Lecture Presentation to accompany Investment Analysis

1
Chapter 12 Macroeconomic and Market Analysis
The Global Asset Allocation Decision
Chapter 12

2
Chapter 12 Macroeconomic and Market Analysis
The Global Asset Allocation Decision

• Questions to be answered
• What are the expected and the empirical
  relationships between economic activity and
  security markets?
• What is the macroeconomic approach to estimating
  future market returns?

3
Chapter 12

• What are the major macroeconomic techniques used
  to project the securities market?
• What is the leading economic indicator approach?
  What are its uses and shortcomings and can it be
  used to predict stock prices?
• What are the expected and the empirical
  relationships between the growth of the money
  supply and stock prices?

4
Chapter 12

• What is meant by excess liquidity and how is it
  measured?
• What is the effect of monetary policy on stock
  prices in the United States and around the world?
• What are the expected and the empirical
  relationships between inflation, interest rates,
  and bond prices?
• What are the expected and empirical relationships
  between inflation and stock prices?

5
Chapter 12

• When analyzing world security markets, what is
  the relationship between inflation and interest
  rates in alternative countries? What is the
  effect of inflation and interest rates on
  exchange rates?
• How do the basic valuation variables differ among
  countries?
• How do stock price returns among countries
  correlate when considering domestic returns and
  returns in U.S. dollars?

6
Chapter 12

• What factors should be considered when analyzing
  the outlook for a foreign economy and its stock
  and bond market?
• What is the asset allocation procedure for a
  global portfolio?
• For a world asset allocation, what is meant by
  normal weighting, underweighting, and
  overweighting?

7
Economies and Markets

• A strong relationship exists between the economy
  and the stock market
• Security markets reflect what is going on in an
  economy because the value of an investment is
  determined by
• its expected cash flows
• required rate of return

8
Economic Activity and Security Markets

• 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

9
Cyclical Indicator Approach to Forecasting the
Economy

• This approach contends that the aggregate
  economy expands and contracts in discernable
  periods

10
Cyclical Indicator Approach to Forecasting the
Economy

• National Bureau of Economic Research (NBER)
• Cyclical indicator categories
• leading indicators
• coincident indicators
• lagging indicators
• Composite series and ratio of series

11
Cyclical Indicator Categories

• Leading indicators economic series that usually
  reach peaks or troughs before corresponding peaks
  or troughs in aggregate economy activity
• Coincident indicators economic series that have
  peaks and troughs that roughly coincide with the
  peaks and troughs in the business cycle

12
Cyclical Indicator Categories

• Lagging indicators economic series that
  experience their peaks and troughs after those of
  the aggregate economy
• Selected series economic series that do not
  fall into one of the three main groups

13
Cyclical Indicator Approach to Forecasting the
Economy

• Analytical measures of performance
• diffusion indexes
• trends
• rates of change
• direction of change
• comparison with previous cycles

14
Cyclical Indicator Approach to Forecasting the
Economy

• Limitations of cyclical indicator approach
• high variability
• currency of the data and revisions
• no series reflects the service sector
• no series represents the global economy
• political and international developments are not
  factored into a statistical system

15
Cyclical Indicator Approach to Forecasting the
Economy

• Leading indicators and stock prices
• Other leading indicator series
• CIBCR
• Long-leading index
• leading employment index
• Leading inflation index
• Analysis of alternative leading indicators of
  inflation
• International leading indicator series
• Survey of sentiment and expectations

16
Monetary Variables, the Economy, and Stock Prices

• Money supply and the economy
• Money supply and stock prices
• Excess liquidity and stock prices
• year to year percentage change in M2 money supply
  adjusted for small time deposits less the
  year-to-year percentage change in nominal GDP

17
Money Supply and the Economy

• Declines in the rate of growth of the money
  supply have preceded business contraction by an
  average of 20 months
• Increases in the rate of growth of the money
  supply have preceded economic expansions by about
  8 months

18
Money Supply and Stock Prices

• Excess Liquidity and Stock Prices
• Historical Excess Liquidity in the United States
• Historical Excess Liquidity in Foreign Countries

19
Monetary Variables, the Economy, and Stock Prices

• Other economic variables and stock prices
• growth in industrial production
• changes in the risk premium
• twists in the yield curve
• measures of unanticipated inflation
• changes in expected inflation during periods of
  volatile inflation

20
Inflation, Interest Rates, and Security Prices

• Inflation and interest rates
• generally move together
• investors are not good at predicting inflation
• Inflation rates and bond prices
• negative relationship
• more effect on longer term bonds
• Interest rates and stock prices
• not direct and not consistent
• effect varies over time

21
Analysis of World Security Markets

• Goldman, Sachs Co.
• World Investing Strategy Highlights
• Inflation and exchange rates
• Correlations among returns
• Individual country stock price changes
• Individual country analysis
• World asset allocation

22
The InternetInvestments Online

• www.ms.com
• www.dri.mcgraw-hill.com/index.htm
• www.yardeni.com
• www.whitehouse.gov/fsbr/esbr.html
• www.bog.frb.fed.us
• www.phil.frb.org/econ/index.html
• www.worldbank.org
• www.bankamerica.com/econ_indicator/econ_indicator.
  html
• www.personalwealth.com
• www.spglobal.com/index.html

23
The InternetInvestments Online

• www.treasury.boi.ie
• www.dkb.co.jp/english/index.html
• www.boj.or.jp/en/index.htm
• www.indobiz.com
• www.bankofengland.co.uk
• www.bundesbank.de/index_e.html
• www.banque-france.fr/gb/home.htm
• www.ecb.int

24

• End of Chapter 12
• The Analysis of Alternative Economies and
  Securities Markets The Global Asset Allocation
  Decision

25
Future TopicsChapter 13

• Stock Market Analysis
• Microanalysis of a countrys stock market
• Application of the DDM and the FCFE models to the
  aggregate stock market
• How to arrive at an expected market value and an
  expected rate of return for the stock market?