1. Llad Phillips1 Introduction to Economics Linking Personal Investment with the US Economy Macroeconomics

2. Llad Phillips2 Part Two Macroeconomics and the US Economy 5. Tuesday, Oct. 13, Lecture Five: "Capital Asset Pricing Model" Tracking asset markets and the US economy capital asset pricing model Growth rate of your personal wealth Value of a share of stock The impact of business cycles on corporate profits Reading Assignment: O’Sullivan and Sheffrin, Ch. 20, “The Big Ideas in Macroeconomics” emphasis: measuring the ouput of the economy, unemployment, inflation O’Sullivan and Sheffrin, Ch. 21, “Behind the Economic Statistics” Problems O & S Text p. 420: 1, 2, 3, 4, 5, 6, 7, 8 p. 441: 1, 2, 3, 4, 5, 6, 7, 8 Thursday, Oct. 15, 25 minute QUIZ, You will need scantron sheet and #2 pencil.

3. Llad Phillips3 Outline: Lecture Five Tracking Asset Markets and the US Economy Tracking Asset Markets and the US Economy Growth Rate of Personal Wealth Growth Rate of Personal Wealth  the importance of savings relative to rate of return on wealth Value of a share of stock Value of a share of stock  depends on the stream of expected future net earnings per share The Impact of the Business Cycle on Corporate Profits The Impact of the Business Cycle on Corporate Profits

4. Llad Phillips4 Your Stocks Market Indices The Economy corporate earnings(profits)

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8. 8 Two Kinds of Assets low rate of return- low variability low rate of return- low variability want high rate of return return on average want high rate of return return on average want low variability want low variability  predictable average return high return-high variability high return-high variability want high rate of return on average want high rate of return on average want low variability want low variability Dilemma: which kind of asset to hold?

9. Llad Phillips9 Investment Principles or Maxims Don’t put all of your eggs in one basket Don’t put all of your eggs in one basket  hold a diversified portfolio  cash  bonds  stocks  real estate  advantage of a mutual fund  instead of holding one stock, e.g. Coca-Cola, you hold a bundle of stocks Choose the asset with the highest reward for a given level of risk Choose the asset with the highest reward for a given level of risk

10. Llad Phillips10 Measures of Average Rate of Return and Variability: Mean & Std. Dev.

11. Llad Phillips11 Aug. ‘98

13. Llad Phillips13 Mean Returns & Standard Deviations

14. Llad Phillips14 Efficient Investment Portfolio

15. Llad Phillips15 Your portfolio should be on the efficient frontier But where on the frontier? But where on the frontier?  depends on your taste for reward and risk  reward, i.e. the mean rate of return is a good  risk is a bad

16. Llad Phillips16 Economic Paradigm: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M,R) Mean Return, M Risk, R better worse Iso - Preference Curves A B C Prefer B to A; Prefer B to C

17. Llad Phillips17 Efficient Investment Portfolio Investor A: very risk averse

18. Llad Phillips18 Efficient Investment Portfolio Investor B: not very risk averse

19. Llad Phillips19 Efficient UC Investment Portfolio f*insurance contract + (1-f)*equity fund f*insurance contract + (1-f)*equity fund  where f can range from zero to one  example: 50:50, i.e one half of your nest egg is invested in the Insurance Contract and the other half is invested in the Equity Fund. mean return: 1/2 *0.62 + 1/2*1.92 = 1.27 % per monthmean return: 1/2 *0.62 + 1/2*1.92 = 1.27 % per month expected risk(standard deviation: 1/2*0.02 + 1/2*3.02 =1.52expected risk(standard deviation: 1/2*0.02 + 1/2*3.02 =1.52

20. Llad Phillips20 Tracking Assets and Markets What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ? What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ?

21. Llad Phillips21 Example: The UC Index Fund and the Standard & Poor’s 500 mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks  capital asset pricing model

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24. Llad Phillips24 Capital Asset Pricing Model return to an asset varies with the return to the market return to an asset varies with the return to the market  if the relationship is perfect, R 2 =1, and all the risk in the asset is market risk  if the relationship is nonexistent, R 2 =0, and all of the risk is asset specific In symbols In symbols  r UC =  +  r S&P + e  r is the return  if  is greater than 1, the asset is riskier than the market  e is the residual or error

25. Llad Phillips25 Sources of Information: stock prices Daily Quotes Daily Quotes  Business Section of Los Angeles Times  Wall Street Journal Internet graphics Internet graphics  http://www.stockmaster.com  http://www.networth.galt.com

