INVESTMENTS: Analysis and Management Third Canadian Edition 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

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 Describe the relationship between the stock market and the economy. Analyze the determinants of stock market values. Make basic forecasts of market changes. Learning Objectives

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 The Economy and the Stock Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 The Economy and the Stock Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 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, 3 rd Canadian Edition, Chapter 15

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 Business Cycle

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Business Cycle

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 The Business Cycle GDP Growth (%) Time Expansion Peak Recession Trough Recovery Expansion

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 Figure 15-1 Real GDP per Capita and Real Income Per Capita ( )

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Statistics Canada’s Leading Indicators

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Coincident and Lagging Indicators

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Stock Market and Business Cycle

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 Global economic factors o The state of US economy is a critical factor for Canadian economy o 70 to 80 percent of Canadian trade is with the US. Other Factors Affecting the Aggregate Economy

Cleary Jones/Investments: Analysis and Management, 3 rd 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, 3 rd Canadian Edition, Chapter 15 Other Factors Affecting the Aggregate Economy Exchange rates o Higher exchange rate tends to reduce trade balance Inflation o It erodes the standard of living o It reduces the real value of investment o It distorts signals to economy participants o It tends to raise interest rate, which may lead to recessionary periods

Cleary Jones/Investments: Analysis and Management, 3 rd 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, 3 rd Canadian Edition, Chapter 15 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 Macroeconomic Forecasts of the Economy

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Understanding the Stock Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Uses of Market Measures

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 Exogenous or predetermined variables  Potential output of economy (Y*) Productivity, resources, investment opportunities  Corporate tax rate (t x )  Government spending (G)  Nominal money supply (M) Three policy variables subject to governmental decisions Determinants of Stock Prices

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 G and M affect stock prices by  Affecting total aggregate spending (Y), which together with the tax rate (t x ) 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) Determinants of Stock Prices

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Determinants of Stock Prices

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 From constant growth version of Dividend Discount Model P 0 =D 1 /(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 Determinants of Stock Prices

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Valuing the Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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: (ignoring 2001)  P/E ratios tend to be high when inflation and interest rates are low Put earnings estimate and multiplier together Valuing the Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Forecasting Changes in the Market

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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) Using the Business Cycle to Make Forecasts

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Using the Business Cycle to Make Market Forecasts

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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? Using Key Variables to Make Market Forecasts

Cleary Jones/Investments: Analysis and Management, 3 rd Canadian Edition, Chapter 15 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 Conclusions

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