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Economy/Market Analysis Chapter 13 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) 04/30/2017----1 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 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 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 04/30/2017----2 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 04/30/2017----3 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 04/30/2017----4 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 04/30/2017----5