sm12 - CHAPTER 12 MACROECONOMIC AND MARKET ANALYSIS THE...

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CHAPTER 12 MACROECONOMIC AND MARKET ANALYSIS: THE GLOBAL ASSET ALLOCATION DECISION Answers to Questions 1. The reason for the strong relationship between the aggregate economy and the stock market is obvious if one considers that stock prices reflect changes in expectations for firms and the results for individual firms are affected by the overall performance of the economy. In essence, you would expect earnings of firms to increase in an expansion. Then, if the P/E ratio remains constant or increases because of higher expectations and there is no reason why it should not, you would expect an increase in stock prices. 2. Stock prices turn before the economy for two reasons: First, investors attempt to estimate future earnings and thus current stock prices are based upon future earnings and dividends, which in turn are determined by expectations of future economic activity. The second possible reason is that the stock market reacts to various economic series that are leading indicators of the economy - e.g., corporate earnings, profit margins, and money supply. 3. Virtually all research has shown the existence of a strong relationship between money supply and stock prices as is evident from high R 2 s when money supply is used to explain stock price changes. However, it is not possible to use money supply changes to predict changes in stock prices, and this is not contradictory, since the stock market apparently reacts immediately to changes in money supply or investors’ attempts to predict this important variable. As a result, it is impossible to derive excess profits from watching current or recent past changes in the growth rate of the money supply. 4. Excess liquidity is the year-to-year percentage change in the M2 money supply less the year-to-year percentage change in nominal GDP. The economy’s need for liquidity is given by its nominal growth. Any growth in M2 greater than that indicates excess liquidity that is available for buying securities, which would drive up prices. On the other hand, monetary growth in excess of GDP growth may lead to expected inflation. The rise in expected inflation would cause the nominal RFR to rise, in turn causing the required return to rise. This effect would lead to a decline in stock prices.
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