Lecture 39: Top Down Market 2

Investment Analysis: Top-Down Approach Market Analysis - Part 2

Interest Rates Overview

• Approaches to Track the Economy:

  • Leading Economic Indicators: Metrics that change before the economy follows particular patterns.

  • Sentiment Indicators: Measures of consumer and business sentiment affecting spending and investment.

  • Interest Rates: Critical for guiding economic policy, impacting borrowing costs and spending.

Key Interest Rate Dimensions:

• Real Federal Funds Rate: Adjusted for inflation; indicates borrowing costs.

• Yield Curve: Difference in interest rates for bonds of different maturities, reflecting economic expectations.

• Risk Premium: Yield over the risk-free rate indicating market sentiment.

• The Fed Model: Compares earnings yields to bond yields for valuation.

The Real Federal Funds Rate

• Definition: Set by the FOMC; represents interbank lending rates.

• Purpose: Indicates whether the economy is being stimulated or restricted.

Fed's Dual Mandate

1. Full Employment: Maintain the lowest possible unemployment rate.

2. Stable Prices: Target inflation rate around 2%.

Natural Rate (Neutral Rate)

• Definition: Interest rate that neither stimulates nor restricts the economy.

• Post-2008 Context: Estimated low or negative rates post-financial crisis.

• 2022 Trends: Raising rates to exceed the neutral rate.

Evaluating Fed Policy

• Accommodative Policy: Rates below neutral to encourage growth.

• Restrictive Policy: Rates above neutral to control inflation.

Key Interest Rates Trends

• Historical analysis from 2004 to 2022 highlights shifts between policies influenced by crises and inflation.

The Yield Curve

• Definition: Represents interest rates of bonds with varying maturities.

• Types:

  • Normal: Long-term higher rates indicate growth.

  • Flat: Similar rates show uncertainty.

  • Inverted: Short-term rates higher indicate potential recession.

Risk Premium Analysis

• Definition: Yield difference between corporate bonds and Treasury bonds reflecting risk perception.

• Market Sentiment: Higher premiums signal risk aversion during economic distress.

The Fed Model

• Origin: Developing from Alan Greenspan’s report; values the S&P 500 via earnings vs. bond yield.

• Formula: S&P 500 Value = Next Year’s Earnings / 10-Year Treasury Yield.

• Limitations: Assumes zero growth, which can limit its predictive reliability in dynamic markets.