1. Macroeconomic and Industry Analysis
Chapter 12
Macroeconomic and Industry Analysis

2. 12.1 The Global Economy
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3. Framework of Analysis Fundamental Analysis
Analysis of the determinants of firm value, specifically attempting to forecast the earnings and dividends of a firm.
Top down approach:  The Global Economy
 Analyze economy  Analyze industry Analyze firm
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4. Framework of Analysis Approach to Fundamental Analysis
Domestic and global economic analysis
Performance in countries and regions is highly variable
Politics affects the economy
Foreign exchange rates affect U.S. firms and their competitors
Political effects are manifold; the most recent of which is the financial crisis, which perhaps had its origins in monetary policy and government involvement in the mortgage markets and certainly the politics of handling the crisis have affected the stock markets.
Ski resort in Aspen: Competition includes ski resorts in Europe. As euro strengthens, it becomes cheaper to fly to Aspen and ski in Colorado. At times this has been cheaper for a European than gong to a ski resort in the French alps such as Chamonix.
Rocky Mountain Logs is exports many homes to Japan. If the dollar strengthens against the yen, it is more costly for a Japanese buyer to buy the U.S. product.
Yen profit on Toyota cars. Toyota is a Japanese firm and they have extensive U.S. operations, in part to limit the exchange rate risk. If the yen strengthens the yen value of the dollar revenue from the sale of a car in the U.S. is reduced, putting pressure on Toyota to lose profit margin, or increase the dollar price and risk losing market share. Their choices will affect the competition and vice versa.
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5. Framework of Analysis Approach to Fundamental Analysis
Industry analysis
Critical to understand the competitiveness of the industry
Company analysis
Detailed strategic and financial analysis of the firm
Why use the top-down approach?
Why use the top down approach? Economy has a major effect on stock returns as does the industry, particularly for growth stocks. It is hard to find a well performing stock in a poor industry when the economy is not doing well!
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6. Economic Performance, 2008
The real value of the dollar has dropped against the euro and the Canadian dollar. over this time period. This indicates that firms that sell product in these markets may face reduced $ profit margins.
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7. Change in Real Exchange Rate: Dollar Versus Major Currencies. 1999-2008
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8. 12.2 The Domestic Macroeconomy
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9. Key Economic Variables
Gross domestic product
The market value of gods and services produced domestically in a given time period
Unemployment rate
The ratio of number of people classified as unemployed to the total labor force
Inflation
The rate of change in the general price level as measured by some price index:
Consumer Price Index, Producer Price Index, GDP Deflator
The CPI is the most commonly reported measure of inflation. It attempts to measure price changes for the typical urban consumer. So called core inflation as measured by the CPI excludes more volatile items such as energy prices.
There are various PPIs that measure price changes of raw materials, intermediate and finished goods. These indices typically lead changes in the CPI.
The GDP deflator is the broadest measure of inflation , it measures the changes in prices for all goods and services in the economy.
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10. Key Economic Variables
Interest rates
Major impact on security prices (stocks and bonds) and the level of economic growth
Budget Deficits
Budget deficits can crowd out private investment, private investment generates more growth than public sector investment.
Alternative to crowding out is overreliance on foreign borrowing.
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11. Key Economic Variables
Consumer sentiment
Consumers’ optimism or pessimism concerning the economy and job prospects.
See the St. Louis Fed website, National Economic Trends, for the latest graph of consumer confidence over recent periods. Consumer confidence hit all time lows during the Financial Crisis of 2008.
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12. S&P 500 Versus EPS Estimate
Stock prices tend to rise & fall with earnings. The normal price earnings ratio (P/E) is in the range 12 to 25.
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13. 12.3 Interest Rates
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14. Factors Determining the Level of Interest Rates
Supply of funds from savers
Demand for funds from businesses
Government’s net supply and demand for funds
Fiscal policy
Monetary policy
Expected rate of inflation
Interest rates contain a premium for expected inflation
The Federal Reserve typically raises interest rates proactively when inflation is expected to increase
Fiscal policy is government spending that is designed to stimulate the economy,
Monetary policy is manipulating the money supply to stimulate the economy or reduce inflationary pressures. In the Financial Crisis of 2008, the Fed brought interest rates down to essentially zero, but the economy continued to slide. The Fed then pursued a policy of quantitative easing. Namely, directly buying debt from private entities.
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15. Determination of the Equilibrium Real Rate of Interest
Note the Fed can affect nominal interest rates but it may be tougher to bring about long run changes in real rates
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16. 12.4 Demand and Supply Shocks
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17. Demand Shocks Demand Shock
An event that affects the demand for goods and services, some examples include:
Change in tax rates
Change in the money supply
Change in government spending
Change in foreign export demand
The economic growth rate in the 1990s was very high because of technological growth, low commodity prices, low interest rates and low taxes.
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18. Supply Shocks
An event that influences production capacity and input costs, including labor costs; examples:
Changes in the price or availability of imported oil
Freezes, Floods, Droughts
Changes in wage rates
Negative supply shocks result in reduced output, slower economic growth.
demand > supply, which is inflationary.
