Need Need to unde unders rstan tand d econ econom omic ic act actor ors s that that a! a!ec ectt stoc stock k pric prices es initially "se valuation models applied to the overall market and consider how to orecast market chan#es $toc $tock k mark marke et%s t%s investors
lik likely ely
direc irecti tion on is o e& e&tr trem eme e
impo import rtan ance ce to
$hould also take a #lo'al perspective 'ecause o linka#es
Economy and the $tock Market (irect relationship 'etween the two Economic 'usiness cycle )ecurrin# pattern o a##re#ate economic e&pansion and contraction Cycles have a common ramework trou#h
peak
trou#h
Can only 'e neatl neatly y cate# cate#ori orized zed 'y len#th len#th and turnin# turnin# point points s in hindsi#ht
*usiness Cycle National *ureau Economic )esearch Monitors economic indicators (ates 'usiness cycle when possi'le Composite inde&es o #eneral economic activity $eries o leadin#+ coincident+ and la##in# indicators o economic activity to assess the status o the 'usiness cycle
$tock Market and *usiness Cycle $tock prices lead the economy
2
,istorically+ the most sensitive indicator $tock prices consistently turn 'eore the economy ,ow relia'le is the relationship The a'ility o the market to predict recoveries is much 'etter than its a'ility to predict recessions
Macroeconomic .orecasts o the Economy ,ow #ood are availa'le orecasts rominent orecasters have similar predictions and di!erences in accuracy are very small 0nvestors can use any such orecasts (oes monetary activity initiated 'y the .E( orecast economic activity Chan#es due to shits in supply or demand Actions o .ederal )eserve important
)eadin# ield Curves $hows relationship 'etween market yields and time to maturity+ holdin# all other characteristics+ like credit risk+ constant "pward slopin# and steepenin# curve implies acceleratin# economic activity .lat structure implies a slowin# economy 0nverted curve may imply a recession Actions o .E(+ e&pectations important
"nderstandin# the $tock Market Market measured 'y inde& or avera#e Most inde&es desi#ned or particular market se#ment 2e& 'lue chips4 Most popular inde&es (ow-5ones 0ndustrial Avera#e $6 788 Composite $tock 0nde&
3
.avored 'y most institutional investors and money mana#ers
"ses o Market Measures $hows how stocks in #eneral are doin# at any time 9ives a eel or the market $hows where in the cycle the market is and sheds li#ht on the uture Aids investors in evaluatin# downside ,elps :ud#e overall perormance "sed to calculate 'etas
(eterminants o $tock rices Corporate earnin#s and e&pected in;ation a!ects e&pected real earnin#s 0nterest rates and re
(eterminants o $tock rices .rom constant #rowth version o (ividend (iscount Model P0 =D1 /(k-g) 0nverse relationship 'etween interest rates 2re
=aluin# the Market To apply undamental analysis to the market+ estimates are needed o $tream o shareholder 'ene>ts Earnin#s or dividends )e
4
$teps in estimatin# earnin#s stream Estimate 9(+ corporate sales+ corporate earnin#s 'eore ta&es+ and >nally corporate earnin#s ater ta&es The earnin#s multiplier More volatile than earnin#s component (i?cult to predict Cannot simply e&trapolate rom past /E ratios+ 'ecause chan#es can and do occur 1@8-881 avera#e or $6 788B 1 /E ratios tend to 'e hi#h when in;ation and interest rates are low ut earnin#s estimate and multiplier to#ether
.orecastin# Chan#es in the Market (i?cult to consistently orecast the stock market+ especially short term EM, states that uture cannot 'e predicted inormation
'ased on past
Althou#h market timin# di?cult+ some situations su##est stron# action 0nvestors tend to lose more 'y missin# a 'ull market than 'y dod#in# a 'ear market
"sin# the *usiness Cycle to Make .orecasts Deadin# relationship e&ists 'etween stock market prices and economy Can the market 'e predicted 'y the sta#e o the 'usiness cycle Consider 'usiness cycle turnin# points well in advance+ 'eore they occur $tock total returns could 'e ne#ative 2positive4 when 'usiness cycle peaks 2'ottoms4 0 investors can reco#nize the 'ottomin# o the economy 'eore it occurs+ a market rise can 'e predicted $witch into stocks+ out o cash As economy recovers+ stock prices may level o! or even decline
5
*ased on past+ the market /E usually rises :ust 'eore the end o the slump
