1. 1 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Fin2802: Investments Spring, 2010 Dragon Tang Lecture 16 Macroeconomic and Industry Analysis March 23, 2009 Readings: Chapter 17 Practice CFA Problem Sets: 4,6,9,12,15

2. 2 The Greenspan/Bernanke Put Investors hold a put option from the Fed/Government When market drops, government rescues What’s the problem? FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis

3. 3 Current Problem Long term vs. short term Growth vs. inflation Trust vs. gaming … FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis

4. 4 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis What is this? What’s daily trading volume of US stock market? What’s daily trading volume of US Treasury bonds? Total market size $250.8 trillion Daily trading volume $1.8 trillion

5. 5 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis What is this? What’s daily trading volume of US stock market? –$10 billion What’s daily trading volume of US Treasury bonds? –$300 billion Total market size $250.8 trillion –Interest rate derivatives Daily trading volume $1.8 trillion –Foreign exchanges

6. 6 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis “The actual interest rate forecast record of the world's highest paid financial ‘experts’ for forecasting interest rates is nothing short of disastrous.” http://www.opalmagazine.com/members/_financial_arti cles/articles/Wall_March-2001_files/Wall_March- 2001.htm

7. 7 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Macroeconomic and Industry Analysis Objectives: Effect of monetary and fiscal policies Economic indicators (leading, coincident, and lagging) Business cycles Effect of industry life cycles and structure

8. 8 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Fundamental Analysis Economics –Investment and consumption Finance Accounting

9. 9 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Internet: Google Geography and Finance

10. 10 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Fundamental Analysis Approach to Fundamental Analysis –Domestic and global economic analysis –Industry analysis –Company analysis Why use the top-down approach Framework of Analysis

11. 11 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Finance and Growth

12. 12 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Shocks to Finance and Growth Shock to both stock market and macroeconomy Shock to macroeconomy Shock to stock market Stock MarketMacroeconomy

13. 13 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Global Economic Considerations Performance in countries and regions is highly variable Political risk Exchange rate risk –Sales –Profits –Stock returns

14. 14 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Change in Real Exchange Rate: Dollar Versus Major Currencies. 1999-2003

15. 15 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Key Economic Variables Gross domestic product Unemployment rates Interest rates & inflation Budget Deficits Consumer sentiment

16. 16 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis S&P 500 Versus EPS Estimate

17. 17 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Determination of the Equilibrium Real Rate of Interest

18. 18 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Federal Government Policy Fiscal Policy - government spending and taxing actions –Direct policy –Slowly implemented

19. 19 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Federal Government Policy (cont.) Monetary Policy - manipulation of the money supply to influence economic activity –Initial & feedback effects Tools of monetary policy –Open market operations( federal funds rate) –Discount rate –Reserve requirements

20. 20 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Demand Shocks Demand shock - an event that affects demand for goods and services in the economy –Tax rate cut –Increases in government spending

21. 21 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Supply shock - an event that influences production capacity or production costs –Commodity price changes –Educational level of economic participants Supply Shocks

22. 22 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Business Cycles Business Cycle –Peak –Trough Industry relationship to business cycles –Cyclical –Defensive

23. 23 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Leading Indicators - tend to rise and fall in advance of the economy Examples –Avg. weekly hours of production workers –Stock Prices –Initial claims for unemployment –Manufacturer’s new orders NBER Cyclical Indicators: Leading

24. 24 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Coincident Indicators - indicators that tend to change directly with the economy Examples –Industrial production –Manufacturing and trade sales NBER Cyclical Indicators: Coincident

25. 25 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Lagging Indicators - indicators that tend to follow the lag economic performance Examples –Ratio of trade inventories to sales –Ratio of consumer installment credit outstanding to personal income NBER Cyclical Indicators: Lagging

26. 26 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Economic Calendar at Yahoo!

