INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management Third Canadian Edition W. Sean Cleary Charles P. Jones

INVESTMENTS:INVESTMENTS:Analysis and ManagementAnalysis and Management

Third Canadian EditionThird Canadian Edition

W. Sean ClearyCharles P. Jones

Prepared by Khalil Torabzadeh

University of Lethbridge

Chapter 15Chapter 15

Analysis of the Economy Analysis of the Economy and the Stock Marketand the Stock Market

Cleary Jones/Investments: Analysis and Management, 3rd 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 ObjectivesLearning Objectives


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 MarketThe 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



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 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



• 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 CycleBusiness Cycle


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 CycleBusiness Cycle


The Business CycleThe Business Cycle

GDP Growth (%)

Time

Expansion

Peak

Recession

Trough

Recovery

Expansion


Figure 15-1 Real GDP per Capita and Figure 15-1 Real GDP per Capita and Real Income Per Capita (1970-2005)Real Income Per Capita (1970-2005)


• 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 Statistics Canada’s Leading IndicatorsIndicators


• 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 IndicatorsCoincident and Lagging Indicators


• 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 CycleStock Market and Business Cycle


• Global economic factorso The state of US economy is a critical

factor for Canadian economyo 70 to 80 percent of Canadian trade is

with the US.

Other Factors Affecting the Other Factors Affecting the Aggregate EconomyAggregate Economy



• Interest ratesThe most important financial variables affecting

securities market

High interest rate tend to o Raise the cost of capital to firmso Discourage consumer spendingo Reduce disposable income available for net

investment



• Exchange rateso Higher exchange rate tends to reduce trade balance

• Inflationo It erodes the standard of living o It reduces the real value of investmento It distorts signals to economy participantso It tends to raise interest rate, which may lead to

recessionary periods



• Unemploymento High unemployment rate may lead to recessionary

periods

• Government policiesGovernments influence general economic

conditions througho Monetary policy (the use of interest rats)o Fiscal policy (the use of government taxation)


• 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 Macroeconomic Forecasts of the EconomyEconomy


• 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 MarketUnderstanding the Stock Market


• 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 MeasuresUses of Market Measures


• Exogenous or predetermined variables Potential output of economy (Y*)

• Productivity, resources, investment opportunities

Corporate tax rate (tx) Government spending (G) Nominal money supply (M)

• Three policy variables subject to governmental decisions

Determinants of Stock PricesDeterminants of Stock Prices


• G and M affect stock prices by Affecting total aggregate spending (Y), which

together with the tax rate (tx) 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)



• 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



• 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



• 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 MarketValuing the Market


• 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: 37.44

(ignoring 2001) P/E ratios tend to be high when inflation and

interest rates are low

• Put earnings estimate and multiplier together

Valuing the MarketValuing the Market


• 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 MarketForecasting Changes in the Market


• 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 CycleUsing the Business Cycleto Make Forecaststo Make Forecasts


• 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 CycleUsing the Business Cycleto Make Market Forecaststo 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 signalling a change? How reliable is the signal? How quickly will the predicted change occur?

Using Key Variables to Make Using Key Variables to Make Market ForecastsMarket Forecasts


• 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

ConclusionsConclusions

Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

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INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management Third Canadian Edition W. Sean Cleary Charles P. Jones