1 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Fin2802: Investments Spring, 2010 Dragon Tang Lecture 16 Macroeconomic and

1FIN 2802, Spring 10 - TangChapter 17: Macroeconomic and Industry Analysis

Fin2802: Investments

Spring, 2010Dragon Tang

Fin2802: Investments

Spring, 2010Dragon Tang

Lecture 16Macroeconomic and Industry Analysis

March 23, 2009

Readings: Chapter 17Practice CFA Problem Sets: 4,6,9,12,15

2

The Greenspan/Bernanke PutThe Greenspan/Bernanke Put

• Investors hold a put option from the Fed/Government

• When market drops, government rescues

• What’s the problem?

FIN 2802, Spring 10 - TangChapter 17: Macroeconomic and Industry Analysis

3

Current ProblemCurrent Problem

• Long term vs. short term

• Growth vs. inflation

• Trust vs. gaming

• …



What is this?What is this?

• What’s daily trading volume of US stock market?

• What’s daily trading volume of US Treasury bonds?

• Total market size $250.8 trillion

• Daily trading volume $1.8 trillion


What is this?What is this?

• What’s daily trading volume of US stock market?

– $10 billion

• What’s daily trading volume of US Treasury bonds?

– $300 billion

• Total market size $250.8 trillion

– Interest rate derivatives

• Daily trading volume $1.8 trillion

– Foreign exchanges


“The actual interest rate forecast record of the world's highest paid financial ‘experts’ for forecasting interest rates is nothing short of disastrous.”

http://www.opalmagazine.com/members/_financial_articles/articles/Wall_March-2001_files/Wall_March-2001.htm


Macroeconomic and Industry AnalysisMacroeconomic and Industry Analysis

Objectives:

• Effect of monetary and fiscal policies

• Economic indicators (leading, coincident, and lagging)

• Business cycles

• Effect of industry life cycles and structure


Fundamental AnalysisFundamental Analysis

• Economics– Investment and consumption

• Finance

• Accounting


Internet:Google

Geography and Finance


• Fundamental Analysis

• Approach to Fundamental Analysis– Domestic and global economic analysis

– Industry analysis

– Company analysis

• Why use the top-down approach

Framework of AnalysisFramework of Analysis


Finance and GrowthFinance and Growth


Shocks to Finance and GrowthShocks to Finance and Growth

Shock to bothstock market andmacroeconomy

Shock tomacroeconomy

Shock tostock market

Stock Market Macroeconomy


Global Economic ConsiderationsGlobal Economic Considerations

• Performance in countries and regions is highly variable

• Political risk

• Exchange rate risk– Sales

– Profits

– Stock returns


Change in Real Exchange Rate: Dollar Versus Major Currencies. 1999-2003

Change in Real Exchange Rate: Dollar Versus Major Currencies. 1999-2003


Key Economic VariablesKey Economic Variables

• Gross domestic product

• Unemployment rates

• Interest rates & inflation

• Budget Deficits

• Consumer sentiment


S&P 500 Versus EPS EstimateS&P 500 Versus EPS Estimate


Determination of the Equilibrium Real Rate of InterestDetermination of the Equilibrium Real Rate of Interest


Federal Government PolicyFederal Government Policy

• Fiscal Policy - government spending and taxing actions– Direct policy

– Slowly implemented


Federal Government Policy (cont.)Federal Government Policy (cont.)

• Monetary Policy - manipulation of the money supply to influence economic activity– Initial & feedback effects

• Tools of monetary policy– Open market operations( federal funds rate)

– Discount rate

– Reserve requirements


Demand ShocksDemand Shocks

• Demand shock - an event that affects demand for goods and services in the economy– Tax rate cut

– Increases in government spending


• Supply shock - an event that influences production capacity or production costs– Commodity price changes

– Educational level of economic participants

Supply ShocksSupply Shocks


Business CyclesBusiness Cycles

• Business Cycle– Peak

– Trough

• Industry relationship to business cycles– Cyclical

– Defensive


Leading Indicators - tend to rise and fall in advance of the economy

Examples– Avg. weekly hours of production workers

– Stock Prices

– Initial claims for unemployment

– Manufacturer’s new orders

NBER Cyclical Indicators: LeadingNBER Cyclical Indicators: Leading


Coincident Indicators - indicators that tend to change directly with the economy

Examples– Industrial production

– Manufacturing and trade sales

NBER Cyclical Indicators: CoincidentNBER Cyclical Indicators: Coincident


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

NBER Cyclical Indicators: LaggingNBER Cyclical Indicators: Lagging


Economic Calendar at Yahoo!Economic Calendar at Yahoo!


