Investment Analysis and Portfolio Management Frank K. Reilly & Keith C. Brown C HAPTER 12 BADM 744: Portfolio Management and Security Analysis Ali Nejadmalayeri

Economies and Markets A strong relationship exists between the economy and the stock market Security markets reflect what is going on in an economy because the value of an investment is determined by –its expected cash flows –required rate of return

Economic Activity and Security Markets Stock Market As A Leading Indicator –Stock prices reflect expectations of earnings, dividends, and interest rates –Stock market reacts to various leading indicator series –Stock prices consistently turn before the economy does

Cyclical Indicator Approach to Forecasting the Economy This approach contends that the aggregate economy expands and contracts in discernable periods

Cyclical Indicator Approach to Forecasting the Economy National Bureau of Economic Research (NBER) Cyclical indicator categories –leading indicators –coincident indicators –lagging indicators Composite series and ratio of series

Cyclical Indicator Categories Leading indicators – economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity Coincident indicators – economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle Lagging indicators – economic series that experience their peaks and troughs after those of the aggregate economy Selected series – economic series that do not fall into one of the three main groups

Cyclical Indicators Leading indicators –Treasury spread, Avg. weekly hours production workers, building permits, vendor performance, consumer expectations, etc. Coincident indicators –Employment (nonagricultural), personal income, Industrial production, manufacturing and trade sales Lagging indicators –Manufacturing and trade inventories, prime rate, commercial and industrial loans, consumer credit to personal income, duration of unemployment

Cyclical Indicator Approach to Forecasting the Economy Analytical measures of performance –diffusion indexes trends rates of change direction of change comparison with previous cycles

Cyclical Indicator Approach to Forecasting the Economy Limitations of cyclical indicator approach –high variability –currency of the data and revisions –no series reflects the service sector –no series represents the global economy –political and international developments are not factored into a statistical system

Cyclical Indicator Approach to Forecasting the Economy Leading indicators and stock prices Other leading indicator series –CIBCR: Long-leading index leading employment index Leading inflation index –Analysis of alternative leading indicators of inflation –International leading indicator series –Survey of sentiment and expectations

Monetary Variables, the Economy, and Stock Prices Money supply and the economy Money supply and stock prices Excess liquidity and stock prices –year to year percentage change in M2 money supply adjusted for small time deposits less the year-to-year percentage change in nominal GDP

Money Supply and the Economy Declines in the rate of growth of the money supply have preceded business contraction by an average of 20 months Increases in the rate of growth of the money supply have preceded economic expansions by about 8 months

Monetary Variables, the Economy, and Stock Prices Other economic variables and stock prices –growth in industrial production –changes in the risk premium –twists in the yield curve –measures of unanticipated inflation –changes in expected inflation during periods of volatile inflation

Inflation, Interest Rates, and Security Prices Inflation and interest rates –generally move together –investors are not good at predicting inflation Inflation rates and bond prices –negative relationship –more effect on longer term bonds Interest rates and stock prices –not direct and not consistent –effect varies over time

Findings Flannery and Protopapadakis (2002) –If reaction to the surprise at the announcement day is considered, then: Market return affected by: – CPI negatively – PPI negatively – M1 negatively Market vol. affected by: – EMPNF positively – HOMSTART positively – M1 and M2 positively

Sector Rotation and Economic Condition This chart is based on Sam Stovall's S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle.S&P's Guide to Sector Rotation

Model Performance Information Coefficient –Actual Rank = α + IC Forecasted Rank + ε For a set of models use the weighted average IC method