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Chapter 13 Economy/Market Analysis

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 markets
investors

likely

direction

is

of

extreme

importance

to

Should also take a global perspective because of linkages

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

Business Cycle
National Bureau Economic Research
Monitors economic indicators
Dates business cycle when possible
Composite indexes of general economic activity
Series of leading, coincident, and lagging indicators of economic
activity to assess the status of the business cycle

Stock Market and Business Cycle

Stock prices lead the economy

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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

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 initiated by the FED forecast economic activity?
Changes due to shifts in supply or demand
Actions of Federal Reserve important

Reading Yield Curves

Shows relationship between market yields and time to maturity, holding
all other characteristics, like credit risk, constant
Upward sloping and steepening curve implies accelerating economic
activity
Flat structure implies a slowing economy
Inverted curve may imply a recession
Actions of FED, expectations important

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

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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

Determinants of Stock Prices

Corporate earnings and expected inflation affects 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

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

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

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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
Difficult to predict
Cannot simply extrapolate from past P/E ratios, because changes
can and do occur
1920-2001 average for S&P 500: 17
P/E ratios tend to be high when inflation and interest rates are low
Put earnings estimate and multiplier together

Forecasting Changes in the Market

Difficult to consistently forecast the stock market, especially short term
EMH states
information

that

future

cannot

be predicted

based

on past

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
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)
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

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Based on past, the market P/E usually rises just before the end of
the slump

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 signaling a change?
How reliable is the signal?
How quickly will the predicted change occur?

FEDs Approach
Asset allocation changes imply the returns on equity and fixed-income
securities are related
Compare 10-yr. Treasury yields with the earnings yield (E/P) on the S&P
500
E/P > (<) T-note yield implies stocks are attractive (unattractive)
relatively
Problems: Loses reliability when rates low, earnings estimated into future

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

Q.1 why is market analysis is so important?

Ans: Market analysis is important because some 30% to 50% of the variability
in an individual stock's return is attributable to aggregate market effects. Not
only is the market the largest single factor explaining fluctuations in individual
stock returns, it has an even greater impact on a diversified portfolio.

Q.2 Why should investors be concerned with GDP growth?

Ans: GDP ups and downs directly affect companies, thereby affecting investors.

Q.3 How have business cycle expansions and contractions changed since
WWII?
Ans: Since WWII expansions have typically been longer than before, and
contractions shorter.

Q.4 What is the historical relationship between stock prices, corporate

profits and interest rates?
Ans: Historically, a close direct relationship has existed between corporate
profits and stock prices. A parallel between the two series can often be seen,
both upward and downward, although stock prices may move first.
An inverse relationship exists between stock prices and interest rates. Because
interest rates are closely tied to discount rates, a rise in interest rates will
have a negative impact on stock prices.

Q.5 How can investors go about valuing the market?

Ans: To value the market, investors need to analyze the expected earnings (or
dividends) for a market index as well as an expected P/E ratio (or discount
rate). These values are difficult to accurately predict; however, the concept is
simple and intuitive. If earnings are expected to rise and the P/E to at least
remain constant, the market should rise. If a decline is expected, ceteris
parabus, a drop in value can be expected. And so forth.
It is desirable for instructors to impress upon students the basic nature of this
process, even if exact estimates are difficult to obtain. No one is ever going to
be able to forecast the market accurately on a consistent basis, but it is
possible to make some astute judgments periodically (such as in 1982 before
the peak in interest rates) and benefit from them.

Q.6 What is the typical business cycle-stock-price relationship?

Ans: Stock prices tend to lead the economy's turning points, both peaks and
troughs. However, there are finer points to consider:
(a)Stock prices almost always rise as the business cycle is approaching a
trough. Furthermore, these increases have been large.

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(b)Stock prices often drop suddenly as the business cycle enters into the
initial phase of recovery. Prices stabilize, or even decline, as the economy
moves ahead.

Q.7 If an investor can determine when the bottoming out of the economy
will occur, when should stocks be purchased-before, during or after such
a bottom? Would stock prices be expected to continue to rise as the
economy recovers (based on historical experience)?
Ans:
Stocks should be purchased before a bottoming of the economy occurs
because prices almost always rise before the trough.
As the economy recovers, be prepared for a leveling off, or even a decline.

Q.8 Can money supply changes forecast stock-price changes?

Ans: Considerable evidence suggests that investors cannot use past changes in
money supply to forecast stock prices. Stock price movements may lead
changes in money supply. As in numerous other areas of research in
investments, this relationship has been controversial, and the evidence
presented has been mixed.

Q.9 What is the historical relationship between the markets P/E ratio
and recessions?
Ans: The market P/E is higher at the end of the slump than at its low point of
the slump; in other words, the P/E ratio usually rises toward the end of each
slump relative to its low point during the downturn. It then remains roughly
unchanged over the next year.

Q.10 What was the primary cause of the rise in stock prices in 1982?
Ans: The primary cause of a rise in stock prices in 1982 was a dramatic decline
in interest rates, and therefore discount rates. While it is not likely that many
investors caught the exact bottom, a sizeable number did benefit by expecting
such a decline sometime in 1982.

