Investment Analysis and Portfolio Management Frank K' Reilly

1
Investment Analysis and Portfolio
ManagementFrank K. Reilly Keith C. Brown
CHAPTER 12
BADM 744 Portfolio Management and Security
AnalysisAli Nejadmalayeri
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Economies and Markets

• A strong relationship exists between the economy
  and the stock market
• Security markets reflect what is going on in an
  economy because the value of an investment is
  determined by
• its expected cash flows
• required rate of return

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Economic Activity and Security Markets

• Stock Market As A Leading Indicator
• Stock prices reflect expectations of earnings,
  dividends, and interest rates
• Stock market reacts to various leading indicator
  series
• Stock prices consistently turn before the economy
  does

4
Cyclical Indicator Approach to Forecasting the
Economy

• This approach contends that the aggregate
  economy expands and contracts in discernable
  periods

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Cyclical Indicator Approach to Forecasting the
Economy

• National Bureau of Economic Research (NBER)
• Cyclical indicator categories
• leading indicators
• coincident indicators
• lagging indicators
• Composite series and ratio of series

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Cyclical Indicator Categories

• Leading indicators economic series that usually
  reach peaks or troughs before corresponding peaks
  or troughs in aggregate economy activity
• Coincident indicators economic series that have
  peaks and troughs that roughly coincide with the
  peaks and troughs in the business cycle
• Lagging indicators economic series that
  experience their peaks and troughs after those of
  the aggregate economy
• Selected series economic series that do not
  fall into one of the three main groups

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Cyclical Indicators

• Leading indicators
• Treasury spread, Avg. weekly hours production
  workers, building permits, vendor performance,
  consumer expectations, etc.
• Coincident indicators
• Employment (nonagricultural), personal income,
  Industrial production, manufacturing and trade
  sales
• Lagging indicators
• Manufacturing and trade inventories, prime rate,
  commercial and industrial loans, consumer credit
  to personal income, duration of unemployment

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Cyclical Indicator Approach to Forecasting the
Economy

• Analytical measures of performance
• diffusion indexes
• trends
• rates of change
• direction of change
• comparison with previous cycles

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Cyclical Indicator Approach to Forecasting the
Economy

• Limitations of cyclical indicator approach
• high variability
• currency of the data and revisions
• no series reflects the service sector
• no series represents the global economy
• political and international developments are not
  factored into a statistical system

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Cyclical Indicator Approach to Forecasting the
Economy

• Leading indicators and stock prices
• Other leading indicator series
• CIBCR
• Long-leading index
• leading employment index
• Leading inflation index
• Analysis of alternative leading indicators of
  inflation
• International leading indicator series
• Survey of sentiment and expectations

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Monetary Variables, the Economy, and Stock Prices

• Money supply and the economy
• Money supply and stock prices
• Excess liquidity and stock prices
• year to year percentage change in M2 money supply
  adjusted for small time deposits less the
  year-to-year percentage change in nominal GDP

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Money Supply and the Economy

• Declines in the rate of growth of the money
  supply have preceded business contraction by an
  average of 20 months
• Increases in the rate of growth of the money
  supply have preceded economic expansions by about
  8 months

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Monetary Variables, the Economy, and Stock Prices

• Other economic variables and stock prices
• growth in industrial production
• changes in the risk premium
• twists in the yield curve
• measures of unanticipated inflation
• changes in expected inflation during periods of
  volatile inflation

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Inflation, Interest Rates, and Security Prices

• Inflation and interest rates
• generally move together
• investors are not good at predicting inflation
• Inflation rates and bond prices
• negative relationship
• more effect on longer term bonds
• Interest rates and stock prices
• not direct and not consistent
• effect varies over time

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Findings

• Flannery and Protopapadakis (2002)
• If reaction to the surprise at the announcement
  day is considered, then

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Sector Rotation andEconomic Condition

• This chart is based on Sam Stovall's SP's Guide
  to Sector Rotation and states that different
  sectors are stronger at different points in the
  economic cycle.

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Model Performance

• Information Coefficient
• Actual Rank a IC Forecasted Rank e
• For a set of models use the weighted average IC
  method