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Introduction to Economics Linking Personal Investment with the US Economy Macroeconomics Llad Phillips 1 Part Two Macroeconomics and the US Economy 5. Tuesday, Oct. 13, Lecture Five: "Capital Asset Pricing Model" Tracking asset markets and the US economy capital asset pricing model Growth rate of your personal wealth Value of a share of stock The impact of business cycles on corporate profits Reading Assignment: O’Sullivan and Sheffrin, Ch. 20, “The Big Ideas in Macroeconomics” emphasis: measuring the ouput of the economy, unemployment, inflation O’Sullivan and Sheffrin, Ch. 21, “Behind the Economic Statistics” Problems O & S Text p. 420: 1, 2, 3, 4, 5, 6, 7, 8 p. 441: 1, 2, 3, 4, 5, 6, 7, 8 Thursday, Oct. 15 , 25 minute QUIZ, You will need scantron sheet and #2 pencil. Llad Phillips 2 Outline: Lecture Five Tracking Asset Markets and the US Economy Growth Rate of Personal Wealth the importance of savings relative to rate of return on wealth Value of a share of stock depends on the stream of expected future net earnings per share The Impact of the Business Cycle on Corporate Profits Llad Phillips 3 Your Stocks Market Indices corporate earnings(profits) The Economy Llad Phillips 4 UC Funds: Monthly Rate of Return 8 6 2 97.05 97.03 97.01 96.11 96.09 96.07 96.05 96.03 96.01 -2 95.11 0 95.09 Rate 4 Equity Insurance -4 -6 Year:Month Llad Phillips 5 UC Funds Monthly Rate of Return 0.7 0.6 0.4 0.3 Insurance Money Market Savings 0.2 0.1 97.05 97.03 97.01 96.11 96.09 96.07 96.05 96.03 96.01 95.11 0 95.09 Rate 0.5 Year:Month Llad Phillips 6 UC Funds: Monthly Rates of Return 8 Bond Equity Multi-Asset 6 2 97.05 97.03 97.01 96.11 96.09 96.07 96.05 96.03 96.01 -2 95.11 0 95.09 Rate 4 -4 -6 Year:Month Llad Phillips 7 Two Kinds of Assets low rate of returnlow variability want high rate of return return on average want low variability predictable high return-high variability want high rate of return on average want low variability average return Dilemma: which kind of asset to hold? Llad Phillips 8 Investment Principles or Maxims Don’t hold put all of your eggs in one basket a diversified portfolio cash bonds stocks real estate advantage of a mutual fund instead of holding one stock, e.g. Coca-Cola, you hold a bundle of stocks Choose the asset with the highest reward for a given level of risk Llad Phillips 9 Measures of Average Rate of Return and Variability: Mean & Std. Dev. Date Bond 95.09 95.1 95.11 95.12 96.01 96.02 96.03 96.04 96.05 96.06 96.07 96.08 96.09 96.1 96.11 96.12 97.01 97.02 97.03 97.04 97.05 97.06 standard deviation mean Llad Phillips Equity Insurance 2.66 2.4 3.9 2.83 -0.51 -5.42 -0.63 -0.75 0.78 1.68 0.34 0.35 4.21 7 5.56 -4.16 0.04 1.35 -3.59 2.23 2.59 2.75 4 -0.26 4.07 -0.13 3.32 2.35 -0.24 1.6 2.56 -0.12 -5.01 2.33 4.59 0.39 7.69 -1.25 4.59 0.42 -2.33 4.09 6.16 3.5 0.64 0.66 0.64 0.66 0.64 0.6 0.64 0.61 0.63 0.61 0.63 0.63 0.61 0.63 0.61 0.62 0.62 0.56 0.64 0.6 0.62 0.6 3.00 1.16 2.95 1.92 0.02 0.62 10 Distribution of Monthly Rates of Return, UC Equity Fund, Sept. '95- Aug. '98 6 5 3 2 Aug. ‘98 1 7 5 3 1 -1 -3 -5 -7 -9 -11 0 -13 Number 4 Monthly Rate Llad Phillips 11 Mean Returns & Standard Deviations UC Funds: Mean Return Vs. Risk (Standard Deviation) 2.00 Equity 1.80 1.60 Mean Return 1.40 1.20 Multi-Asset Bond 1.00 0.80 0.60 Insurance Savings 0.40 Money Market 0.20 0.00 0.00 Llad Phillips 0.50 1.00 1.50 2.00 Standard Deviation 2.50 3.00 3.50 13 Efficient Investment Portfolio UC Funds: Mean Return Vs. Risk (Standard Deviation) 2.00 Equity 1.80 1.60 Mean Return 1.40 1.20 Multi-Asset Bond 1.00 0.80 