26. Llad Phillips26 http://www.stockmaster.com beta for Apple = 0.67

27. Llad Phillips27 http://www.networth.galt.com

28. Llad Phillips28 Apple Computer

29. Llad Phillips29 How do you make your nest egg grow? Do you need to take risks and get a high rate of return? Do you need to take risks and get a high rate of return?  not if your ratio of savings to wealth is high

30. Llad Phillips30 Relative Importance of Savings Younger Years Younger Years  income & savings are lower  wealth is smaller  ratio of savings to wealth may be high  savings is most important, rate of return less so  example  income of $60,000  savings of $6,000  wealth of $50,000  ratio of savings to wealth of 0.12 Older Years Older Years  wealth accumulates  ratio of savings to wealth falls  rate of return on wealth becomes more important  example  income of $100,000  savings of $20,000  wealth of $500,000  ratio of savings to wealth of 0.04

31. Llad Phillips31 Rate of Growth of Personal Wealth savings, s + increase in wealth, ∆w Stock of wealth, w rate of return, r + yield, r*w rate of growth of wealth, ∆w/w  rate of return, r + savings/wealth ∆w/w  r + s/w

32. Llad Phillips32 Rate of Growth of Personal Wealth If the rate of return, r, on wealth is zero If the rate of return, r, on wealth is zero  then the only source of growth in wealth is savings: ∆w/w = s/w  i.e. the only change in wealth, ∆w, is savings: ∆w = s If savings is zero If savings is zero  then the only source of growth in wealth is rate of return, r, and wealth will grow exponentially at the rate r: ∆w/w = r

33. Llad Phillips33 Years to Double Wealth

34. Llad Phillips34 rate of return on wealth, r 4% 8% 12% 4%8%12% ratio of savings to wealth, s/w rate of growth of wealth, ∆w/w ∆w/w  r + s/w 0

35. Llad Phillips35 Where does the growth in financial wealth come from? What is the relationship between financial markets and the economy? What is the relationship between financial markets and the economy?

36. Llad Phillips36 weekly rate of growth =.0023 annual rate of growth = 52*.0023 =.12

37. Llad Phillips37 Economic Concept present value of a stream of expected future net earnings, or profits, per share present value of a stream of expected future net earnings, or profits, per share  PV(t) = ENE(t) + ENE(t+1)/(1+i)  may know this year’s net earnings, NE(t)  your expectations of the future affect your best guess for next year, ENE(t+1)  at an interest rate of 7%, $1.07 next year is equivalent to a $1 this year to compare dollar values for different years, they have to be discounted to a common yearto compare dollar values for different years, they have to be discounted to a common year  PV(t) = ENE(t) + ENE(t+1)/(1+i) + ENE(t+2)/(1+i) 2 +...

38. Llad Phillips38 Income-Expense Statement for an Individual IncomeExpenditure Savings Income-Expense Statement for a Business Firm Gross RevenueCost Profit(net revenue, net earnings)

39. Llad Phillips39 http://www.globalexposure.com/ Last Ten Years 1948-

40. Llad Phillips40 Corporate profits after taxes doubled from $160 billion in early 1987 to $320 billion in early 1994 doubled from $160 billion in early 1987 to $320 billion in early 1994 doubling in about seven years implies an average rate of growth of about 10% per year doubling in about seven years implies an average rate of growth of about 10% per year this rate of growth is comparable to the 11% rate of growth in the Dow since 1986 this rate of growth is comparable to the 11% rate of growth in the Dow since 1986

41. Llad Phillips41 Your Stocks Market Indices The Economy corporate earnings(profits) Index of Leading Economic Indicators Gross Domestic Product Unemployment Rate

42. Llad Phillips42 1948- Index of Leading Indicators

43. Llad Phillips43 Recall Lab One: Resources for Economists on the Internet http://rfe.wustl.edu/

44. Llad Phillips44 The US Business Cycle expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough

45. Llad Phillips45 US Postwar Expansions 90

46. Llad Phillips46 US Business Cycle Note the long expansions in the eighties and the nineties Note the long expansions in the eighties and the nineties  is there a new economic regime or order?  are business cycles a relic of the past? Note the long expansion in the sixties Note the long expansion in the sixties  economists then talked about “fine tuning” the economy  then came along the problems of the seventies  a couple of recessions  inflation

47. Llad Phillips47 Summary-Vocabulary-Concepts capital asset pricing model capital asset pricing model market risk market risk asset specific risk asset specific risk stock’s beta,  stock’s beta,  moving average moving average exponential growth exponential growth Dow Jones Industrials Dow Jones Industrials present value present value net earnings per share net earnings per share expectations expectations discount factor discount factor corporate profits after taxes corporate profits after taxes business cycle business cycle peak peak trough trough index of leading indicators index of leading indicators