"sin# ey =aria'les to Make Market .orecasts *est known market indicator is the price/earnin#s ratio Fther indicatorsB dividend yield+ earnin#s yield ro'lems with key market indicatorsB Ghen are they si#nalin# a chan#e ,ow relia'le is the si#nal ,ow
.E(%s Approach Asset allocation chan#es imply the returns on e&ed-income securities are related Compare 18-yr Treasury yields with the earnin#s yield 2E/4 on the $6 788 E/ H 2I4 T-note yield implies stocks are attractive 2unattractive4 relatively ro'lemsB Doses relia'ility when rates low+ earnin#s estimated into uture
Conclusions Market orecasts are not easy+ and are su':ect to error 0nvestors should count on the une&pected occurrin# 0ntelli#ent and useul orecasts o the market can 'e made at certain times+ at least as to the likely direction o the market
6
J1 why is market analysis is so important AnsB Market analysis is important 'ecause some 38K to 78K o the varia'ility in an individual stockLs return is attri'uta'le to a##re#ate market e!ects Not only is the market the lar#est sin#le actor e&plainin# ;uctuations in individual stock returns+ it has an even #reater impact on a diversi>ed portolio
J Ghy should investors 'e concerned with 9( #rowth AnsB 9( ups and downs directly a!ect companies+ there'y a!ectin# investors
J3 ,ow have 'usiness cycle e&pansions and contractions chan#ed since GG00 AnsB $ince GG00 e&pansions have typically 'een lon#er than 'eore+ and contractions shorter
J Ghat is the historical relationship 'etween stock prices+ corporate pro>ts and interest rates AnsB ,istorically+ a close direct relationship has e&isted 'etween corporate pro>ts and stock prices A parallel 'etween the two series can oten 'e seen+ 'oth upward and downward+ althou#h stock prices may move >rst An inverse relationship e&ists 'etween stock prices and interest rates *ecause interest rates are closely tied to discount rates+ a rise in interest rates will have a ne#ative impact on stock prices
J7 ,ow can investors #o a'out valuin# the market AnsB To value the market+ investors need to analyze the e&pected earnin#s 2or dividends4 or a market inde& as well as an e&pected /E ratio 2or discount rate4 These values are di?cult to accurately predict however+ the concept is simple and intuitive 0 earnin#s are e&pected to rise and the /E to at least remain constant+ the market should rise 0 a decline is e&pected+ ceteris para'us+ a drop in value can 'e e&pected And so orth 0t is desira'le or instructors to impress upon students the 'asic nature o this process+ even i e&act estimates are di?cult to o'tain No one is ever #oin# to 'e a'le to orecast the market accurately on a consistent 'asis+ 'ut it is possi'le to make some astute :ud#ments periodically 2such as in 1@O 'eore the peak in interest rates4 and 'ene>t rom them
JP Ghat is the QtypicalR 'usiness cycle-stock-price relationship AnsB $tock prices tend to lead the economyLs turnin# points+ 'oth peaks and trou#hs ,owever+ there are >ner points to considerB 2a4$tock prices almost always rise as the 'usiness cycle is approaching a trou#h .urthermore+ these increases have 'een lar#e
7
2'4$tock prices oten drop suddenly as the 'usiness cycle enters into the initial phase o recovery rices sta'ilize+ or even decline+ as the economy moves ahead
J 0 an investor can determine when the 'ottomin# out o the economy will occur+ when should stocks 'e purchased-'eore+ durin# or ater such a 'ottom Gould stock prices 'e e&pected to continue to rise as the economy recovers 2'ased on historical e&perience4 AnsB S $tocks should 'e purchased 'eore a 'ottomin# o the economy occurs 'ecause prices almost always rise 'eore the trou#h S As the economy recovers+ 'e prepared or a levelin# o!+ or even a decline
JO Can money supply chan#es orecast stock-price chan#es AnsB Considera'le evidence su##ests that investors cannot use past chan#es in money supply to orecast stock prices $tock price movements may lead chan#es in money supply As in numerous other areas o research in investments+ this relationship has 'een controversial+ and the evidence presented has 'een mi&ed
