CH 17 Macroeconomic
and Industry Analysis
Framework of Analysis
Fundamental Analysis
– Top-down approach (“Three-Step” Valuation
Approach
Domestic and global economic analysis
Industry analysis
Company analysis
– Bottom-up approach
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Top-Down Approach
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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
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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
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1. THE GLOBAL ECONOMY
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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.
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Economic Performance 2009
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Change in Real Exchange Rates
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2. THE DOMESTIC MACROECONOMY
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The Domestic Macroeconomy
Stock prices rise with earnings.
P/E ratios are normally in the range of 1225.
The first step in forecasting the
performance of the broad market is to
assess the status of the economy as a
whole.
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S&P 500 vs. EPS Estimate
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Key Economic Variables
Gross domestic product
Employment
Inflation
Interest rates
Budget Deficits
Consumer sentiment
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U.S. GDP
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GDP by State
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Monthly Unemployment Rate
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Inflation Rate in U.S.
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Interest rates :
Market data from WSJ
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U.S. National Debt
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Country foreign exchange reserves minus
external debt
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Michigan Consumer Sentiment Index
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3. INTEREST RATES
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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
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Determination of the
Equilibrium Real Rate of Interest
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4. DEMAND AND SUPPLY SHOCKS
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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
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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
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5. FEDERAL GOVERNMENT POLICY
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Demand-side Policy
Fiscal policy – the government’s spending
and taxing actions
Monetary policy – manipulation of the
money supply
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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)
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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
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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
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6. BUSINESS CYCLES
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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.
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The Business Cycle
Cyclical 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
Defensive Industries
Little sensitivity to the
business cycle
Examples include food
producers and
processors,
pharmaceutical firms, and
public utilities
Low betas
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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.
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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
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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
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Stock Market as a Leading Indicator
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S&P 500 Index Since 2007
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Economic Indicators (cont)
Coincident Indicators - indicators that tend
to change directly with the economy
Examples
– Industrial production
– Manufacturing and trade sales
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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
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Indexes of Economic Indicators
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Cyclical Indicators
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Leading, Coincident, and Cyclical Indicators
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Useful Economic Indicators
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Economic Calendar
Many sources,
such as The
Wall Street
Journal and
Yahoo!
Finance,
publish the
public
announcement
dates of
various
economic
statistics.
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Economic Calendar at Yahoo!
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7. INDUSTRY ANALYSIS
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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
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Return on Equity by Industry
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Industry Stock Price Performance, 2006
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Industry Stock Price Performance, 2009
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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
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Examples of NAICS Industry Codes
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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)
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Industry Cyclicality
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Sensitivity to the Business Cycle
2. 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.
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Operating Leverage of Firms A and B
Throughout the Business Cycle
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Sensitivity to the Business Cycle
3. Financial leverage:
– the use of borrowing
– Interest is a fixed cost that increases the
sensitivity of profits to the business cycle.
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Stylized Depiction of the Business Cycle
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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
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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
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Sector Rotation
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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
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The Industry Life Cycle
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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
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Industry Structure and Performance:
Five Determinants of Competition
Michael Porter has highlighted five
determinants of competition:
1.
2.
3.
4.
5.
Threat of entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers
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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.
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Basic Sectors
Information Technology
– AAPL, MU, GOOG
Telecommunication
Services
– T, VZ
Industrials
– GE, CAT
Consumer Discretionary
– GPS, GM
Basic Materials
Energy
– XOM, VLO
Consumer Staples
– KO, PG
Health Care
– PFE, LLY, MRK, JNJ
Utilities
– DUK, FE
Financials
– WFC, JPM
– MON, DOW
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