0.60 Insurance Savings 0.40 Money Market 0.20 0.00 0.00 0.50 Llad Phillips 1.00 1.50 2.00 Standard Deviation 2.50 3.00 3.50 14 Your portfolio should be on the efficient frontier But where on the frontier? depends on your taste for reward and risk reward, i.e. the mean rate of return is a good risk is a bad Llad Phillips 15 Economic Paradigm: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M,R) better Mean Return, M worse B C A Iso - Preference Curves Prefer B to A; Prefer B to C Llad Phillips Risk, R 16 Efficient Investment Portfolio UC Funds: Mean Return Vs. Risk (Standard Deviation) 2.00 Investor A: very risk averse 1.80 Equity 1.60 Mean Return 1.40 1.20 Multi-Asset Bond 1.00 0.80 0.60 Insurance Savings 0.40 Money Market 0.20 0.00 0.00 0.50 Llad Phillips 1.00 1.50 2.00 Standard Deviation 2.50 3.00 3.50 17 Efficient Investment Portfolio UC Funds: Mean Return Vs. Risk (Standard Deviation) 2.00 Investor B: not very risk averse Equity 1.80 1.60 Mean Return 1.40 1.20 Multi-Asset Bond 1.00 0.80 0.60 Insurance Savings 0.40 Money Market 0.20 0.00 0.00 0.50 Llad Phillips 1.00 1.50 2.00 Standard Deviation 2.50 3.00 3.50 18 Efficient UC Investment Portfolio f*insurance where contract + (1-f)*equity fund f can range from zero to one example: 50:50, i.e one half of your nest egg is invested in the Insurance Contract and the other half is invested in the Equity Fund. • mean return: 1/2 *0.62 + 1/2*1.92 = 1.27 % per month • expected risk(standard deviation: 1/2*0.02 + 1/2*3.02 =1.52 Llad Phillips 19 Tracking Assets and Markets What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ? Llad Phillips 20 Example: The UC Index Fund and the Standard & Poor’s 500 mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks capital Llad Phillips asset pricing model 21 Monthly Rates of Return: UC Index Fund, S&P500 8 UC Equity S&P 500 6 2 97.05 97.03 97.01 96.11 96.09 96.07 96.05 96.03 96.01 -2 95.11 0 95.09 Percent 4 -4 -6 Date Llad Phillips 22 Variation of Rewards: UC Index Fund Vs. S&P 500 8 96.11 6 UC Index 4 2 0 -6 -4 -2 0 2 4 6 8 -2 y = 0.8127x + 0.0474 2 R = 0.8727 -4 96.07 -6 S&P 500 Llad Phillips 23 Capital Asset Pricing Model return to an asset varies with the return to the market if the relationship is perfect, R2 =1, and all the risk in the asset is market risk if the relationship is nonexistent, R2 =0, and all of the risk is asset specific In symbols + rS&P + e r is the return if is greater than 1, the asset is riskier than the market e is the residual or error Llad Phillips 24 rUC = Sources of Information: stock prices Daily Quotes Business Section of Los Angeles Times Wall Street Journal Internet graphics http://www.stockmaster.com http://www.networth.galt.com Llad Phillips 25 beta for Apple = 0.67 http://www.stockmaster.com Llad Phillips 26 http://www.networth.galt.com Llad Phillips 27 Apple Computer Llad Phillips 28 How do you make your nest egg grow? Do you need to take risks and get a high rate of return? not Llad Phillips if your ratio of savings to wealth is high 29 Relative Importance of Savings Younger Years income & savings are lower wealth is smaller ratio of savings to wealth may be high savings is most important, rate of return less so example income of $60,000 savings of $6,000 wealth of $50,000 Llad Phillipsof savings to wealth of ratio Older Years wealth accumulates ratio of savings to wealth falls rate of return on wealth becomes more important example income of $100,000 savings of $20,000 wealth of $500,000 ratio of savings to wealth of 0.04 30 Rate of Growth of Personal Wealth savings, s + + increase in wealth, ∆w Stock of wealth, w yield, r*w