1. CH 17 Macroeconomic and Industry Analysis

2. Framework of Analysis Fundamental Analysis
Top-down approach (“Three-Step” Valuation Approach
Domestic and global economic analysis
Industry analysis
Company analysis
Bottom-up approach

3. Top-Down Approach

4. Three-Step Valuation Approach
1. General economic influences
First examine the influence of the general economy on all firms and the security markets
Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash (Go to “Economic Performance 2010” slide)
2. Industry influences
Determine which industries will prosper and which industries will suffer on a global basis and within countries (Go to “Return on Equity by Industry” slide)
Analyze the prospects for various global industries with the best outlooks in this economic environment
3. Company analysis
Turn to the analysis of individual firms in the preferred industries and to the common stock of these firms.
Determine which companies in the selected industries will prosper and which stocks are undervalued

5. Does the Three-Step Process Work?
Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry
Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production
Most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry

6. 1. THE GLOBAL ECONOMY

7. Global Economic Considerations
Performance in countries and regions is highly variable
Political risk
The global environment may present much greater risks than normally found in U.S.-based investments.
Exchange rate risk
Changes the prices of imports and exports.

8. Economic Performance 2009

9. Change in Real Exchange Rates

10. 2. THE DOMESTIC MACROECONOMY

11. The Domestic Macroeconomy
Stock prices rise with earnings.
P/E ratios are normally in the range of
The first step in forecasting the performance of the broad market is to assess the status of the economy as a whole.

12. S&P 500 vs. EPS Estimate

13. Key Economic Variables
Gross domestic product
Employment
Inflation
Interest rates
Budget Deficits
Consumer sentiment

14. U.S. GDP

15. GDP by State

16. Monthly Unemployment Rate

17. Inflation Rate in U.S.

18. Interest rates : Market data from WSJ
Friday, December 29, 2006
The key U.S. and foreign annual interest rates below are a guide to general levels but don't always represent actual transactions.
Commercial Paper: Yields paid by corporations for short-term financing, typically for daily operation
Prime Rate: 8.25% (effective 06/29/06). The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks.
Discount Rate (Primary): 6.25% (effective 06/29/06).
Federal Funds: 5.375% high, 4.500% low, 5.125% near closing bid, 5.250% offered. Effective rate: 5.20%. Source: Tullett Prebon Information, Ltd. Federal-funds target rate: 5.250% (effective 06/29/06).
Call Money: 7.00% (effective 06/29/06).
Commercial Paper: Placed directly by General Electric Capital Corp.: 5.23% 30 to 60 days; 5.22% 61 to 90 days; 5.20% 91 to 122 days; 5.19% 123 to 151 days; 5.17% 152 to 180 days; 5.14% 181 to 210 days; 5.11% 211 to 241 days; 5.09% 242 to 270 days.
Euro Commercial Paper: Placed directly by General Electric Capital Corp.: 3.58% 30 days; 3.62% two months; 3.68% three months; 3.72% four months; 3.76% five months; 3.81% six months.
Dealer Commercial Paper: High-grade unsecured notes sold through dealers by major corporations: 5.27% 30 days; 5.28% 60 days; 5.30% 90 days.
Certificates of Deposit: 5.30% one month; 5.33% three months; 5.33% six months.

19. U.S. National Debt

20. Country foreign exchange reserves minus external debt

21. Michigan Consumer Sentiment Index

22. 3. INTEREST RATES

23. Factors Determining the Level of Interest Rates
Supply of funds from savers
Demand for funds from businesses
Government’s net supply and/or demand for funds
Expected rate of inflation
The Fisher Effect

24. Determination of the Equilibrium Real Rate of Interest

25. 4. DEMAND AND SUPPLY SHOCKS

26. Demand Shocks
Demand
An event that affects the demand for goods and services in the economy
Reduction in tax rates
Increases in the money supply
Increases in government spending
Increases in foreign export demand

27. Supply Shocks
Supply
An event that influences production capacity and production costs
Changes in the price of imported oil
Commodity price changes
Floods, Droughts
Changes in the wage rates
Educational level of economic participants

28. 5. FEDERAL GOVERNMENT POLICY

29. Demand-side Policy
Fiscal policy – the government’s spending and taxing actions
Monetary policy – manipulation of the money supply

30. Fiscal Policy Most direct way to stimulate or slow the economy
Formulation of fiscal policy is often a slow, cumbersome political process
To summarize the net effect of fiscal policy, look at the budget surplus or deficit.
Deficit stimulates the economy because:
it increases the demand for goods (via spending) by more than it reduces the demand for goods (via taxes)

31. Monetary Policy
Manipulation of the money supply to influence economic activity.
Initial & feedback effects
Increasing the money supply lowers interest rates and stimulates the economy.
Less immediate effect than fiscal policy
Tools of monetary policy
Open market operations (federal funds rate)
Most important
Discount rate
Reserve requirements

32. Supply-Side Policies
Goal: To create an environment in which workers and owners of capital have the maximum incentive and ability to produce and develop goods.
Supply-siders focus on how tax policy can be used to improve incentives to work and invest.
Lowering tax rates will
elicit more investment
Improve incentives to work

33. 6. BUSINESS CYCLES

34. Business Cycles
Recurring patterns of recession and recovery—business cycles
Peak
Trough
Industry relationship to business cycles
Cyclical
Defensive
The transition points across cycles are called peaks and troughs.
A peak is the transition from the end of an expansion to the start of a contraction.
A trough occurs at the bottom of a recession just as the economy enters a recovery.

