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

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

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

6. 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. 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 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)

19. 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