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Transcript of INVESTMENTS: Analysis and Management Third Canadian Edition INVESTMENTS: Analysis and Management...
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
The Economy and the Stock MarketThe Economy and the Stock Market
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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 Economy and the Stock MarketThe Economy and the Stock Market
The Economy and the Stock MarketThe Economy and the Stock Market
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
The Business CycleThe Business Cycle
GDP Growth (%)
Time
Expansion
Peak
Recession
Trough
Recovery
Expansion
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the Other Factors Affecting the Aggregate EconomyAggregate Economy
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
Other Factors Affecting the Other Factors Affecting the Aggregate EconomyAggregate Economy
• 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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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)
Determinants of Stock PricesDeterminants of Stock Prices
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Determinants of Stock PricesDeterminants of Stock Prices
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Determinants of Stock PricesDeterminants of Stock Prices
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 15
• 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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