Macroeconomic and Industry

Analysis

Chapter 12

12.1 The Global Economy

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Framework of Analysis

• Fundamental Analysis– Analysis of the determinants of firm value,

specifically attempting to forecast the earnings and dividends of a firm.

– Top down approach: Analyze economy

Analyze industryAnalyze firm

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Framework of Analysis

• Approach to Fundamental Analysis– Domestic and global economic analysis

• Performance in countries and regions is highly variable

• Politics affects the economy

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Framework of Analysis

• Approach to Fundamental Analysis– Foreign exchange rates affect U.S. firms

and their competitors• How are the following affected by a change in

the value of the dollar?– Ski resort in Aspen Colorado– Profits of Rocky Mountain Log homes, an exporter of

log homes around the world– Yen profit on sale of Toyota cars in U.S.

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Exchange Rate Risk

• Exchange rate risk can affect:– Sales– Profits– Stock returns

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Framework of Analysis• Approach to Fundamental Analysis

– Industry analysis• Critical to understand the competitiveness of

the industry

– Company analysis• Detailed strategic and financial analysis of the

firm

• Why use the top-down approach?

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12.2 The Domestic Macroeconomy

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• Gross domestic product– The market value of gods and services produced

domestically in a given time period

• Unemployment rate– The ratio of number of people classified as unemployed

to the total labor force

• Inflation– The rate of change in the general price level as

measured by some price index:• Consumer Price Index• Producer Price Index• GDP Deflator

Key Economic Variables

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Key Economic Variables• Interest rates

– Major impact on security prices (stocks and bonds) and the level of economic growth

• Budget Deficits– The budget deficit is the amount by which government

spending exceeds government revenues– Budget deficits can crowd out private investment,

private investment generates more growth than public sector investment.

– Alternative to crowding out is overreliance on foreign borrowing.

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Key Economic Variables• Consumer sentiment

– Consumers’ optimism or pessimism concerning the economy and job prospects.

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12.3 Interest Rates

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Factors Determining the Level of Interest Rates

1. Supply of funds from savers

2. Demand for funds from businesses

3. Government’s net supply and/or demand for funds– Fiscal policy

– Monetary policy

4. Expected rate of inflation– Interest rates contain a premium for expected

inflation

– The Federal Reserve typically raises interest rates proactively when inflation is expected to increase

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12.4 Demand and Supply Shocks

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Demand Shocks

• Demand Shock– An event that affects the demand for

goods and services, some examples include:

• Change in tax rates• Change in the money supply • Change in government spending• Change in foreign export demand

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Supply Shocks• Supply Shocks

– An event that influences production capacity and input costs, including labor costs, examples include

• Changes in the price or availability of imported oil• Freezes• Floods• Droughts• Changes in wage rates

– Negative supply shocks tend to result in demand > supply, which is inflationary. Negative supply shocks also may result in reduced output, leading to slower economic growth.

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Tie to investmentsChoose industries that will be helped by your expected economic scenario and avoid those that will be hurt.– For example, choose consumer cyclicals if the

economy is projected to do well, but not if the economy will weaken,

– May choose consumer staples and necessities such as utilities if the economy is not expected to do well.

To earn abnormal returns you must have better information (unlikely) or

better analysis than the competition.

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12.5 Federal Government Policy

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Fiscal Policy• Government spending and taxing actions to

stabilize or spur growth in the economy– Most direct policy method in terms of its effect on

the economy (Keynesian policy)– Often implemented too slowly due to political

process– Leaky budget analogy– Poor means to fine tune an economy, can be

inflationary– May be necessary when monetary policy is

ineffective such as in the Financial Crisis of 2008

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Monetary Policy• Manipulation of the money supply to

influence economic activity by influencing the demand for goods and services to be produced and consumed– Initial & long run effects– Potentially long lags– Changes incentives to purchase and

invest, but may not lead to desired effect on demand

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• Tools of monetary policy– Open market operations (federal funds

rate)– Discount rate– Reserve requirements

Monetary Policy

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Supply-Side Policies• Supply-siders focus on incentives and

marginal tax rates• Lowering tax rates tends to

– encourage more investment – Improve incentives to work– generate faster economic growth

• “Lift all boats”

Can we rely solely on supply side

policies in a severe recession such as

the Financial Crisis of 2008?12-22

Supply-Side Policies

• Income inequality may also rise– Those with better ideas, education,

opportunities, work ethic, providence, etc. will do better, others may not.

– If the majority are better off, but some much more so than others does this indicate that we should not use supply side policies?

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12.6 Business Cycles

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The Business Cycle• Recurring patterns of recession and recovery

– Peak

– Trough

• Industry relationship to business cycles– Cyclical industries

• Industries with above average sensitivity to the state of the economy

– Defensive• Industries with below average sensitivity to the state

of the economy

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Economic Indicators• Leading Indicators - tend to rise and fall

in advance of the economy

• Coincident Indicators - indicators that tend to change at the same time as the economy

• Lagging Indicators - indicators that tend to follow or lag economic performance

• Other Indicators such as Walmart sales

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Figure 12.6 Economic Calendar at Yahoo!

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12.7 Industry Analysis

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Defining an Industry• It can be difficult to define an industry

– Use Google Finance for Industry Classification !!

– North American Industry Classification System (NAICS) attempts to define industry groups with a four or five digit code:

• The first two digits broadly define the industry group: NAIC code 23 = construction

• The last two or three digits define the industry more narrowly

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Sensitivity to Business Cycle

• Factors affecting sensitivity of earnings to business cycles– Sensitivity of sales of the firm’s product to the

business cycles

– Fixed costs and leverage• Fixed costs are costs that do not vary with the level

of production.

• Fixed costs contribute to higher profitability when sales are high, but will result in lower profitability when sales are lower.

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Sensitivity to Business Cycle

– Operating leverage• Proportion of fixed operating costs as a percent of

total costs• Greater operating leverage results in greater

swings in profits over the business cycle– Airlines, automobiles

– Financial leverage• Proportion of fixed financing costs as a percent of

total costs• Greater financial leverage results in greater swings

in profits over the business cycle– Airlines, banks, investment banks

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Sector Rotation

Selecting Industries in line with the stage of the business cycle:

• Peak • Contraction• Trough • Expanding

natural resource firmsdefensive firmsequipment, transportation and construction firmscyclical industries

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Sector Rotation Illustrated

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Industry Structure and Performance (Porter’s Five Model)

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