Economy / Market Analysis

1
Economy / Market Analysis

• Chapter 15

2
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 markets likely direction is of extreme
  importance to investors

3
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 countrys nationals, whether at home or
  abroad

4
Economy and the Stock Market

• Direct relationship between the two
• Market varies over the economic business cycle
• Cycle of expansions and contractions
• General definition two consecutive quarters of
  negative GDP growth recession
• Analyzing economys position in the cycle helps
  analyze the market

5
Business Cycles
GDP Growth ()
Peak
Expansion
Expansion
Recession
Recovery
Trough
Time
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THE BUSINESS CYCLE

• 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

7

• StatsCan produces a Composite Leading Indicator
  based on a number of different variables
• Stock prices tend to 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

8
Coincident Lagging Indicators

• 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

9
Another Variable of Interest- Yield Curve

• Shows yields on bonds of different terms
• Inverted yield curve slopes down
• Often sign of coming recession

yield
Term to maturity
10
Some Factors Affecting the Economy

• Interest Rates
• higher rates discourage borrowing and spending
• decrease stock prices
• interest rates affected by
• inflation
• exchange rate
• demand for funds/supply of funds
  (borrowing/saving)
• short term rates set by Bank of Canada
• risk premia

11

• Exchange Rate
• higher Can reduces exports, increase imports
• higher Can reduces inflation
• exchange rate determined by supply and demand
  for the currency
• affected by
• inflation differentials
• interest rate differentials
• current account balance
• affected by government debt (flow of interest)
• exports and imports
• performance of economy
• risk

12

• Inflation
• high inflation reduces real return on
  investments
• may lead to higher interest rates
• erodes standard of living
• increases risk in economy
• inflation related to output gap
• difference between potential output of economy
• and current level
• inflation related to money supply

13

• Unemployment
• 1) cyclical unemployment
• 2) structural unemployment
• part is frictional unemployment
• Government Policies
• 1) Monetary Policy
• 2) Fiscal Policy
• Four main effect of fiscal policy
• Spending
• Taxes
• Deficits/Surpluses
• Putting 1 and 2 together
• Affects interest rates
• Automatic stabilizers

14
Stock Prices and the Economy

• stock prices affected by economic factors
  through
• affect on current and future profitability
• affect on required returns (interest rates,
  inflation, risk)

15
Stock Prices and the Economy

• predictions of economy can help (hopefully)
  predict changes in the components of stock prices
• using economic factors to predict general stock
  market movements very hard
• stock is leading indicator of economy

16
Valuing the Overall Stock Market

• stock investments affected immensely by general
  market movements
• general market movements linked to economic
  changes
• overall market can be valued in the same ways as
  individual stocks (DDM, or based on justified
  ratios)
• notoriously hard to predict future level of
  market

17
Valuing the Overall Stock Market

• To estimate market earnings need to
• Estimate GDP
• From that, estimate corporate sales
• From that, estimate corporate profit before tax
• From that, estimate corporate profit after tax
• more generally, analysts try to predict general
  future direction of market
• often done by looking at level of key market
  variables

18
Two Key Market Variables

• 1) Price Earnings Ratio
• level of index divided by a measure of aggregate
  earnings of those firms
• compare todays level to historic norm to see
  if market is over- (high P\E) or under- (low PE)
  valued
• normal for TSX often considered P\E of 16 to 18
• However, P\E can be very volatile and the
  appropriate PE depends on risk, growth and
  interest rates (economic variables)

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Two Key Market Variables

• 2) Dividend Yield
• aggregate dividends divided by level of index
• compare todays level to historic norm to see
  if market is over- (low yield) or under- (high
  yield) valued
• normal sometimes considered approx. 2.5
• however, what is justified can vary with
  economic conditions