rate of return, r rate of growth of wealth, ∆w/w rate of return, r + savings/wealth ∆w/w r + s/w Llad Phillips 31 Rate of Growth of Personal Wealth If the rate of return, r, on wealth is zero then the only source of growth in wealth is savings: ∆w/w = s/w i.e. the only change in wealth, ∆w, is savings: ∆w = s If savings is zero then the only source of growth in wealth is rate of return, r, and wealth will grow exponentially at the rate r: ∆w/w = r Llad Phillips 32 Years to Double Wealth Rate of Growth of Wealth, 100*² w/w 4% Llad Phillips Years to Double 17.3 8% 8.7 10% 6.9 16% 4.3 33 rate of return on wealth, r rate of growth of wealth, ∆w/w ∆w/w r + s/w 12% 8% 4% 0 Llad Phillips 4% 8% 12% ratio of savings to wealth, s/w 34 Where does the growth in financial wealth come from? What is the relationship between financial markets and the economy? Llad Phillips 35 Index of Dow Jones Industrials, Weekly Closing . 10000.00 9000.00 DJIWKLY exponential trend 8000.00 7000.00 DJI 6000.00 5000.00 weekly rate of growth = .0023 annual rate of growth = 52*.0023 =.12 10/9/98 4000.00 3000.00 0.0023x 2000.00 1000.00 y = 1601.9e R2 = 0.933 1/3/86 0.00 0 Llad Phillips 100 200 300 400 Week 500 600 700 36 Economic Concept present value of a stream of expected future net earnings, or profits, per share PV(t) = ENE(t) + ENE(t+1)/(1+i) may know this year’s net earnings, NE(t) your expectations of the future affect your best guess for next year, ENE(t+1) at an interest rate of 7%, $1.07 next year is equivalent to a $1 this year • to compare dollar values for different years, they have to be discounted to a common year PV(t) = ENE(t) + ENE(t+1)/(1+i) + ENE(t+2)/(1+i)2 + ... Llad Phillips 37 Income-Expense Statement for an Individual Income Expenditure Savings Income-Expense Statement for a Business Firm Gross Revenue Cost Profit (net revenue, net earnings) Llad Phillips 38 http://www.globalexposure.com/ Last Ten Years 1948Llad Phillips 39 Corporate profits after taxes doubled from $160 billion in early 1987 to $320 billion in early 1994 doubling in about seven years implies an average rate of growth of about 10% per year this rate of growth is comparable to the 11% rate of growth in the Dow since 1986 Llad Phillips 40 Your Stocks Market Indices corporate earnings(profits) The Economy Llad Phillips Index of Leading Economic Indicators Gross Domestic Product Unemployment Rate 41 Index of Leading Indicators 1948- Llad Phillips 42 Recall Lab One: Resources for Economists on the Internet http://rfe.wustl.edu/ Llad Phillips 43 The US Business Cycle expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough Llad Phillips 44 US Postwar Expansions Trough - Peak Oct. ‘45 - Nov. ‘48 Oct. ‘49 - July ‘53 May ‘54 - Aug. ‘57 April ‘58 - April ‘60 Feb. ‘61 - Dec. ‘69 Nov. 70 - Nov. ‘73 March ‘75 - Jan. ‘80 July’80 - July ‘81 Nov. ‘82 - July ‘90 March ‘91 - ? Llad Phillips Duration, Months 37 45 39 24 106 36 58 12 92 ?, 77+ 90 45 US Business Cycle Note the long expansions in the eighties and the nineties is there a new economic regime or order? are business cycles a relic of the past? Note the long expansion in the sixties economists then talked about “fine tuning” the economy then came along the problems of the seventies a couple of recessions inflation Llad Phillips 46 Summary-Vocabulary-Concepts capital asset pricing model market risk asset specific risk stock’s beta, moving average exponential growth Dow Jones Industrials present value Llad Phillips net earnings per share expectations discount factor corporate profits after taxes business cycle peak trough index of leading indicators 47