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Macroeconomic and Industry Analysis

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1 Macroeconomic and Industry Analysis
CHAPTER 12 Macroeconomic and Industry Analysis

2 Framework of Security Analysis
Security Analysis (or Fundamental analysis) The analysis to determine values of firms, by predicting earnings and dividends with publicly economic and accounting information Three levels of security analysis Global and domestic economic analysis (Ch 12) Industry analysis (Ch 12) Company analysis (equity valuation in Ch 13 and financial statement analysis in Ch 14) Why use the top-down sequence Sometimes macroeconomic and industry circumstances might have a greater influence on profits than the firm’s relative competitiveness within its industry

3 The Goals of Chapter 12 International economic analysis
Illustrate the global economic risk, regional or country risks, and exchange rate risk Domestic economic analysis Introduce key domestic economic variables Interest rates analysis Analysis of demand and supply shocks Fiscal and monetary policies of the government Business cycle analysis Industry analysis Sensitivity of industry performance to business cycle (sector rotation strategy) Life cycles of an industry


5 Global Economic Analysis
Global economic risks Subprime and credit crises in 2008 (introduced in Ch 2) The subprime crisis in the U.S. spreads over the world through MBS Credit crisis: Financial institutions worldwide lose much capital in the subprime crisis and stop the lending business due to the doubt of the credit quality of other banks and business firms The economies of most countries are affected by the subprime and credit crises in 2008 (Table 12.1) Stock markets in virtually all countries were deeply affected, with average returns typically worse than –40% Different performance in countries and regions implies the existence of regional and country risks

6 Table 12.1 Economic Performance, 2008
※ There is considerable variation in economic performance across countries, e.g., while China grew by 9.6% in GDP, the GDP in Japan grew by only 0.3% ※ Exchange rate risk: due to the depreciation of the Venezuela currency, there is a substantial difference between the stock market return in local currency and in U.S. dollars

7 Global Economic Analysis
Regional or country risks – two crises Asian financial crisis in 1997 The boom of Thailand economy in 1996 and attracted international capital inflow, which resulted in the highly sufficient currency supply in Thai economy Thai banks extended credit to domestic firms beyond what Thailand could support, which resulted in serious depreciation of Thai baht and economic recession The international speculators attacked not only Thailand but also neighboring Asian nations, some with and some without characteristics similar to Thailand, like Indonesia, Philippines, Malaysia, South Korea, Taiwan, etc ※These events in different nations highlighted the close interplay between politics and economics, and the currency value and stock market performance

8 Global Economic Analysis
Russian financial crisis in 1998 From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital, i.e., to borrow dollar-denominated Eurobonds Falling global commodity prices reduced the trade surplus of Russia since its exports were predominantly commodity-based, e.g., oil sales were 45% of the amount of exports in 1997 With the deterioration in general economic conditions and the deficiency of currency reserves of the Russian Central Bank in August of 1998, the Russian ruble devaluated and Russian government rescheduled the payment of sovereign (government) debt It was the first time that the government debt defaulted

9 Global Economic Analysis
Exchange rate risks Affect the international competitiveness of a country’s industries and thus affect sales and profits of business firms and stock returns of investors The depreciation of the local currency will benefit exporters but hurt importers in that country The gains for the investment in foreign stocks may be enhanced or reduced after taking the exchange rate into consideration The poor performance of the stock market of Venezuela in U.S. dollars demonstrates the effect of the exchange rate risk could be substantial


11 Key Economic Variables
In order to earn abnormal profits with the macroeconomic analysis, you must forecast the economic condition better than others Introduce some key economic variables to assess the status of the macroeconomy Gross domestic product (GDP) (國內生產毛額) The measure of the economy’s total production of goods and services Rapidly growing GDP indicates an expanding economy Industrial production index (工業生產指數) A measure of economic activity narrowly focused on the manufacturing side of the economy (ignoring services)

12 Key Economic Variables
Employment (就業) The unemployment rate is the percentage of the total labor force (those who are either working or actively seeking employment) yet to find work The unemployment rate measures the extent to which the economy is operating at full capacity Capacity utilization rate (focusing on the manufacturing side) (產能利用率) The ratio of actual output from factories to potential output Measure the extent to which the manufacturing of the economy is operating at full capacity ※Higher levels of these two rates imply that the macroeconomy performs as could as it can

13 Key Economic Variables
Inflation (通貨膨脹) The rate at which the general level of prices is rising High Inflation rates are often associated with “overheated” economies, i.e., the demand for goods and services exceeds productive capacity, which leads to upward pressure on prices Trade-off between inflation and unemployment: stimulate the economy enough to maintain nearly full employment, but not so much as to bring inflationary pressures

