FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 13

Economy/Market Analysis

Top-Down Approach

Analyze economy first

Understand economic factors that affect stock prices

Use economy-stock market relationship to apply valuation models to stock market

Stock market’s direction is of extreme importance to investors

Same analysis can generally be applied to foreign markets

Currency changes affect returns

Assessing the Economy

Gross Domestic Product (G D P)

Value of goods and services produced within a country

Real G D P is single best measure of overall economic activity in a country

Gross National Product (G N P)

Value of goods and services produced by domestic firms in, or outside, a country

Business Cycle 1

Business Cycle: Recurring pattern of aggregate economic expansion and contraction

Cycles have a common framework

trough  peak  trough

Peak to trough is recession

Trough to peak is expansion

Can only be precisely identified in hindsight

National Bureau of Economic Research

Officially determines turning points

Business Cycle 2

Composite indexes of economic activity

Leading, coincident, and lagging indicators indicate peaks and troughs in business activity

Foreign trade affects G D P

Economic Forecast Accuracy

Prominent forecasters produce similar predictions

Evidence indicates forecasts are informative

Forecast accuracy appears to have increased over time

U.S. Real G D P

Business Cycle 3

Monetary policy has an important effect on the economy

Increases in money supply tend to promote economic activity

Federal Reserve’s impact

Sets monetary policy, which impacts interest rates and the availability of money

Estimates vary on economic impact of some policy variables

Reading Yield Curves

Yield curve shows relationship between bond yields and time to maturity

Reflects investors’ views about future interest rates

Yield curve shape is related to business cycle

Upward sloping and steepening curve implies accelerating economic activity

Flat structure implies a slowing economy

Inverted curve may imply a recession

Treasury Yield Curves

Stock Market and the Economy 1

Stock market and economy are closely related

Stock market generally leads the economy

Stock market is the most sensitive indicator of business cycle

Relationship generally considered reliable

Market’s ability to predict recoveries is much better than its ability to predict recessions

By the time investors recognize economic change, stock market has usually already reacted

Stock Market and the Economy 2

Since 19 57 there have been nine U.S. recessions

Average recession length was about 12 months

Longest –18 months; Shortest –6 months

Average stock return during recessions was –1.5 percent

Market averaged 15.3% in year after recession

Booms, Slowdowns, Bond Markets

Stock market booms

Usually coincide with rapid economic growth

Productivity growth is also important

Stock market slowdowns

Bear market is a decline of at least 20%

Recession leads to higher investor risk premiums

Bond markets reflect interest rate changes, what bond traders think about economy

Understanding the Stock Market

Fundamental analysis approach based on P/E

Uses estimate of P/E

Estimating earnings is not easy

Real G D P growth may be best guide

E P S can be constructed in various ways

P/E ratios affected by several factors

Interest rates, inflation, variation from year to year

Market is always looking ahead, but how far ahead?

Market Returns and E P S

Making Market Forecasts 1

Accurate forecasts impossible to make consistently, especially for short-term

Important variables

Interest rates

Expected corporate profits

Best for investors is to realize forecasting is usually, but not always, futile

Making Market Forecasts 2

Grinold Kroner model – separates market return (RS) into 3 parts: income, earnings growth and repricing

Income = dividend yield (D/P) and share repurchases

Earnings growth = inflation (i)+real growth (g)

Repricing = change in market P/E

Using the Business Cycle to Make Forecasts 1

Leading relationship exists between stock market and economy

Investors need to anticipate business cycle turning points

Stock returns can be negative (positive) when business cycle peaks (bottoms)

Stock prices often rise shortly prior to trough

Stock prices have often remained steady or declined in initial phase of recovery

Using the Business Cycle to Make Forecasts 2

Fed Model

Compares earnings yield (E/P) to nominal yield on a long-term T-bond

Used to determine when stocks are relatively attractive

Used to determine “fair value” for S&P 500

Tends to not work well when interest rates are very low

Other Variables Used in Forecasting

Market’s P/E ratio

History suggests investors should pay attention to this measure

Interest rates

Monetary policy

Volatility

January market performance

U.S. Stock Market P/E Ratio

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FNCE 625 – Investment Analysis and Management

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