Chapter 13

Charles P. Jones, Investments: Analysis and Management,

Eleventh Edition, John Wiley & Sons

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 Objective
Understand the relationship between the
stock market & the economy
Analyze conceptually the determinants of the
stock market
Make some basic forecasts of possible
changes in the level of the market

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 Top-down Approach
An Overview of the Valuation Process
Three-Step Top-Down
Process
 First examine the
influence of the general
economy on all firms and
the security markets
 Then analyze the
prospects for various
global industries with the
best outlooks in this
economic environment
 Finally turn to the analysis
of individual firms in the
preferred industries and
to the common stock of
these firms.
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 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
Should also take a global perspective because of
linkages

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 Top-down Approach
Investors begin with the economy and the overall
market
Understand economic factors that affect stock prices
GDP (real vs nominal)
Inflation
Labour
Use economy-stock market relationship to apply
valuation models to stock market
 Stock market’s likely direction is of extreme
importance to investors

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• Same analysis can generally be applied to foreign
markets
• Currency changes can affect
⇒Should also take a global perspective because of linkages
• Ie; how is the euro currency performing, and how will
expected movements in the euro affect return to U.S
investors?
• Ie rise in euro mean that the dollar depreciated against the
euro. A falling dollar helps the earnings of the US corporation
with significant international operation. ⇒ US investors
benefited from the dollar decline

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 Assessing the economy***
• A basic measure of the economy is GDP
• DEFINITION: Market value of final goods and services
produced by economy, usually in a year
GDP = C + I + G + Net Export
• Real and nominal measures
• Real GDP is equal to the economic output adjusted for the
effects of inflation.
• Nominal GDP is economic output without the inflation
adjustment
• Real GDP is single best measure of overall economic
activity
• Increases and decreases directly affect companies
• If growth GDP is slow  corporate revenue will slow and
profits will slow  the stock market reacts to this prospect
negatively

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Economy and the Stock Market
Direct relationship between the two
Economic business cycle
Recurring pattern of aggregate economic
expansion and contraction
Cycles have a common framework
 trough  peak  trough
Can only be neatly categorized by length and
turning points in hindsight

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Business Cycle
National Bureau Economic Research
Is a private nonprofit organization, measures
business cycles and officially decides on the
economic” turning points”
 Monitors economic indicators
 Dates business cycle when possible

Composite indexes of general economic activity

Series of leading, coincident, and lagging indicators
of economic activity to assess the status of the
business cycle
Used to indicate peaks and troughs in business cycle

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 Composite indexes
Leading indices:
 stock prices
 consumer expectations
 money supply
 interest rate spread

Coincident indicators:
 industrial production
 manufacturing
 trade sales

Lagging indicators:
 duration of unemployment
 commercial and industrial loans outstanding
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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
 1970 oil price shock
2001 collapse of technology sector and with it
the technology stocks…

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Stock Market and Business Cycle

Stock prices lead the economy

 Historically, the most sensitive indicator
 Stock prices consistently turn before the economy
 If the economy is doing badly, most companies will
also be performing badly, as will the stock market
 If the stock price are falling sharply, confidence is
impacted and spending power is decreased.
How reliable is the relationship?
 The ability of the market to predict recoveries is much
better than its ability to predict recessions
Expansions typically end for one of the following
reasons:
 Overheating of the economy with rising inflation (Fed comes in to control)
 External shock—such as sharp rise in oril prices or a financial crash following a break
in an speculative bubble

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Macroeconomic Forecasts of the Economy

How good are available forecasts?

Prominent forecasters have similar predictions
and differences in accuracy are very small
 Investors can use any such forecasts
Does monetary activity initiated by the FED
forecast economic activity?
Changes due to shifts in supply or demand
Actions of Federal Reserve important

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Forecast of the economy***
• Monetary policy assumed to have important
effect on economy,
• Increases in money supply (demand) tend to
increase (decrease) economic activity •
• Federal Reserve’s impact •
• Affects monetary policy and interest rates

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Reading Yield Curves
Shows relationship between bond yields and
time, holding issuer constant
Upward sloping and steepening curve implies
accelerating economic activity
Flat structure implies a slowing economy
Inverted curve may imply a recession

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• The economy and stock market booms
• Most stock market booms have occurred during
periods of relatively economic growth and
productivity growth

• Economic slowdowns and bear markets

• When economic activity slowdown possibly
resulting a recession,
⇒ bear market: a decline in a major market index
of at least 20%

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Understanding the Stock Market

Market measured by index or average

Most indexes designed for particular market
segment (ex. blue chips)
Most popular indexes
Dow-Jones Industrial Average
S&P 500 Composite Stock Index
 Favored by most institutional investors and money
managers

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 Uses of Market Measures
• Shows how stocks in general are doing at any time
• Gives a feel for the market
• Many investors are encouraged to invest if stocks
are moving upward,
• Downward trends, may encourage some to liquidate
their holding and invest
• Shows where in the cycle the market is and sheds
light on the future
• Aids investors in evaluating downside
• Helps judge overall performance

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Determinants of Stock Prices
Corporate earnings and expected inflation
affects expected real earnings
Interest rates and required rates of return also
affected by expected inflation
Stock prices affected by earnings, rates
If economy is prospering, earnings and stock
prices will be expected to rise

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Determinants of Stock Prices
• From constant growth version of Dividend
Discount Model
P0 =D1/(k-g)
• Inverse relationship between interest rates
(required rates of return) and stock prices is
not linear
• Determinants of interest rates also affect
investor expectations about future

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 Forecasting Changes in the Market
• Difficult to consistently forecast the stock market,
especially short term
• future cannot be predicted based on past information
• Can not forecast the market using available information
• Reasonable estimates of the future involves analyzing the
overall economy
• To understand the stock market and make reasonable
judgment about future movements in stock price,
Investors must analyze:
• Interest rates
• Expected corporate profit

• Investors tend to lose more by missing a bull market

than by dodging a bear market

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Using the Business Cycle to Make Forecasts

Leading relationship exists between stock

market prices and economy
Can the market be predicted by the stage of the
business cycle?
Consider business cycle turning points well in
advance, before they occur
Stock total returns could be negative (positive)
when business cycle peaks (bottoms)
Stock price decline in recession ,and the
steeper the recession the steeper the decline.

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Using the Business Cycle to Make Market Forecasts

If investors can recognize the

bottoming of the economy
before it occurs, a market
rise can be predicted
Switch into stocks, out of
cash
As economy recovers, stock
prices may level off or even
decline
Based on past, the market
P/E usually rises just before
the end of the slump
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