Economy / Market Analysis Chapter 15

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 market’s likely direction is of extreme importance to investors 2

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 country’s nationals, whether at home or abroad

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 economy’s position in the cycle helps analyze the market 3

Business Cycles GDP Growth (%) Peak Expansion Expansion Recession Recovery Trough Time

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

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

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

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

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

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

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

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

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)

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

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

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

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

Two Key Market Variables 2) Dividend Yield aggregate dividends divided by level of index compare today’s 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