Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 29 Tying It All Together.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 29

Tying It All Together

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 29-2

Learning Objectives

• Understand the role of economic indicators and their importance to financial markets

• Realize the complexities of modern financial markets and their importance to the economy


Introduction

• This chapter ties all the concepts together– Markets and instruments– Banks– Central banking– Monetary theory

• Discussion of the key economic indicators and how these influence securities prices


The Economic Indicators

• Economic indicators measure economic performance• Some indicators are very important

– GDP growth, unemployment and inflation

– These embody the ultimate objectives or goals set by the Federal Reserve

• However, other economic indicators are more focused on specific measures and provide insight into how the economy is performing


The Economic Indicators (Cont.)

• Table 29.1 and Figure 29.1– Lists and displays the most important economic

indicators with the source of the data and frequency of release

– These indicators can also influence the price movement of stocks and bonds

– Because of the importance of indicators, traders know exactly when these indicators will be released


TABLE 29.1 Key economic indicators.


FIGURE 29.1 Selected economics indicators.


FIGURE 29.1 Selected economics indicators. (Cont.)



• Table 29.1 (Cont.)– Understanding how the market reacts to a particular

indicator requires a two-step procedure• Understand what the indicator is and its connector to

security prices

• Understand the way the indicator behaves relative to changes in the economy



• The Employment Report– Compiled monthly by the Bureau of Labor Statistics and the

U.S. Department of labor– Contains information on employment, average workweek and

hourly earnings – Primary focus from the press is on the unemployment rate

and the level of payroll employment– Because this report is released monthly, the employment

statistics offer a frequent update on the state of economic activity



• The Employment Report (Cont.)– Household Survey

• Based on a monthly sample of about 6,000 households

• Estimates the unemployment rate based on two questions—1) are you employed, and 2) if not, are you actively looking

• The unemployment rate is the ratio of the number of people unemployed to the number of people in the labor force (those working plus those not working, but looking)

• Possible bias is a person’s reluctance to admit they are no longer actively looking for a job, but has dropped out of the labor force



• The Employment Report (Cont.)– Establishment Survey

• This is the basis for payroll employment

• The source of data comes from canvassing business establishments rather than households

• Excludes self-employed and domestic workers

• Persons who hold multiple jobs can be counted several times



• The Employment Report (Cont.)– Market brokers/dealers place more weight on the

payroll numbers compared with the unemployment rate because the measurement problems are less

– Both reports are lagging indicators—follow behind changes in overall economic activity



• Housing Starts and Building Permits– This report reflects activity in a very important

sector of the economy– Housing accounts for more than 25% of the

investment component of GDP and 40% of the household budget

– This report is a leading indicator—housing increases have a ripple effect in the economy



• Housing Starts and Building Permits (Cont.)– Two components to this report

• Housing Starts—recorded when excavation begins for a new house or apartment

• Building Permits—precedes housing starts since most localities require building permits before excavation begins

• Housing starts are about 10% greater than building permits because some localities do not require permits



• Purchasing Management Index (PMI)– Based on a survey conducted by the Institute for

Supply Management (ISM)– Consists of six questions about production, orders,

prices, inventories, vendor performance and employment

– Respondents are asked to characterize each activity as either up, down, or unchanged



• Purchasing Management Index (PMI) (Cont.)– A composite index is formed—A number over 50

represents an expanding manufacturing sector and below 50 implies contraction

– This is a coincident indicator meaning that its movements occur simultaneously with economic activity



• Index of Leading Economic Indicators (LEI)– A group of 10 components that form the basis for

predicting recessions and economic upturns– This index is released each month by the Conference

Board– As a general rule of thumb, the LEI turns down

before a decline in GDP and turns up before GDP resumes its uptrend



• Index of Leading Economic Indicators (LEI) (Cont.)– Market participants view three consecutive monthly

changes in one direction as anticipating a change in economic activity

– On average, the LEI seems better in terms of accuracy and lead time in predicting downturns compared with upturns, although neither set of forecasts are all that accurate


Valuation, The Fed, and Market Reaction

• The basic question is: “How do the stock and bond markets react to improvements in each of the economic indicators?”

• The final column in Table 29.1 shows the “conventional wisdom” about how prices react to good news about an indicator

• In general, good news about any of the indicators related to expenditure drives stock prices up and bond prices down


Valuation, The Fed, and Market Reaction (Cont.)