14 Key Economic Variables
Budget Deficits (預算赤字) The budget deficit of the government is the difference between government spending and taxes Any budgetary shortfall must be offset by government borrowing (through issuing T-bonds) Large amounts of government borrowing could force up the interest rate and thus “crowd out” private borrowing and investing Interest rates (利率) High interest rates reduce the PV of future CFs, thereby reducing the attractiveness of investment opportunities Therefore, high interest rates could restrain the overheated economy

15 Key Economic Variables
Sentiment indicator (消費者心理因素指標) Consumers’ and producers’ optimism or pessimism concerning the economy are important determinants of economic performance Beliefs influence how much consumption and investment will pursued and thus affect the aggregate demand for goods and services For example, the consumer confidence index (CCI) is calculated and published in many countries (in Taiwan, the CCI survey is conducted by NCU) The P/E ratio rule: For S&P 500 index, the P/E ratio tends to be in the range of 12 to 25 (see Fig 12.2) The exact P/E ratios for market indexes vary with the above mentioned economic variables

16 Figure 12.2 S&P 500 versus EPS Estimate
25 12 ※ EPS is defined as the earnings per share for the S&P 500 index portfolio ※ The series of S&P 500 is almost between the series of 12 × EPS and 25 × EPS, which implies that the P/E ratio is on average in the rage of 12 to 25


18 Interest Rates The level of IRs is one of the most important macroeconomic factor to be considered in one’s investment analysis Forecasts of IRs affect present values and thus expected returns for investments (especially fixed-income investments) For stock markets, increases in interest rates tend to be bad news High IRs reduce the PVs of stock investment High IRs attract investors to deposit capital in banks (or invest in fixed-income securities offering high yields) and thus affect the incentive to invest in stocks However, forecasting IRs is one of the most difficult parts of applied macroeconomics

19 Interest Rates Four factors determining the IRs
※The first three factors determine the level of real interest rates (see Fig. 12.3) and the last factor is the expected inflation rate 1. Supply of funds from savers Supply ↑  the supply curve is shifted to the right (for the same real IR, funds supply ↑)  equilibrium real IR ↓ 2. Demand for funds from businesses Demand ↑  the demand curve is shifted to the right (for the same real IR, funds demand ↑)  equilibrium real IR ↑ (from point E to point E’) 3. Government’s net supply or demand for funds Currency supply ↑  real IR ↓ (stimulate economic growth) Government borrowing demand ↑  real IR ↑

20 Figure 12.3 Determination of the Equilibrium Real Rate of Interest
※ The fund-supply curve slopes up from left to right because the higher the real interest rate, the greater the fund supply from household savings ※ The fund-demand curve slopes down from left to right because the lower the real interest rate, the more projects firms will undertake, due to the lower capital cost

21 Interest Rates 4. Expected rate of inflation
Interest rates contain a premium for expected inflation The Federal Reserve (the central bank) typically raises interest rates proactively when inflation is expected to increase ※Short-run effect of money supply from the government: to shift the supply curve to the right and lower the equilibrium real IR ※Long-run effect of money supply from the government: to increase prices of goods (thus increase the inflation rate and the nominal IR), but has no permanent impact on the real economic activities (like aggregate output, consumption level, and employment) and the real interest rates


23 Demand Shocks Demand shock
An event that affects the demand for goods and services Demand could increase due to, for example, Reduction in tax rates Increases in the money supply, governmental spending, and foreign export demand Positive demand shocks is usually associated with the increases of IRs and inflation rates (demand ↑  demand > supply  price and thus inflation rate ↑  nominal IR ↑; or demand ↑  funds needed by businesses ↑  IR ↑) Increases of demand generally implies the expansion and boom of the economy

24 Supply Shocks Supply shock
An event that influences production capacity and costs Supply decreases due to, for example, Increases of prices of raw materials Freezes, floods, or droughts that may destroy agricultural crops Decreases in the wage rates Negative supply shocks are usually associated with the increases of IRs and inflation rates (supply ↓  demand > supply  price and thus inflation rate ↑  nominal IR ↑) Negative supply shocks result in reduced output, leading to slower economic growth

25 Demand and Supply Shocks
How to relate the above knowledge to investment analysis? Choose industries that will be helped by your expectation about the change of the demand and supply and avoid those that will be hurt For example, positive demand shock  choose the automobile or luxury producers, which benefit most from the positive demand shock (in contrast, food producers, for example, also benefit from the positive demand shock but not much)


27 Government Policy Demand-side policy Supply-side policy
The economy will not by itself arrive at a full employment equilibrium, so macroeconomic policies are used to affect the demand for goods and services to stimulate the economy toward this goal Most fiscal and monetary policies are based on this demand-oriented argument Supply-side policy The goal is to create an environment in which workers and owners of capital have the maximum incentive and ability to produce and develop goods For example, the proponents of this method argue that lowering tax rates will elicit more investment and improve incentives to work, thereby enhancing economic growth