35. The Business Cycle Cyclical Industries Defensive Industries
Above-average sensitivity to the state of the economy.
Examples include producers of consumer durables (e.g. autos) and capital goods (i.e. goods used by other firms to produce their own products.)
High betas
Little sensitivity to the business cycle
Examples include food producers and processors, pharmaceutical firms, and public utilities
Low betas

36. Economic Indicators
Leading indicators tend to rise and fall in advance of the economy.
Coincident indicators move with the market.
Lagging indicators change subsequent to market movements.

37. Economic Indicators
Leading Indicators - tend to rise and fall in advance of the economy
Examples
Avg. weekly hours of production workers
Stock Prices or Stock market indexes
Initial claims for unemployment
Manufacturer’s new orders

38. Leading Indicator Stock Market as a Leading Indicator
Stock prices reflect expectations of earnings, dividends, and interest rates
Stock market reacts to various leading indicator series
Stock prices consistently turn before the economy does

39. Stock Market as a Leading Indicator

40. S&P 500 Index Since 2007

41. Economic Indicators (cont)
Coincident Indicators - indicators that tend to change directly with the economy
Examples
Industrial production
Manufacturing and trade sales

42. Economic Indicators (cont)
Lagging Indicators - indicators that tend to follow the lag economic performance
Examples
Ratio of trade inventories to sales
Ratio of consumer installment credit outstanding to personal income

43. Indexes of Economic Indicators

44. Cyclical Indicators

45. Leading, Coincident, and Cyclical Indicators

46. Useful Economic Indicators

47. Economic Calendar
Many sources, such as The Wall Street Journal and Yahoo! Finance, publish the public announcement dates of various economic statistics.

48. Economic Calendar at Yahoo!

49. 7. INDUSTRY ANALYSIS

50. Industry Analysis
It is unusual for a firm in a troubled industry to perform well.
Economic performance can vary widely across industries.
ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry

51. Return on Equity by Industry

52. Industry Stock Price Performance, 2006

53. Industry Stock Price Performance, 2009

54. Defining an Industry
Where to draw the line between one industry and another
North American Industry Classification System, or NAICS codes
Codes assigned to group firms for statistical analysis
Firms with the same four-digit NAICS codes are commonly taken to be in the same industry.
Industry classifications are never perfect

55. Examples of NAICS Industry Codes

56. Sensitivity to the Business Cycle
Three factors determine how sensitive a firm’s earnings are to the business cycle.
1. Sensitivity of sales:
Necessities (food, drugs, and medical services) vs. discretionary goods (jewelry)
Items that are not sensitive to income levels (such as tobacco and movies) vs. items that are, (such as machine tools, steel, autos, transportation)

57. Industry Cyclicality

58. Sensitivity to the Business Cycle
Operating leverage
The split between fixed and variable costs
Firms with low operating leverage (less fixed assets) are less sensitive to business conditions.
Firms with high operating leverage (more fixed assets) are more sensitive to the business cycle.

59. Operating Leverage of Firms A and B Throughout the Business Cycle

60. Sensitivity to the Business Cycle
Financial leverage:
the use of borrowing
Interest is a fixed cost that increases the sensitivity of profits to the business cycle.

61. Stylized Depiction of the Business Cycle

62. Sector Rotation
Sector rotation: Portfolio is shifted into industries or sectors that should outperform, according to the stage of the business cycle.
Selecting Industries in line with the stage of the business cycle
Peaks: The economy might be overheated with high inflation and interest rates, and price pressures on basic commodities.
Invest on natural resource extraction firms such as minerals or petroleum

63. Sector Rotation, cont’d
Contraction: The economy enters a contraction or recession.
Invest on defensive industries such as pharmaceuticals and food
Trough: The economy is poised for recovery and subsequent expansion.
Invest on capital goods industries such as equipment, transportation and construction firms
Expansion: The economy is growing rapidly.
Invest on cyclical industries such as consumer durables

64. Sector Rotation

65. Industry Life Cycles Stages
Start-up: Rapid and increasing sales growth
Consolidation: Stable sales growth
Maturity: Slowing sales growth
Relative Decline: Minimal or negative sales growth

66. The Industry Life Cycle

67. Which Life Cycle Stage is Most Attractive?
Quote from Peter Lynch in One Up on Wall Street:
" Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry in a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or the oil-drum retrieval business], there’s no problem with competition. You don’t have to protect your flanks from potential rivals and this gives you the leeway to continue to grow.”
Peter Lynch in One Up on Wall Street

68. Industry Structure and Performance: Five Determinants of Competition
Michael Porter has highlighted five determinants of competition:
Threat of entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers

69. An Example of Industry Analysis
Go to TxState Library Web Site
Go to Database
Under Database, find “Standard & Poor’s Net Advantage”
Click on “Industries.”
Choose the industry you want to find S&P industry analysis for recent quarter or year.

70. Basic Sectors Information Technology Telecommunication Services
AAPL, MU, GOOG
Telecommunication Services
T, VZ
Industrials
GE, CAT
Consumer Discretionary
GPS, GM
Basic Materials
MON, DOW
Energy
XOM, VLO
Consumer Staples
KO, PG
Health Care
PFE, LLY, MRK, JNJ
Utilities
DUK, FE
Financials
WFC, JPM