Industry AnalysisIndustry Analysis

• Sensitivity to business cycles• Sector Rotation• Industry life cycles


Estimates of Earnings Growth Rates in Several Industries, 2004

Estimates of Earnings Growth Rates in Several Industries, 2004


Sensitivity to Business CycleSensitivity to Business Cycle

• Factors affecting sensitivity of earnings to business cycles– Sensitivity of sales of the firm’s product to the

business cycles– Operating leverage– Financial leverage


Industry CyclicalityIndustry Cyclicality


A Stylized Depiction of the Business CycleA Stylized Depiction of the Business Cycle

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Figure 17.6 Returns on Equity, 2005 Figure 17.6 Returns on Equity, 2005


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Figure 17.7 Rate of Return, 2005Figure 17.7 Rate of Return, 2005



Sector RotationSector Rotation• Selecting Industries in line with the stage of

the business cycle

• Peak – natural resource firms

• Contraction – defensive firms

• Trough – equipment, transportation and construction firms

• Expanding – cyclical industries


Sector Rotation GainsSector Rotation Gains


Historical Sector PerformanceHistorical Sector Performance

Total returns on a representative group of Fidelity Select funds from 1999 to 2003 (fund with highest return for the year in blue).

Yr Biotech Finance Const. Media Gas Tech Wilshire

1999 77.8% 30.6% 12.5% 44.1% 26.2% 132.4% 23.6%

2000 32.8% 28.3% 8.8% -23.1% 71.0% -31.8% -10.9%

2001 -25.0% -9.2% 20.0% -1.0% -22.9% -31.7% -11.0%

2002 -40.5% -17.2% -8.5% -12.8% -9.6% -37.8% -20.9%

2003 32.9% 36.5% 44.1% 43.9% 28.7% 59.4% 31.6%


Industry Life CyclesIndustry Life Cycles

Stage Sales Growth

Start-up Rapid & Increasing

Consolidation Stable

Maturity Slowing

Relative Decline Minimal or Negative


The Industry Life CycleThe Industry Life Cycle


PracticePracticeChoose an industry and identify the factors that will

determine its performance in the next three years. What is your forecast for performance in that time period.


Case Analysis: Tech Bubble/Bust and the FedCase Analysis: Tech Bubble/Bust and the Fed

• 1990s—especially second half—saw dramatic rise in stock prices

– Growth in real GDP averaged 4.2% annually from 1995-2000

• Technological changes of 1990s were an example of a shock to both stock market and economy

• The market—especially high-tech NASDAQ stocks—began to decline in early 2000

• Faced with these demand shocks, Federal Reserve would ordinarily have raised its interest rate target to prevent real GDP from exceeding potential output

• Fed increased rates 6 times in 1999 and 2000 from 5% to 6.5%, then reduced rates 11 times in 2001 to 1.75% (1.00% by 6/25/2003)


The Fed’s Problem In 2000: An AS-AD ViewThe Fed’s Problem In 2000: An AS-AD View

Real GDP

Price Level

Y1 Y2

(a)

P1 AD2A

BP2

AD1

AS AS1

AS2

A AD2

AD1

(b)

Real GDP

P1

P2

Y1 Y2

B

CP3

Price Level

If output exceeds potential, the self-correcting mechanism will raise the price level further

Wealth effect of rising stock prices shifts AD rightward, raising real GDP and the price level


The Fed’s Problem in 2000: A Phillips Curve ViewThe Fed’s Problem in 2000: A Phillips Curve View

A

C

B

D

4%5%

2.5%

5.0%

1.5%

PC1 PC2

. . . or recession

Unemployment Rate

InflationRate

A

4%

2.5%

PC1

UN?

(a) (b)Inflation

RateIf the natural rate of unemployment is 4%, the Fed can keep the economy at point A in the long run

Unemployment Rate

UN?

But if the natural rate is above 4% the Phillips curve will shift upward and the Fed must choose between higher inflation . . .


The Fed and the Stock Market The Fed and the Stock Market

• Might think Fed can estimate natural rate by a process of trial and error– Bring unemployment rate to a certain level (such as 4%) and see

what happens to inflation

• However, Fed looks ahead and determines whether current economic conditions are likely to raise inflation rate in the future– By raising interest rates to rein in the economy, Fed also brought

down stock prices– By 2001, high-tech bust, recession of 2001, and attacks of

September 11 brought criticism to an end– As the economy began a slow expansion, in 2002 and early 2003,

Fed kept the interest rate low

• Unresolved question: Who should be setting the general level of share prices—millions of stockholders who buy and sell shares, or Federal Reserve?


SummarySummary

• Economic environment

• Monetary and fiscal policies

• Economic indicators

• Business and industry cycles

• Next: Asset Pricing Theory

Documents

1 FIN 2802, Spring 10 - Tang Chapter 17: Macroeconomic and Industry Analysis Fin2802: Investments Spring, 2010 Dragon Tang Lecture 16 Macroeconomic and