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IPMIPMEconomy/Market Economy/Market

AnalysisAnalysis

December 22, 2011December 22, 2011

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OBJECTIVES OF THE DAY Assessing the Economy

Understanding the Stock Market

Making Market Forecasts

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Assessing the Economy: Gross Domestic Product (GDP)

• A basic measure of the economy is Gross Domestic Product (GDP). It is the market value of final goods and services produced by an economy for some time period.

• The GDP numbers constitute a basic measure of the economic health and strength of the economy.

• GDP ups and downs directly affect companies. If growth in GDP slows, as it did by the end of 2000, corporate revenues will BE slow.

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Cont`d• The market, of course, reacts to this prospect negatively.

• While real GDP growth in 2000 was 3.8 percent, it was 0.3 percent in 2001, and 2.4 in 2002.

• A recession officially began in 2001, and the stock market suffered decline in 2001 and 2002.

• Investors are very concerned about whether the economy is experiencing an expansion or a contraction.

• Because stock prices, interest rates, and inflation will clearly be affected.

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The Business Cycle• The business cycle reflects movements in economic activity as a

whole, which comprises many diverse parts.

• The recurring patterns of expansion, boom, contraction, and recession in an economy.

• Cycles do have a common framework, the economic activity starts in depressed conditions, builds up in the expansionary phase, and ends in a downturn, only to start again.

• The National Bureau of Economic Research (NBER), measures business cycles and officially decides on the economic “turning points”.

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CONT`D• It is possible to identify those components of economic activity that

move at different times from each other.

• Such variables can serve as indicators of the economy in general and called Composite Indexes of General Economic Activity.

• Standard practice is to identify leading, coincident, and lagging composite economic indexes.

• The leading indicators consist of variables such as stock prices, index of consumer expectations, money supply, and interest rate spread.

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• The coincident indicators consist of variables such as industrial production and manufacturing and trade sales.

• The lagging indicators consist of variables such as duration of unemployment and commercial and industrial loans outstanding.

• These are used to indicate peaks and troughs in the business cycle.

• The intent is to summarize and reveal turning patterns.

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The Global Perspective• Economies around the world are now more integrated and linked to

each other because of increased trade and capital flows among countries.

• The most important reason for synchronized recession among many countries is a common shock that is felt around the world.

• The collapse of the technology sector, and with it the technology stocks, was the common shock that occurred in several countries.

• Due to this there was a synchronized global downturn.

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The Stock Market & the Business Cycle

• If the economy is doing badly, most companies will also be performing poorly, as will the stock market and vice versa.

• Stock prices generally lead the economy, it is the most sensitive indicator of the business cycle.

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Forecasts of the Economy

• Good economic forecasts are of obvious significant value to investors.

• How good are such forecasts, which are widely available?

• McNees concluded that forecasts made by the prominent forecasters are very similar and that differences in accuracy are very small.

• Suggesting that investors can use any of a number of such forecasts.

• Obviously, not all forecasters are equally accurate, and all forecasters make errors.

• The only good news is that forecast accuracy apparently has increased over time.

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Cont`d• Monetary policy traditionally has been assumed to have an important

effect on the economy, stock prices, and interest rate.

• Almost all theories of the macroeconomy postulate a relationship between money and future economic activity.

• For example, increases in money supply tend to increase economic activity.

• Whereas increases in money demand tend to reduce economic

activity.

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Understanding the Stock Market

• What Do We Mean By the “Market”:

• Everyone investing in stocks wants a general idea of how the overall market for equity securities is performing.

• To guide their actions and to act as a benchmark against which to judge the performance of their securities.

• When most investors refer to the “market”, they mean the stock market in general as proxied by some market index or indicator.

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Uses of Market Measures• Market measures tell investors how all stocks in general are doing

at any time or give them a “feel” for the market.

• Many investors are encouraged to invest if stocks are moving upward and vice versa.

• The historical records of market measures are useful for gauging where the market is in a particular cycle and possibly for shedding light on what will happen.

• Market measures are useful to investors in quickly judging their overall portfolio performance.

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What Determines Aggregate Stock Prices?

• Dividend Discount Model

• P/E ratio model

• To value the stock market, we use as our foundation the P/E ratio or multiplier approach, because a majority of investors focus on

earnings and P/E ratio.

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The Earnings Stream• IT is the earnings per share for a market index or, in general

corporate profits after taxes.

• Corporate profits are derived from corporate sales, which in turn are related to GDP.

• A detailed, top-down fundamental analysis of the economy/market would involve estimating each of these variables, starting with GDP, then corporate sales, working down to corporate earnings before taxes, and finally to corporate earnings after taxes.

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CONT`D

• Looking at earnings growth, we would expect it to correlate closely with real GDP growth over the long run.

• It is reasonable to expect corporate earnings to grow, on average, at about the rate of the economy as whole.

• Share repurchases by firms may increase the rate of earnings growth relative to historical rates.

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Making Market Forecasts

• Accurate forecasts of the stock market, particularly short-term forecasts, are impossible for anyone to do consistently.

• There is strong evidence that the market is efficient; this implies that changes in the market cannot be predicted on the basis of information about previous changes.

• Another implication is that even professional money managers cannot consistently forecast the market using available information.

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Cont`d• Nevertheless, most investors ultimately want to make some

estimates of likely changes in the stock market.

• Not only do they want to try to understand what the market is doing currently and why.

• But also they want some reasonable estimates of the future.

• Ideally, investors need estimates of corporate earnings and estimates of the market’s P/E ratio for some future periods.

• We will consider some approaches that investors can and do use to make some types of market forecast.

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Focus on the Important Variables

• Stock prices are closely related to corporate earnings, and that interest rates play a major role in affecting both bond and stock prices.

• Consider an interview in late 2001 with Warren Buffett, he argued that long-term movements in stock prices in the past, and likely in the future, are caused by significant changes in “two critical economic variables”.

1. Interest rates2. Expected corporate profits

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Corporate Earnings, Interest Rates, and Stock Prices

• Interest rates and P/E ratios are inversely related.

• Investors must be concerned with earnings and interest rates as they assess the outlook for stocks.

• The figure shows the three series together—interest rates, percent change in corporate profits after taxes annually, and the percent change in total returns annually for the S&P 500 index for the period 1978 to 2002.

• The shades area indicate recessions, as determined by National Bureau of Economic Research.

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• In general, in the recessionary periods, interest rates trended upward before the recession, corporate profit changes were downward, and stock return changes were downward.

• What is the relationship between Corporate profits and stock prices variables?

• Corporate earnings growth is thought of by most market observes as the basis for share price growth.

• What is the relationship between interest rates and stock prices?

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Using the Business Cycle to Make Market Forecasts

• Stock prices are one of the leading indicators, tending to lead the economy’s turning points, both peaks and troughs.

• Stock prices generally decline in recessions.

• Investors need to think about the business cycle’s turning points months before they occur in order to have a handle on the turning points in the stock market.

• If a business cycle downturn appears to be likely in the future, the market will also be likely to turn down some months ahead of the economic downturn.

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Cheers !!!!!!!!!!