Note: Monetary policy is note very effective at correcting supply shocks, except perhaps in the very short run.
If a negative supply shock is serious enough, stagflation (a stagnant economy with inflation) can occur.
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19. Implications for investments
Choose industries that will be helped by your expected economic scenario and avoid those that will be hurt.
Choose consumer cyclicals if the economy is projected to do well, but not if the economy will weaken,
May choose consumer staples and necessities such as utilities if the economy is not expected to do well.
To earn abnormal returns you must have better information (unlikely) or better analysis than the competition.
Consumer cyclicals would include consumer durables such as appliances, autos, etc., and luxury items. Notice how many motorcycles have been for sale during the recession. Also, dividends of phone companies and other utilities look good during a recession.
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20. 12.5 Federal Government Policy
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21. Fiscal Policy
Government spending and taxing actions to stabilize or spur growth in the economy
Most direct policy method in terms of its effect on the economy (Keynesian policy)
Often implemented too slowly due to political process
Poor means to fine tune an economy, can be inflationary
May be necessary when monetary policy is ineffective such as in the Financial Crisis of 2008
Leaky budget analogy: Government spending is very inefficient and it can be likened to carrying a leaky bucket to fill up the trough. The process is highly politicized and government does not have a profit motive; hence, it is rarely an efficient operation and much money is poorly spent, resulting in little growth. If growth does not occur, then future taxpayers will face higher taxes to repay the debt used to finance the spending. This is the problem with Keynesian policy mentioned in the related text box.
Be aware that the evidence indicates that fiscal stimulus probably was called for during the crisis of Evidence shows that severe recessions result in governments having to borrow more than a temporary fiscal stimulus, even one of the size the U.S. instituted. Whether the actual stimulus bill Congress passed was a good bill or not is another question. Many students will not understand this issue.
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22. Monetary Policy
Manipulation of the money supply to influence economic activity by influencing the demand for goods and services to be produced and consumed
Initial & long run effects
Potentially long lags
Changes incentives to purchase and invest, but may not lead to desired effect on demand
The Fed can increase the money supply and lower interest rates in the short term (albeit with lags up to 18 months to full policy effect), but many believe money supply creation is inflationary in the long run and the inflation would push interest rates back up. This is the expectations problem of monetary policy and it can be self-fulfilling. In the inflationary periods in the 1970s when the Fed increased the money supply interest rates fell, but quickly began to rise again due to inflationary expectations in the economy. For this reason the Fed tries to keep inflation out of the system.
Tools: Note that changes in the discount rate is used as a signal of what direction the Fed wants interest rate to move rather than as a direct policy tool. Changing reserve requirements changes the money multiplier and is not generally used to change the money supply. The most direct tool is open market operations. In open market operations the Fed buys government securities from government securities dealers. To pay for the purchase the Fed ‘hits a computer button’ and creates more deposits on reserve at the Fed for the seller. This is the main way that the money supply is expanded, rather than ‘printing money’ as people often euphemistically say.
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23. Supply-Side Policies
Supply-siders focus on incentives and marginal tax rates
Lowering tax rates tends to
encourage more investment
Improve incentives to work
Income inequality may also rise
Can we rely solely on supply side policies in a severe recession such as the Financial Crisis of 2008? No because these are incentives to stimulate production and consumption (aggregate demand) for goods and services. With the debt overhang (high levels of indebtedness) these policies are unlikely to be sufficiently effective on their own.
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24. Supply-Side Policies Income inequality may also rise
Those with better ideas, education, opportunities, work ethic, providence, etc. will do better, others may not.
If the majority are better off, but some much more so than others does this indicate that we should not use supply side policies?
Income inequality: If I give you the following choice which would you prefer? Alternative 1: I give you $20 and your friend $100 or Alternative 2: I give both of you $10 each. Studies show that many people will prefer Alternative 2, even though both parties are better off in Alternative 1. Supply side policies, capitalism and global trade all can lead to higher wealth, but greater inequalities. For your information, this answer employs a utilitarian ethic.
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25. Supply-Side Policies Income inequality may also rise
Those with better ideas, education, opportunities, work ethic, providence, etc. will do better, others may not.
If the majority are better off, but some much more so than others does this indicate that we should not use supply side policies?
Income inequality: If I give you the following choice which would you prefer? Alternative 1: I give you $20 and your friend $100 or Alternative 2: I give both of you $10 each. Studies show that many people will prefer Alternative 2, even though both parties are better off in Alternative 1. Supply side policies, capitalism and global trade all can lead to higher wealth, but greater inequalities. For your information, this answer employs a utilitarian ethic.
