates are _____ and inflation is ________. a. b. c. d. high; low low; high high; high low: low (c, moderate) Making Market Forecasts 28. Many market participants believe that when the dividend yield on the Standard and Poor's 500 is ____, the market is in for a downward correction. a. b. c. d. above 6 percent below 6 percent above 3 percent below 3 percent (d, difficult) 29. The Fed model, which uses the E/P ratio in its calculations, : a. b. c. d. is relatively complex. uses the yield on the 3-month Treasury bill as the risk-free rate. assumes investors can easily switch between stocks and bonds. all of the above (c, difficult) 30. Which of the following types of yield curves is typically followed by a declining stock market? a. b. c. d. an upward-sloping yield curve a flat yield curve an inverted yield curve a skewed yield curve (c, moderate) Chapter Thirteen Economy/Market Analysis 169 31. Warren Buffett thinks long-term movements in stock prices are caused by which of the following two economic variables? a. b. c. d. interest rates and corporate profits interest rates and inflation inflation and unemployment corporate profits and growth in GDP (a, difficult) 32. Which of the following statements regarding market P/E ratios is true? a. b. c. d. P/E ratios are higher when interest rates are lower. P/E ratios are higher when interest rates are higher. P/E ratios are higher when inflation is higher. P/E ratios are lower when unemployment is higher. (a, moderate) 33. The earnings yield, which is used in the Fed model, is the: a. b. c. d. same as the dividend yield. inverse of the dividend yield. same as the P/E ratio. inverse of the P/E ratio. (d, moderate) True-False Questions A Global Perspective 1. Despite political, cultural and economic differences, foreign markets are driven by the same factors that drive U.S. markets. (F, moderate) Assessing The Economy 2. The longest peacetime expansion ran from 1991 to 2000. (T, moderate) 3. To value the market, an investor must analyze both corporate earnings and multipliers. (T, moderate) Chapter Thirteen Economy/Market Analysis 170 4. Most analysts today agree that using money as an indicator of future economic activity is extremely inaccurate. (F, moderate) 5. The stock market is a leading indicator of the economy because investors discount future earnings. (T, moderate) 6. The typical business cycle in the United States seems to lead the stock market’s turning point by a few months. (F, moderate) 7. Most investors should keep a watch on the Federal Reserve because of the effect of the money supply on interest rates. (T, easy) Understanding the Stock Market 8. Most market indexes are designed to measure the entire stock market. (F, moderate) 9. P/E ratios are generally inflated when interest rates and inflation are high. (F, moderate) 10. If interest rates rise, the riskless rate of return declines. (F, moderate) 11. If the economy is prospering, investors expect corporate earnings to rise. (T, easy) 12. When using the P/E valuation model, it is important to remember that the multiplier is more volatile than the earnings component. (T, moderate) Making Market Forecasts 13. Assuming a constant P/E ratio, the growth in stock prices should equal the growth in earnings. (T, moderate) Chapter Thirteen Economy/Market Analysis 171 14. According to available evidence, investors lose more by staying in a bear market than by missing a bull market. (F, moderate) 15. Stock prices have almost always risen as the business cycle is approaching a trough. (T, moderate) 16. Over the past 30 years, the P/E ratio for the S&P 500 Index has ranged from 5 to 50. (F, moderate) 17. During periods of restrictive Federal Reserve monetary policy, the stock market usually performs poorly. (T, moderate) Short-Answer Questions Assessing the Economy 1. Why is the stock market a leading indicator of the economy? Use the constant-growth dividend discount model in your explanation. (moderate) Answer: 2. Stock prices are based on investors’ expectations about the future and are, therefore, indicators of the future. The model P0 = D1/(k – g) shows that the current price depends on future dividends, thus making market prices a leading indicator of the economy. Why do stock investors pay attention to the bond market? (easy) Answer: The bond market provides daily information about the economy through interest rates. This information is useful to stock investors. Understanding the Stock Market 3. Is it useful to do a trend analysis of P/E ratios of the S&P 500 Composite Index over time and extrapolate it to project future expected P/Es? (easy) Chapter Thirteen Economy/Market Analysis 172 Answer: 4. No. P/Es vary too much from year to year. The financial news reports that the market is overvalued at a near record high based on the earnings multiplier. What does that mean to you? (moderate) Answer: 5. This suggests that prices are increasing faster than earnings, thus P/E ratios (also called earnings multipliers) are higher than usual. Some analysts would prepare for the market to fall back to more “normal” P/E levels, meaning that price declines are in store. Others would expect the exuberance to continue. Use the constant-growth dividend discount model to explain why stock prices have an inverse relationship to interest rates. (moderate) Answer: 6. The stock price (P0) based on the model P0 = D1/(k – g) increases as the required rate of return (k) decreases. Why is there an inverse relationship between P/Es and dividend yield? (moderate) Answer: Price is in the numerator on P/Es and in the denominator in dividend yield. Dividends are paid from earnings, which links the other variable in each ratio. Making Market Forecasts 7. Explain how dividend yield on the S&P 500 Index can be used to make market forecasts. (moderate) Answer: Chapter Thirteen Economy/Market Analysis When dividend yield drops below three percent, the market is expected to fall in the near future. Investors will sell stocks and seek higher yielding bonds, causing prices to adjust. 173 Critical Thinking/Essay Questions 1. How does the increased globalization of business and finance affect business cycles and the leading, lagging, and coincident economic indicators? (difficult) Answer: 2. It may be that economic cycles may be more attuned to global economics instead of domestic economics. Likewise, traditional domestic economic indicators may lose some of their effectiveness as global business exercises more influence over the domestic economy. What are the implications of the article “Overcoming the Bear Market Blues” for investors? (moderate) Answer: Two points emerge: The first is that the investor is better off in the market than out of the market waiting for the right time to invest, because one has more to lose by missing the bull markets than by avoiding the bear markets. The second point is that depressed markets are the best time to buy, so investors should overcome their emotional inclination to sell when the market is down. Problems 1. Assume that the dividends to be paid on a particular market index next period are $20. Investors require 15 percent to invest in stocks, and expect dividends to grow at 10 percent per year. What is the value of this index? (moderate) Solution: P0 $400 = D1/(k – g) = 20/(0.15 – 0.10) = 2. Value Line's estimated dividends on its Industrial Composite for 199X are $2.00 while estimated earnings are $4.30. The expected spread between k and g is .04. (a) (b) What is the P/E ratio? What is the estimated price for this Index? (moderate) Chapter Thirteen Economy/Market Analysis 174 Solution: 3. (a) = P/E = 11.63 (D1/E1)/(k – g) = (2.00/4.30)/(0.04) (b) = P $50 (P/E)(EPS) (11.63)(4.30) = = The earnings per share on a composite stock index this past year was $3.25. The earnings are expected to grow at a constant rate of 7 percent forever. The dividend payout ratio is expected to continue at its current rate of 35 percent and the dividend yield is expected to be 4 percent. Calculate the intrinsic value of the composite stock index. (moderate) Solution: = D1 = = (0.35)(3.25)(1.07) D0(1 + g) (D0/E0)(E0)(1 + g) = $1.22 D1/P0 = 1.22/P0 = P0 = Dividend Yield 0.04 $30.50 Expected price = 36.45(20) = 729 Chapter Thirteen Economy/Market Analysis 175