27. 27 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Industry Analysis Sensitivity to business cycles Sector Rotation Industry life cycles

28. 28 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Estimates of Earnings Growth Rates in Several Industries, 2004

29. 29 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Sensitivity to Business Cycle Factors affecting sensitivity of earnings to business cycles –Sensitivity of sales of the firm’s product to the business cycles –Operating leverage –Financial leverage

30. 30 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Industry Cyclicality

31. 31 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis A Stylized Depiction of the Business Cycle

32. 32 Figure 17.6 Returns on Equity, 2005 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis

33. 33 Figure 17.7 Rate of Return, 2005 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis

34. 34 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Sector Rotation Selecting Industries in line with the stage of the business cycle Peak – natural resource firms Contraction – defensive firms Trough – equipment, transportation and construction firms Expanding – cyclical industries

35. 35 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Sector Rotation Gains

36. 36 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Historical Sector Performance Total returns on a representative group of Fidelity Select funds from 1999 to 2003 (fund with highest return for the year in blue).Fidelity Select funds Yr Biotech Finance Const. Media Gas Tech Wilshire 199977.8% 30.6% 12.5% 44.1% 26.2% 132.4% 23.6% 200032.8% 28.3% 8.8% -23.1% 71.0% -31.8%-10.9% 2001-25.0% -9.2% 20.0% -1.0% -22.9% -31.7%-11.0% 2002-40.5% -17.2% -8.5% -12.8% -9.6% -37.8%-20.9% 200332.9% 36.5% 44.1% 43.9% 28.7% 59.4%31.6%

37. 37 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Industry Life Cycles StageSales Growth Start-upRapid & Increasing ConsolidationStable MaturitySlowing Relative DeclineMinimal or Negative

38. 38 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis The Industry Life Cycle

39. 39 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Practice Choose an industry and identify the factors that will determine its performance in the next three years. What is your forecast for performance in that time period.

40. 40 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Case Analysis: Tech Bubble/Bust and the Fed 1990s—especially second half—saw dramatic rise in stock prices –Growth in real GDP averaged 4.2% annually from 1995-2000 Technological changes of 1990s were an example of a shock to both stock market and economy The market—especially high-tech NASDAQ stocks—began to decline in early 2000 Faced with these demand shocks, Federal Reserve would ordinarily have raised its interest rate target to prevent real GDP from exceeding potential output Fed increased rates 6 times in 1999 and 2000 from 5% to 6.5%, then reduced rates 11 times in 2001 to 1.75% (1.00% by 6/25/2003)

41. 41 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis The Fed ’ s Problem In 2000: An AS-AD View Real GDP Price Level Y1Y1 Y2Y2 (a) P1P1 AD 2 A B P2P2 AD 1 AS AS 1 AS 2 A AD 2 AD 1 (b) Real GDP P1P1 P2P2 Y1Y1 Y2Y2 B C P3P3 Price Level If output exceeds potential, the self-correcting mechanism will raise the price level further Wealth effect of rising stock prices shifts AD rightward, raising real GDP and the price level

42. 42 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis The Fed ’ s Problem in 2000: A Phillips Curve View A C B D 4%5% 2.5% 5.0% 1.5% PC 1 PC 2... or recession Unemployment Rate Inflation Rate A 4% 2.5% PC 1 UN?UN? (a)(b) Inflation Rate If the natural rate of unemployment is 4%, the Fed can keep the economy at point A in the long run Unemployment Rate UN?UN? But if the natural rate is above 4% the Phillips curve will shift upward and the Fed must choose between higher inflation...

43. 43 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis The Fed and the Stock Market Might think Fed can estimate natural rate by a process of trial and error –Bring unemployment rate to a certain level (such as 4%) and see what happens to inflation However, Fed looks ahead and determines whether current economic conditions are likely to raise inflation rate in the future –By raising interest rates to rein in the economy, Fed also brought down stock prices –By 2001, high-tech bust, recession of 2001, and attacks of September 11 brought criticism to an end –As the economy began a slow expansion, in 2002 and early 2003, Fed kept the interest rate low Unresolved question: Who should be setting the general level of share prices—millions of stockholders who buy and sell shares, or Federal Reserve?

44. 44 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Summary Economic environment Monetary and fiscal policies Economic indicators Business and industry cycles Next: Asset Pricing Theory