28 Fiscal Policy Fiscal policy
The use of government spending and taxing actions to stabilize or spur the economy Increases in government spending directly inflate the demand for goods and services Increases in tax rates immediately siphon income from consumers and result in fairly rapid decreases in consumption With most direct impact on the economy However, slowly implemented because of the requirement the negotiation and compromise between executive and legislative branches So, the fiscal policy cannot in practice be used to fine- tune the economy

29 Fiscal Policy Government’s budget deficit or surplus:
Tax income < government spending  budget deficit Tax income > government spending  budget surplus The effect of budget deficits: increase the demand for goods and services (via government spending) by more than it reduces the demand for goods and services (via taxes collection), and therefore stimulate the economy (for most countries, they adopt the budget-deficit policy to stimulate the economy)

30 Monetary Policy Monetary Policy
Manipulation of the money supply to influence economic activity Different from the direct influence from fiscal policies, monetary policies work indirectly through their impact on interest rates and thus on the incentive to purchase and invest Short- and long-term effects on interest rates Increases in the money supply lower short-term real and thus nominal IRs, encouraging investment and consumption Over longer periods, it is believed that a higher money supply leads only to a higher price level and does not have a permanent effect on economic activity ※The stimulation/inflation trade-off is the major consideration to determine how to use monetary policy

31 Monetary Policy Three tools of monetary policy
Open market operations: Central banks trade Treasury securities for its own account (for fine-tune the monetary policy daily) (The most direct and commonly used tool) Buy Treasury securities  increases in money supply Sell Treasury securities  decreases in money supply Reserve requirements: The proportion of deposits that banks must hold as cash on hand or as deposits in the central bank Reserve requirements decreases  banks can lend more loans to firms  effective money supply increases and the economy is stimulated Discount rate: The interest rate that the central bank charges banks on short-term loans Discount rate ↓  expansionary monetary policy The rate is under the direct control of the central bank, and is changed relatively infrequently

32 Monetary Policy Federal funds rate in the U.S. The federal funds rate is the interest rate at which banks make short-term loans to meet the reserve requirement from other banks who have excess funds It is determined by the monetary supply and demand among banks and changes frequently, so it is a better indicator to gauge the monetary policy adopted by the central bank If this rate rises, it indicates that the central bank contracts the money supply If this rate declines, in can be inferred that the central bank expands the money supply Monetary policy is determined by the central bank, and in the U.S., Board of Governors of the Federal Reserve System (Fed) plays the same role as the central banks in other nations

33 12.6 BUSINESS CYCLES (景氣循環)

34 The Business Cycle Recurring patterns of recession and recovery are called business cycles (see Fig ) Peak: The transition from the end of an expansion to the start of a contraction Trough: Occurring at the bottom of a recession just before the economy entering a recovery (expansion) Industry relationship to business cycles (cyclical vs. defensive industries) Cyclical industries Industries with above average sensitivity to the state of the economy For example, the producers of durable goods (e.g., cars) or capital goods (that are used by other firms to produce their own products) Firms in cyclical industries tend to have high betas

35 Figure 12.11 Four Phases of the Business Cycle

36 The Business Cycle Defensive industries
Industries with below-average sensitivity to the state of the economy For example, food producers, pharmaceutical firms, and public utilities The demand of food, drugs, electricity, and gas is consistent regardless of the business cycle Firms in defensive industries tend to have low betas The trading strategy based on the business cycle Optimistic about the economy, hold cyclical stocks Pessimistic about the economy, hold defensive (or counter-cyclical) stocks

37 Economic Indicators Leading Indicators (領先指標) – economic series tend to rise and fall in advance of the economy, for example, Stock prices (S&P 500 stock index) Stock prices are forward-looking estimates for future profitability and thus able to be a leading indicator Since the stock prices themselves are leading indicators, the information of other leading indicators contributes less for stock investment – by the time they predict an upturn, the stock market has already made its move Stock prices can be a leading indicator for the business cycle, but there is no leading indictor for stock prices Money supply growth rate Due to the indirect and lag influence of the monetary policy on the economy

38 Economic Indicators Coincident Indicators (同期指標) – indicators that tend to change at the same time with the economy, e.g., Industrial production Manufacturing and trade sales Lagging Indicators (落後指標) – indicators that tend to follow the lag economic performance, e.g., Ratio of inventories to sales (high inventories suggest the economy is in recession) Ratio of consumer installment credit outstanding to personal income Cyclical indicators are summarized in Table 12.2

39 Economic Indicators

40 Economic Indicators ※ Ten series of leading indicators are grouped to generate a composite index of leading economic index ※ The composite coincident and lagging indexes are constructed similarly ※ The gray bars represent 7 most famous contraction periods in US history, and the numbers near the turning points indicate the length of the lead time or lag time (in months) from the peak and the trough of the corresponding business cycle ※ The leading index consistently turns before the rest of the economy, and the coincident and lagging indexes in general behave as expected