J@ Ghat is the historical relationship 'etween the market%s /E ratio and recessions AnsB The market /E is hi#her at the end o the slump than at its low point o the slump in other words+ the /E ratio usually rises toward the end o each slump relative to its low point durin# the downturn 0t then remains rou#hly unchan#ed over the ne&t year
J18 Ghat was the primary cause o the rise in stock prices in 1@O AnsB The primary cause o a rise in stock prices in 1@O was a dramatic decline in interest rates+ and thereore discount rates Ghile it is not likely that many investors cau#ht the e&act 'ottom+ a sizea'le num'er did 'ene>t 'y e&pectin# such a decline sometime in 1@O
J11 $uppose that you know with certainity that corporate earnin#s ne&t year will rise 17 K a'ove this year%s level o corporate earnin#s *ased on this inormation + should you 'uy stock AnsB ou cannot answer this
8
J1 Ghat does a steepin# yield curve su##ests a'out the economy Ghat a'out an invested yield curve AnsB A steepenin# yield curve su##ests that the economy is acceleratin# in terms o activity as monetary policy stimulates the economy An invested yield curve carries e&pectations o an economic slowdown =irtually every recession since GG00 has 'een preceded 'y a downward-slopin# yield curve
J13 0n #eneral+ what should 'e the relationship 'etween corporate earnin#s #rowth and the #rowth rate or the economy as a whole AnsB 0t is reasona'le to e&pect corporate earnin#s to #row+ on avera#e+ at a'out the rate o the economy as a whole F course+ in some periods earnin#s may #row at a much aster rate This occurred in the last years o the 8th Century
J1 "sin# the so called Q.ed ModelR relatin# the earnin#s yield on the $6 788 0nde& to Treasury 'ond yields+ when would stocks 'e considered an attractive investment AnsB "sin# the so-called .ed model+ stocks are relatively attractive when the earnin#s yield on the $6 788 is #reater than the 18-year Treasury yield Alternatively+ estimate the air value level o the $6 788 0nde& 'y dividin# the estimated earnin#s or this inde& 'y the current 18-year Treasury 'ond yield 0 the estimated air value o the market is #reater than the current level o the market+ stocks are undervalued
J 17 Ghy is so much day-to-day news covera#e devoted to consumer spendin# AnsB Consumer spendin# is the lar#est sin#le component drivin# the economy+ and thereore warrants detailed attention
ro'lems J1 (urin# 1 week in late (ecem'er 88O+ the Nasda< Composite went rom 17P3 to 1738 while the Nasda< 188 0nde& went rom 111@ to 11O7 Ghich 0nde& showed the #reater loss AnsB Nasda< Composite
Nasda< 188
9
17P3 -1738 -38O -38O/17P3 - 881@ & 188 - 1@K Nasda< 188 $howed a #reater loss
J The Nasda< 0nde& lost more than 7K o its value in the early years o the twenty >rst century Assumin# a O8K loss+ Ghat return is needed on this inde& to make up or the O8K loss AnsB A 7 percent loss will re
Computational ro'lem The ollowin# annual data are availa'le or a stock market 0nde&B ear
End o ear rice 24 181
88 88 118 7 88 177 P 88 131 88 17P O 88 186.24 @ The 88@ values in
Earnin# 2E4
(ividend s 2(4
/E
2(/E4188 K
2(/4188 K
131
737
O1
8O
@@
1P8O
P8
73
37P
@@
1P13
P77
@7O
8P1
1P8
88
O1
1@
711
13
11O
11@3
737
7P
15.24
6.!
italics are estimatesB
a Calculate the 88@ values or those columns let 'lank ' Fn the assumption that #88@7+ calculate k or 88@ usin# the ormula k 2(/4 U # and show that k 8137 c "sin# the 88@ values+ show that /E 1
10
d Assumin# a pro:ection that 818 earnin#s will 'e 7 percent #reater than the 88@ value+ show that pro:ected earnin#s are e&pected to 'e 1@87 e Assumin# urther that the dividend-payout ratio will 'e 88+ show that pro:ected dividends or 818 will 'e P "sin# the pro:ected earnin#s and dividends or 818+ and the same k and # used in part ' + show that the e&pected /E or 818 is 18P@ # "sin# these e&pected values or 818+ show that the e&pected price is 83P1 h )ecalculate the value or 818 /E and + usin# the same # 88@7+ 'ut withB 214 81 2'4 k 813 and 234 k 81
$olution NOTE: The earnings ($15.24) and dividends ($6.97) for 2009 are given, as is he !ear" end #rie of 1%6.24. a) &'E 1%6.24'15.24 12.2204 'E (100) 100(6.97'15.24) 45.7*+ '& (100) 100(6.97'1%6.24) *.742+ s an addiiona- #iee of inforaion,
T)88P 188V21OP-17PUP@4/17PW 7OK '4 k P@/1OP U 8@7 137 c4 Calculated in a4 a'ove d4 E&pected Earnin# E 818 2174 2174 1@87 e4ro:ected (ividend ( 284 21@874 P