• Good News Versus Bad News: The Role of Expectations– This would suggest that the stock market should go up if

GDP goes up

– However, the important issue is not whether it goes up, but how the movement relates to the expectations in the market

– Upward movements that are larger than expected will generally increase stock prices, whereas movements upward less than expected will tend to lower stock prices



• Good News Versus Bad News: The Role of Expectations (Cont.)– If the expectations are fully realized, there should be

no change in stock prices since the market has already fully discounted the movement in GDP

– Thus markets react only to unanticipated news—only to new news



• Good News Versus Bad News: The Role of Expectations (Cont.)– The LEI, for example is mostly old news because

most of the component indicators have been released earlier

– Some indicators are less reliable than others because they are subject to substantial future revision

– An indicator that is less vulnerable to revision will be more powerful in moving the market



• Stock and Bond Valuations—A Refresher– To understand why stocks and bonds react in

opposite directions with unanticipated news in the economy, need to reflect on the basics of bond and stock valuations

– These concepts were covered in chapters 4 and 8, respectively, and are reviewed below



• Stock and Bond Valuations—A Refresher (Cont.)– Bond Prices

• Assume a ten-year zero-coupon government bond with a face value of “F”

• Therefore the bond price is as follows:

Bond Price = F/(1 + r)10

Where “r” = the yield on 10 year government bonds



• Stock and Bond Valuations—A Refresher (Cont.)– Bond Prices (Cont.)

• Since the numerator in the formula (F) is a fixed obligation, bond prices will decline with increase in interest rates (r)

• What causes movements in the yield on 10 year government bonds?

• An expanding GDP and expectations of increasing future inflation will cause an increase in “r”



• Stock and Bond Valuations—A Refresher (Cont.)– Bond Prices (Cont.)

• In addition, The Federal Reserve may elect to tighten monetary policy to restrain inflation which drives up interest rates through the term structure of interest rates

• Higher interest rates means that the future cash flow from the ten-year bond will be discounted at a higher rate

• Therefore, fears of emerging inflationary pressure plus concern that the Fed will drive up the federal funds rate will decrease the value of the ten-year zero-coupon bond



• Stock and Bond Valuations—A Refresher (Cont.)– Stock Prices

• Assume a stock paying out all of its earnings in dividends (D) and that these cash flows will last forever

• These cash flows are discounted at a rate (k) which consists of the risk-free rate plus an adjustment for the riskiness of the stock

• Therefore the stock price is as follows:– Stock Price = D/k



• Stock and Bond Valuations—A Refresher (Cont.)– Stock Prices (Cont.)

• Valuation of stocks is more complicated since good news will likely affect both the numerator and denominator of the formula

• The denominator behaves as it does in the bond formula, good news will increase interest rates which lowers value

• However, good news about the economy means that companies will earn more, implying they will pay higher dividends in the future



• Stock and Bond Valuations—A Refresher (Cont.)– Stock Prices (Cont.)

• This indicates that the numerator will increase with good news, driving up the value of the stock

• Thus in the stock valuation formula there are two effects which work in opposite directions

• Which one of these effects dominates--Conventional wisdom on Wall Street is that the effect on the numerator is usually stronger than the denominator, so that stock prices rise on good news



• Stock and Bond Valuations—A Refresher (Cont.)– Figure 29.2

• Summarizes the effects of goods news on stocks and bonds and the linkages just discussed

• One notable departure from the pattern that stocks and bonds move in different directions is the reaction to inflation

• Unanticipated good news about inflation (lower than expected) drives the interest rate down and has a positive effect on both the stock and bond market


FIGURE 29.2 Economic indicators and market behavior.


Putting It All Together

• Economic indicators are at the center of a feedback mechanism operating through economic activity, economic policy, and investor behavior

• These indicators measure how the economy is currently performing and suggest how it will perform in the future


Putting It All Together (Cont.)

• Investors, forecasters, and analysts all observe the indicators and make assessments about the future—mainly future dividends and interest rates

• Because the Federal Reserve monitors the economy through these indicators, favorable or unfavorable news can alter monetary policy


Putting It All Together (Cont.)

• Can individual investor make money on newly released economic indicators—buying stocks and selling bonds on good news or vice-versa – Hinges on the “newness” of news—by the time we read about

an economic indicator, it is old news– Professional stock and bond brokers/dealers probably see the

“new” news immediately after the indicators are released and act accordingly

– U.S. economy is intertwined with international events which impact domestic economic activity

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 29 Tying It All Together.

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Transcript of Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 29 Tying It All Together.