41 Economic Indicators ※ A wide range of economic indicators are released to the public on a regular “economic calendar” ※ The above table lists the release dates and sources for about 20 statistics


43 Industry Analysis The industry analysis is as important as the macroeconomic analysis because it is unusual for a firm in a troubled industry to perform well Performance can vary widely across industries in 2008 Returns of equity can range from 10.2% for the electric utilities industry to 36.8% for the cigarette industry (see Fig. 12.7) Performance of firms in the same industry varies substantially (ROEs of several firms in application software are shown in Fig. 12.9)

44 Figures 12.7 and 12.9 Returns on Equity, 2008

45 Defining an Industry Where to draw the line between one industry and another North American Industry Classification System (北 美產業分類系統) or NAICS Codes There are codes assigned to group firms for statistical analysis (see Table 12.5) Firms with the same 4-digit NAICS codes are commonly taken to be in the same industry S&P classifies firms into about 100 industry groups, and Value Line Investment Survey groups firms into about 90 industries Industry classifications are never perfect For example, both J.C. Penney (high-volume “value” store) and Neiman Marcus (high-margin elite store) might be classified as department stores

46 Table 12.5 Examples of NAICS Industry Codes
※The first two digits define the major industry group: NAICS code 23 = construction ※ The last two or three digits define the industry more narrowly

47 Sensitivity to Business Cycle
It is interesting to see how business cycles affect the performance of specific industries Three factors affecting sensitivity of earnings to business cycles Sensitivity of sales Sales of necessities will show little sensitivity to business conditions, e.g., food, drugs, medical services Sales of luxuries or discretionary goods are more sensitive to business conditions, e.g., jewelry, autos, recreational services Sale growths of jewelry stores vs. grocery stores in Fig

48 Figure 12.10 Industry Cyclicality
※ Sales of jewelry, which is a luxury good, fluctuate more widely than those of grocery stores

49 Sensitivity to Business Cycle
Financial leverage Since interest expenses on debt must be paid regardless of sales, they will increase the sensitivity of profits to sales Profits for high-financial-leverage industries swing more widely with sales (business cycles) Operating leverage The degree to which the operating costs are fixed Fixed operating costs are those the firm incurs regardless of it production level; Variable operating costs are those that rise or fall as the firm produces more or less products Fixed costs ↑  the costs is without flexibility with sales  profits for high-fixed-costs industries swing more widely with sales (business cycles)  using high fixed costs is equivalent to increase operating leverage (similar to the effect of using financial leverage) ※ The above inference is based on the assumption that sales are positively correlated with business conditions

50 Sector Rotation (產業循環)
To select industries in different phases of the business cycle Peak – natural resource firms The economy might be overheated with high inflation Invest in natural resource firms to against the inflation Contraction – defensive firms, e.g., food, drugs, or other necessities These firms are less affected by the contraction Lower inflation and IR rates favor financial firms Trough – equipment, transportation and construction firms Firms might purchase new equipment to meet anticipated increases in demand in the following expansion Expansion – cyclical industries, e.g., consumer durables and luxury items These firms are the most profitable in this phase

51 Sector Rotation ※ The typical sector rotation across different states of the business cycle is shown in the above figure ※ Each sector historically had their “day in the sun” during a typical economic cycle

52 Life Cycles of an Industry
Stage Sales Growth Start-up Rapid & Increasing Consolidation Stable Maturity Slowing Relative Decline Minimal or Negative (Next I will discuss each stage in details)

53 Life Cycles of an Industry
Start-up stage The early stages of an industry are often characterized by a new technology or product, e.g., PC in the 1980s, cell phone in 1990s At this stage, sales and earnings grow at an rapid rate since the new product has not yet saturated in market Consolidation stage The industry survivors and leaders begin to emerge The performance of the surviving firms will closely tract the performance of the overall industry The industry will grow faster than the rest of the economy

54 Life Cycles of an Industry
Maturity stage The product is used extensively in the market The product has become far more standardized There is price competition among firms in the industry Firms at this stage are called as “cash cows,” which are with stable CF but offering little opportunity for profitable expansion Relative decline The industry might grow as less than the rate of the overall economy, or it might even shrink This could be due to the product being out of date or the competition from new products

55 Life Cycles of an Industry
The logic behind the progression from one stage of the industry life cycle to another High growth and fat profits bring new competitors and thus generate new sources of supply to reduce prices, profits, and growth finally Are high-growth industries good investment targets? The historical records tells us they are, as long as they offer high enough expected return to compensate the risks you bear But if the security prices already reflect the likelihood for high growth, then it is too late to make money from this strategy

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