Q.11 Suppose that you know with certainity that corporate earnings next
year will rise 15 % above this years level of corporate earnings. Based
on this information , should you buy stock?
Ans: You cannot answer this question with the information provided. The
reason is that the value of stocks is dependent upon both components of the
valuation model-- returns and risk. Therefore, while you may know with
certainty what corporate earnings will do, you do not know what the discount
rate (or, alternatively, the P/E ratio) will do. It could easily change more than
enough to negate the favorable impact of the increase in corporate earnings.

Q.12 What does a steeping yield curve suggests about the economy?
What about an invested yield curve?
Ans: A steepening yield curve suggests that the economy is accelerating in
terms of activity as monetary policy stimulates the economy. An invested yield
curve carries expectations of an economic slowdown. Virtually every recession
since WWII has been preceded by a downward-sloping yield curve.

Q.13 In general, what should be the relationship between corporate

earnings growth and the growth rate for the economy as a whole?
Ans: It is reasonable to expect corporate earnings to grow, on average, at
about the rate of the economy as a whole. Of course, in some periods earnings
may grow at a much faster rate. This occurred in the last years of the 20th
Century.

Q.14 Using the so called Fed Model relating the earnings yield on the
S&P 500 Index to Treasury bond yields, when would stocks be
considered an attractive investment?
Ans: Using the so-called Fed model, stocks are relatively attractive when the
earnings yield on the S&P 500 is greater than the 10-year Treasury yield.
Alternatively, estimate the fair value level of the S&P 500 Index by dividing the
estimated earnings for this index by the current 10-year Treasury bond yield. If
the estimated fair value of the market is greater than the current level of the
market, stocks are undervalued.

Q. 15 Why is so much day-to-day news coverage devoted to consumer

spending?
Ans: Consumer spending is the largest single component driving the economy,
and therefore warrants detailed attention.

Problems
Q.1 During 1 week in late December 2008, the Nasdaq Composite
went from 1564.32 to 1530.24. while the Nasdaq 100 Index went
from 1217.19 to 1185.44. Which Index showed the greater loss?
Ans:
Nasdaq Composite

Nasdaq 100

1564.32
1217.19
-1530.24
- 1185.44
-34.08
- 31.75
-34.08/1564.32 = - 0.02179 x 100 - 31.75/1217.19 = - 0.026085 x 100
= - 2.179%
= - 2.6085%
Nasdaq 100 Showed a greater loss

Q.2 The Nasdaq Index lost more than 75% of its value in the early
years of the twenty first century. Assuming a 80% loss, What
return is needed on this index to make up for the 80% loss?
Ans: A 75 percent loss will require a 400% gain to make up for the loss.
Assume an index value of 100. A 75% loss reduces the index to 25. A
400% gain is required to return the index to 100.

Computational Problem
The following annual data are available for a stock market Index:
Year

End of
Year
Price (P)
107.21

200
4
200
121.02
5
200
154.45
6
200
137.12
7
200
157.62
8
200
186.24
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The 2009 values in

Earning
(E)

Dividend
s (D)

P/E

(D/E)100
%

(D/P)100
%

13.12

5.35

8.17

40.78

4.99

16.08

6.04

7.53

37.56

4.99

16.13

6.55

9.58

40.61

4.24

16.70

7.00

8.21

41.92

5.11

13.2

17.18

11.93

54.35

4.56

15.24

6.97

italics are estimates:

a. Calculate the 2009 values for those columns left blank.

b. On the assumption that g=0.095, calculate k for 2009 using the
formula k = (D/P) + g and show that k = 0.132425.
c. Using the 2009 values, show that P/E = 12.22.

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d. Assuming a projection that 2010 earnings will be 25 percent

greater than the 2009 value, show that projected earnings are
expected to be 19.05.
e. Assuming further that the dividend-payout ratio will be 0.40, show
that projected dividends for 2010 will be 7.62
f. Using the projected earnings and dividends for 2010, and the same
k and g used in part b , show that the expected P/E for 2010 is
10.69.
g. Using these expected values for 2010, show that the expected price
is 203.61
h. Recalculate the value for 2010 P/E and P, using the same g = 0.095,
but with:
(1) K = 0.14 (b) k = 0.13 and (3) k = 0.12

Solution
NOTE:
The earnings ($15.24) and dividends ($6.97) for 2009 are given, as is the year- end price of 186.24.
a) P/E = 186.24/15.24 = 12.2204
D/E (100) = 100(6.97/15.24) = 45.73%
D/P (100) = 100(6.97/186.24) = 3.742%
As an additional piece of information,
TR2006 = 100[(186.24-157.62+6.97)/157.62] = 22.58%
b) k = 6.97/186.24 + .095 = .132425
c) Calculated in a) above.
d) Expected Earning E2010 = (1.25) (15.24) = 19.05
e)Projected Dividend D= (.40) (19.05) = 7.62

g) P = 7.62/.037425 = 203.61, or
P = Projected Earning (P/E) x Expected Earning (E) = 10.69(19.05) =
203.64
h)

1. P/E = .40/(.14-.095) = .40/.045 = 8.89

P = 7.62/.045 = 169.33
2. P/E = .40/(.13-.095) = .40/.035 = 11.43
P = 7.62/.035 = 217.71
3. P/E = .40(.12-.095) = .40/.025 = 16
P = 7.62/.025 = 304.80

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