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26. 12.6 Business Cycles
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27. The Business Cycle Recurring patterns of recession and recovery
Peak
Trough
Industry relationship to business cycles
Cyclical industries
Industries with above average sensitivity to the state of the economy
Defensive
Industries with below average sensitivity to the state of the economy
Cyclicals: durable goods, anything whose purchase is likely to be delayed during a recession, this will include items that are less likely to be purchased when income is not growing or falling. These might include discretionary goods like jewelry, expensive vacations, RVs, machine tools, steel, autos, and transportation
Defensive: food producers and food processors, pharmaceutical firms, medical services and public utilities, tobacco, movies, cheap beers
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28. Economic Indicators
Leading Indicators - tend to rise and fall in advance of the economy
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29. Economic Indicators (cont)
Coincident Indicators - indicators that tend to change at the same time as the economy
Table 12.2
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30. Economic Indicators (cont)
Lagging Indicators - indicators that tend to follow or lag economic performance
Source: The Conference Board, Business Cycle Indicators
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31. Cyclical Indicators
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32. Other Indicators
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33. Economic Calendar at Yahoo!
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34. 12.7 Industry Analysis
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35. Industry Analysis Performance can vary widely across industries
It is difficult to find a good stock in a poor industry
Note you may be able to find a good value stock in a poorly performing industry. In fact this is Warren Buffet’s and Peter Lynch’ s preferred strategy.
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36. Industry Stock Price Performance, 2008
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37. ROE of Application Software Firms, 2008
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38. Sensitivity to Business Cycle
Factors affecting sensitivity of earnings to business cycles
Sensitivity of sales of the firm’s product to the business cycles
Fixed costs and leverage
Fixed costs are costs that do not vary with the level of production.
Fixed costs contribute to higher profitability when sales are high, but will result in lower profitability when sales are lower.
Sales: Cyclicals: durable goods, anything whose purchase is likely to be delayed during a recession, this will include items that are less likely to be purchased when income is not growing or falling. These might include discretionary goods like jewelry, expensive vacations, RVs, machine tools, steel, autos, and transportation
Defensive: food producers and food processors, pharmaceutical firms, medical services and public utilities, tobacco, movies, cheap beers
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39. Sensitivity to Business Cycle
Operating leverage
Proportion of fixed operating costs as a percent of total costs
Greater operating leverage results in greater swings in profits over the business cycle
Airlines, automobiles
Financial leverage
Proportion of fixed financing costs as a percent of total costs
Greater financial leverage results in greater swings in profits over the business cycle
Airlines, banks, investment banks
Sales: Cyclicals: durable goods, anything whose purchase is likely to be delayed during a recession, this will include items that are less likely to be purchased when income is not growing or falling. These might include discretionary goods like jewelry, expensive vacations, RVs, machine tools, steel, autos, and transportation
Defensive: food producers and food processors, pharmaceutical firms, medical services and public utilities, tobacco, movies, cheap beers
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40. Industry Cyclicality
Grocery business is a necessity and has much smaller swings in sales growth than the luxury good jewelry
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41. A Stylized Depiction of the Business Cycle
“Economic Activity” is often measured as change in GDP,
Unofficially, a recession is often thought to be defined as two successive quarters of falling GDP. Officially, the National Bureau of Economic Research officially declares whether the economy is in a recession (and the start date).
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42. Sector Rotation
Selecting Industries in line with the stage of the business cycle:
Peak
Contraction
Trough
Expanding
natural resource firms
defensive firms
equipment, transportation and construction firms
cyclical industries
It is difficult to achieve above average returns this way, often we don’t know which phase of the cycle we are in until later and the duration of each phase is also unknown.
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43. Sector Rotation Illustrated
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44. Industry Life Cycles Stage Sales Growth Start-up Consolidation
Maturity
Relative Decline
Rapid & Increasing
Stable
Slowing
Minimal or Negative
Stages:
Start-up: Cell phones in the 1990s. Sales and earnings grow rapidly, no or small dividends. Note that it is difficult to pick the eventual winners in this stage. Some firms won’t make it and investing in these type firms can be risky.
Consolidation: Emergence of industry leaders (Verizon), survivors of the start-up phase become more stable, industry still growing faster than the economy overall
Maturity stage: Product has reached saturation level (think McDonald’s), generally more competition and less diversification, so price competition emerges which further limits profitability.
Relative Decline: Growth is lower than the overall economy, may be facing product obsolescence (VCRs)
Biotech is closer to the start up phase and is enjoying high rates of investment, high rates of return on investment and low dividends. High growth rates beget competition however and eventually growth must slow. Utilities are in the mature phase and have lower rates of investment and lower rates of return on investment and higher dividends.
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45. The Industry Life Cycle
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46. Industry Structure and Performance (Porter Model)

47. Determinants of Industry Competition and Profitability
Threat of Entry
New entrants reduce profitability
Barriers to entry preserve profitability
Large scale required to be profitable (autos)
Secure distribution channels
Brand loyalty, unique differentiated product
Proprietary production technology
Intellectual property protections
Learning curve effects
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48. Determinants of Industry Competition and Profitability
Rivalry between existing competitors
Equal competitors reduce profitability
Slow industry growth,
High fixed costs,
Scale economies,
Pressure to cut prices
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49. Determinants of Industry Competition and Profitability
Pressure from substitute products
Substitutes limit profitability (propane, natural gas)
Bargaining power of buyers
A buyer that purchases a large percent of an industry’s output can limit the selling industry’s profitability (auto parts suppliers)
Bargaining power of suppliers
A supplier that controls a key input can limit the buying industry’s profitability (labor unions)
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