Macroeconomic and Industry Analysis — Flashcards

Top-Down Analysis

• Purpose: The intrinsic price of a stock depends on the company’s expected future earnings, which are affected by global and domestic economic variables, industry competition, and the company’s financial standing. This motivates the top-down approach:

  • 1) Examine global macroeconomic factors relevant for company performance

  • 2) Examine the significance of the key domestic U.S. economy variables (government macro policy, determinants of interest rates, business cycles)

  • 3) Industry analysis

  • 4) Company analysis

12.1 Global Economy

• The global economy can affect a firm’s:

  • Export prospects

  • Price competition from foreign competitors

  • Profits on investments abroad

• Table 12-1 shows the different growth rates of GDP in different regions (regional growth variation).

• Differences in stock markets in local currencies vs. U.S. dollars reflect inflation-rate differentials (a negative number indicates a depreciating dollar).

• Real exchange rate movements matter for competitiveness and pricing of imports/exports.

• Real exchange-rate concept (example from Figure 12-1): If the U.S. dollar gains purchasing power relative to foreign currencies, goods become cheaper for U.S. consumers to import, and it becomes more expensive for foreigners to import from the U.S.

• Political risk contributes to economic risk (examples include sovereign debt crises like Greece and political events like Brexit).

• Tax rates (corporate and individual) differ across countries and affect relative profitability.

12.2 The Domestic Macroeconomy

• Forecasting the domestic macroeconomy can translate into investment performance (as seen through the S&P 500).

• Key economic statistics describing the macroeconomy:

  • Gross Domestic Product (GDP): market value of goods and services produced over a period; expected GDP growth is a positive indicator.

  • Unemployment Rate: ratio of unemployed people to the labor force; lower is favorable.

  • Inflation: rate at which the general level of prices rises; lower is generally better for valuation stability.

• Other important macro variables discussed:

  • Interest Rates: influence discount rates and valuations; higher rates tend to reduce stock prices.

  • Budget Deficit: government spending in excess of revenues; deficits can push up interest rates and crowd out investment due to higher debt issuance.

  • Sentiment: consumer and producer optimism affects economic performance.

• Figure 12.2 illustrates the relationship between the S&P 500 index and earnings per share (EPS).

12.3 Interest Rates

• The level of interest rates is among the most important macroeconomic factors guiding investment analysis.

• Interest rates affect returns in fixed-income markets and rising rates are generally negative for the stock market.

• Fundamental determinants of interest rates:

  • 1) Supply of funds from savers (primarily households)

  • 2) Demand for funds from corporate borrowers

  • 3) Government’s net supply/demand for funds, modified by Federal Reserve policy

  • 4) Expected rate of inflation

• The interaction of these factors determines the overall level of interest rates and the shape of the yield curve.

12.5 Federal Government Policy

• Fiscal Policy: the use of taxation and government expenditures to stimulate or slow the economy.

  • To stimulate: reduce taxes, reduce expenditures, or both.

  • Fiscal policy helps manage the government budget, but is difficult to implement because it requires Congressional action and political negotiation.

  • Discretionary vs non-discretionary spending:

  • Discretionary: spending that Congress can adjust (e.g., defense, education, etc.)

  • Non-discretionary (auto-pilot): mandatory programs like Medicare and Social Security.

• Monetary Policy: actions by the Federal Reserve to influence the money supply and interest rates, thereby affecting stock and bond markets.

• Budget context (from the Fed and Treasury perspective): the government can run a budget surplus or deficit; deficits are financed through a mix of sources.

Monetary Policy Tools

• Reserve Requirement: the fraction of deposits that banks must hold as reserves.

  • Example: if reserve requirement is 10% and a $100 deposit is made, $10 must be held in reserve and $90 available for lending.

  • Lowering the reserve requirement (e.g., from 10% to 5%) increases lending capacity and money supply.

  • Raising the reserve requirement (e.g., from 10% to 15%) reduces lending capacity and money supply.

• Discount Rate: the interest rate the Federal Reserve charges banks for borrowing reserves; affects the money supply via bank lending capacity.

• Federal Funds Rate: the rate at which banks borrow reserves from each other; not set directly by the Fed but influenced by Fed actions that affect the supply of funds.

• Open Market Operations (OMO): the Fed’s primary monetary policy tool; buying or selling government securities to influence reserves and the federal funds rate.

  • To stimulate/expand the economy: the Fed buys securities, increasing bank reserves and the money supply.

  • To contract an overheated economy: the Fed sells securities, reducing bank reserves and the money supply.

Quantitative Easing (QE)

• A method to stimulate the economy by increasing the money supply through the purchase of government bonds.

• Impact on stock prices occurs via two channels:

  • Impact on the required rate of return (discount rate)

  • Impact on earnings (via higher or lower discount rates and macroeconomic expectations)

Fiscal Policy (U.S. Department of the Treasury)

• Economic goals: stable prices (inflation control), full employment (job creation), and economic growth (GDP growth).

• Budget concepts:

  • Budget Surplus: revenues exceed spending.

