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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 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 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 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: 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 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? 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 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 Potential output of economy (Y*) • 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 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 Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15 Valuing the Market • The earnings multiplier More volatile than earnings component • 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 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 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 Other indicators: dividend yield, earnings yield • Problems with key market indicators 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 Copyright Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. 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