Chapter_13-EconomyAnalysis - Economy/Market Analysis...

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Unformatted text preview: Economy/Market Analysis Analysis Chapter 13 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University 13-1 Top-down Approach Analyze 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 Should also take a global perspective because because of linkages 13-2 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 13-3 Business Cycle National Bureau Economic Research Monitors economic indicators Dates business cycle when possible Composite indexes of general economic activity Series of leading, coincident, and lagging indicators of economic activity to assess the status of the business cycle 13-4 Stock Market and Business Cycle Stock prices lead the economy Historically, the most sensitive indicator Stock prices consistently turn before the economy How How reliable is the relationship? The ability of the market to predict recoveries is much better than its ability to predict recessions 13-5 Macroeconomic Forecasts of of the Economy 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 initiated by the FED forecast economic activity? Changes due to shifts in supply or demand Actions of Federal Reserve important 13-6 Reading Yield Curves Shows relationship between market yields and time to maturity, holding all other characteristics, like credit risk, constant Upward sloping and steepening curve implies implies accelerating economic activity Flat structure implies a slowing economy economy Inverted curve may imply a recession Actions Actions of FED, expectations important expectations 13-7 Understanding the Stock Market Market measured by index or average Most indexes designed for particular market market segment (ex. blue chips) blue Most popular indexes Dow Dow-Jones Industrial Average S&P 500 Composite Stock Index Favored by most institutional investors and money managers 13-8 Uses of Market Measures 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 and sheds light on the future Aids investors in evaluating downside Helps judge overall performance Used to calculate betas 13-9 Determinants of Stock Prices Corporate earnings and expected inflation affects expected real earnings Interest rates and required rates of return also affected by expected inflation inflation Stock prices affected by earnings, rates If economy is prospering, earnings and earnings stock prices will be expected to rise 13-10 Determinants of Stock Prices 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 13-11 Valuing the Market 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 13-12 Valuing 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 1920-2001 average for S&P 500: 17 P/E ratios tend to be high when inflation and interest rates are low Put earnings estimate and multiplier together 13-13 Forecasting Changes in 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 13-14 Using the Business Cycle to Make Forecasts 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) 13-15 Using the Business Cycle to Make Market Forecasts If investors can recognize the bottoming of the economy before it occurs, 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 13-16 Using Key Variables to Make 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 signaling a change? How reliable is the signal? How quickly will the predicted change occur? 13-17 FED’s Approach Asset allocation changes imply the returns on equity and fixed-income securities are related Compare 10-yr. Treasury yields with the earnings yield (E/P) on the S&P 500 E/P > (<) T-note yield implies stocks are attractive (unattractive) relatively Problems: Loses reliability when rates low, earnings estimated into future 13-18 Conclusions Market forecasts are not easy, and are and 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 13-19 ...
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