  • Budget Deficit: spending exceeds revenues.

• Financing the deficit can involve:

  • Selling government securities to the general public, commercial banks, non-bank public, the Federal Reserve, and foreign central banks.

12.6 Business Cycles

• Business cycles describe recurring recession/contraction and recovery/expansion phases used to guide investment decisions.

• Key cycle terminology:

  • Peak: transition from expansion to contraction.

  • Trough: transition from recession to recovery.

• Implications: profitability of different industry groups varies across cycle stages.

12.6 Industry Groups and Cyclicality

• Cyclical industries:

  • Have above-average sensitivity to the state of the economy.

  • Tend to outperform near the trough and during early recovery.

  • Examples: durable goods (automobiles, large appliances) and capital goods (used by other firms to produce products).

  • Characteristics: high betas.

  • Strategy: overweight cyclical firms when macro outlook is optimistic.

• Defensive industries:

  • Have below-average sensitivity to the state of the economy.

  • Tend to outperform during recessions.

  • Examples: food producers, pharmaceuticals, and public utilities.

  • Characteristics: low betas.

  • Strategy: overweight defensive firms when macro outlook is pessimistic.

12.6 Indicators for the Business Cycle

• Leading indicators (tend to move ahead of the economy):

  • Average weekly hours of production workers

  • Initial claims for unemployment insurance

  • Manufacturers’ new orders

  • Institute of Supply Management (ISM) Index of New Orders

  • New orders for nondefense capital goods

  • New private housing units authorized by local building permits

  • Yield curve (spread between 10-year T-bond yield and federal funds rate)

  • Stock prices (S&P 500), money supply growth (M2)

  • Index of consumer expectations for business conditions

• Coincident indicators (move with the economy):

  • Employees on nonfarm payrolls

  • Personal income less transfer payments

  • Industrial production

  • Manufacturing and trade sales

• Lagging indicators (confirm past cycles):

  • Average duration of unemployment

  • Ratio of trade inventories to sales

  • Change in index of labor cost per unit of output

  • Average prime rate charged by banks

  • Commercial and industrial loans outstanding

  • Ratio of consumer installment credit to personal income

  • Change in the consumer price index for services

12.7 Industry Analysis

• Industry performance shows dispersion in ROE and stock performance:

  • ROE by major industry groups in 2016 ranged from 0.9% (iron & steel) to 24.6% (aerospace).

  • Industry stock performance in 2017 showed wide dispersion, e.g., airlines up ~40.9%, oil & gas down ~8.4%.

• Rarely is it easy to draw strict boundaries between industries (e.g., application software firms vary widely in focus and products).

• ROE variation within a single industry can be substantial:

  • Example: Application software firms ROE from -6.6% (Symantec) to 61.6% (Intuit).

• Figures illustrate dispersion in ROE and stock-price performance across industries and within subgroups.

• 12.9 (ROE of Application Software Firms) highlights the heterogeneity within a single industry subsegment.

Additional notes on figures referenced in the chapter

• Figure 12.2: S&P 500 Index versus Earnings per Share (EPS) – illustrates relationship between stock market level and company earnings.

• Figure 12.1: Change in Real Exchange Rate: U.S. dollar vs. major currencies (2003-2016) – illustrates how real exchange-rate movements affect import/export dynamics.

• Figure 12.4: Leading and Coincident Indicators – visual representation of how indicators align with business cycles.

• Figure 12.6: Return on Equity (ROE), 2016 – distribution of ROE across industries.

• Figure 12.7: Industry Stock Price Performance, 2016 – compares performance across industries.

• Figure 12.8: ROE variation within Application Software – highlights dispersion within a single industry.

• Figure 12.9: ROE of Application Software Firms – further illustration of heterogeneity.

ext{Sample formula reference: Present Value of a future cash flow} \ PV = \sum{t=1}^{T} \frac{CFt}{(1+r)^t}

• This is a standard finance concept underlying how discount rates (r) affect stock valuations in the context of changing interest rates and monetary policy.

Connections to foundational principles and real-world relevance

• The top-down approach links macro environments to industry dynamics and company fundamentals, explaining why macro shocks can alter which industries excel.

• Exchange rates, inflation, and interest rates influence cash flows, discount rates, and competitive positioning across borders.

• Fiscal and monetary policy interact with stock valuations through expectations of future profitability and risk-free rates.

• Business cycle phases guide sector rotation strategies (cyclicals vs defensives) and emphasize the importance of timing and risk assessment in portfolio construction.

• Industry dispersion underscores that even within an sector, firm-specific fundamentals (ROE, product focus) can drive widely different stock performances.

Practical implications and ethical/philosophical notes

• Forecasting macro variables involves uncertainty; prudent investors use scenario analysis and risk management to account for different policy paths and global events.

• The influence of policy actions on market efficiency raises questions about moral hazard, central-bank independence, and the distributional effects of fiscal/monetary stimulus.

• A disciplined approach to industry analysis can reduce heterogeneity in portfolio returns but requires careful data interpretation and avoidance of overfitting to past patterns.