CHAPTER 9 THE TOP-DOWN APPROACH TO MARKET, INDUSTRY, AND COMPANY ANALYSIS

1.              There are three problems with simply tracking the GDP data that has been released in order to make investment decisions:

1. Preliminary GDP data is released approximately one month after each quarter ends. This means that it is not timely.

2. The preliminary GDP data will be revised. Often times, the revisions are meaningful.

3. The stock market moves ahead of the economy. In other words, investors are anticipating future cash flows. As a result, it is hard to identify stocks (which move ahead of the economy) by examining old economic data that may need to be revised significantly.

Analysts want to know the level of the federal funds rate and whether it is

intended to stimulate the economy or restrict the economy. If a low federal funds rate results in lower long-term rates, this can make stocks more attractive. In addition to stocks being more attractive relative to low-yielding bonds, the value of a stock is the present value of future cash flows. Low rates mean that the present value of those distant cash flows is greater.

An inverted yield curve occurs when the long-term yields are lower than short-term yields

The yield curve has inverted prior to every recession since 1970, and evidence shows that the likelihood of a recession increases with the severity of the inversion. If the yield curve inverts:

            (1)  It is usually because the Fed has raised short-term rates, and the expectation is that the Fed will eventually have to lower rates significantly, and even the term premium that longer-term investors require will not be enough to keep the yield curve normal.

            (2)  It is no longer profitable to lend because banks have to pay more for short-term funds, and they can charge less for longer-term loans. As bank lending decreases, the decrease in the availability of credit slows economic growth.

The four factors impact operating margins for the overall market are:

(1) Capacity utilization

(2) Unit labor costs

(3) Rate of inflation

(4) Foreign competition

When calculating the cost of equity a required risk premium should be used,

, the compensation that will justify the risk of investing in equities as opposed to investing in risk-free bonds.

The four categories of structural (noncyclical) economic changes that an analyst should review are:

(1) Demographics

            (2) Lifestyles

            (3) Technology

            (4) Politics and regulations

Growth companies  are those that consistently grow sales and earnings at a rate that is faster than the overall economy

A growth stock is a stock with a higher expected rate of return than other stocks in the market with similar risk characteristics.

 

            A defensive stock’s rate of return is not expected to decline during an overall market decline, or it is expected to decline less than the overall market. A stock with low or negative systematic risk (a small positive or negative beta) may be considered a defensive stock according to this theory because its returns are unlikely to be harmed significantly in a bear market.

 

            A cyclical stock will experience changes in its rates of return greater than changes in overall market rates of return. In terms of the CAPM, these would be stocks that have high betas.