CHAPTER 13

ECONOMY/MARKET ANALYSIS MUST BE CONSIDERED BY ALL INVESTOR

Lecture:
Dr. Vinola Herawaty, Ak., MSc.

Group 2:
Raisafira Astriani (023001800054)
Mutia Rasya Azzahra (023001801148)
Aurora Azzahra (023001801154)
Saviera Fasha (023001801199)

JURUSAN AKUNTANSI
FAKULTAS EKONOMI DAN BISNIS
UNIVERSITAS TRISAKTI
JAKARTA
2020
01. INTRODUCTION
Many investors want to make intelligent judgments about the current state of the financial
markets as well as changes that have a high probability of occurring in the future. Investors
need to :
• Understand economic factor that affect stock prices initially
• Use valuation models applied to the overall market and consider how to forecast
market changes
• Stock Market’s likely direction is of extreme importance to investors

02. TAKING A GLOBAL PERSPECTIVE

Investors must think globally and must think about economies in other countries and parts
of the world. This is because if, for example, US investors want to choose equities from
various countries, that equity covers more than half of world market capitalization and two
thirds of world GDP. Then investors should also pay attention to how the Euro currency is
performing, and how the expected movement in the Euro will affect returns to US investors.

Foreign equity markets will be driven by revenue growth and changes in interest rates, as
will the U.S. market. By understanding the U.S. equity market, investors are in a better
position to understand the foreign equity market despite cultural, economic, and political
differences.
03. ASSESSING THE ECONOMY
Gross Domestic Product (GDP) is the basic measure of a country’s output used in
National Income accounts. Defined as the market value of final goods and services
produced by an economy for some time period (typically a year).

GDP = C + I + G + (X-M)

It consists of the sum of consumption spending, invest spending, government spending,

and net exports. GDP numbers are prepared quarterly and released a few weeks following
the end of the quarter. These numbers constitute a basic measure of the economic health
and strength of the economy. GDP is revised twice in the first three months after its initial
release. The Bureau of Economic Analysis releases an advance estimate of quarterly GDP
in the first month following quarter end.

The mechanism is relatively straightforward—if growth in GDP slows, the stock market
reacts negatively to the prospect of diminished economic activity. Investors are very
concerned about whether the economy is experiencing an expansion or a contraction
because stock prices, interest rates, and inflation will clearly be affected. The recurring
pattern of expansion and contraction in economic activity is referred to as the business
cycle.

The Business Cycle The business cycle reflects movements in economic activity as a
whole, which is comprised of many diverse parts. The diversity of the parts ensures that
business cycles are virtually unique, with no two parts identical. However, cycles do have
a common framework, with a beginning (they start from a trough), a peak, and an ending
(a new trough). Thus, economic activity starts in depressed conditions, builds up in the
expansionary phase, and ends in a downturn, only to start again (perhaps because of
government stimulus). The word “trough” is used to indicate when the economy has hit
bottom.
Ø The period from a peak to a trough is a recession.
Ø The period from a trough to a peak is an expansion.
The National Bureau of Economic Research (NBER), a private nonprofit organization,
measures business cycles and officially decides on the economic “turning points,” the dates
at which the economy goes from an expansion mode to a contraction mode, vice versa.

Leading, lagging, and coincident indicators are used to monitor the economy in terms of
business cycle turning dates (Composite Economic Indexes). The leading indicators
consist of variables such as stock prices, an index of consumer expectations, money supply,
and interest rate spread. The coincident indicators consist of four variables, such as
industrial production and manufacturing and trade sales, and the lagging indicators consist
of seven variables such as duration of unemployment and commercial and industrial loans
outstanding. The composite indexes are used to indicate peaks and troughs in the business
cycle. The intent of using all three is to better summarize and reveal turning point patterns
in economic data.

Forecasts of The Economy

Good economic forecasts are of obvious significant value to investors. Investors can find
forecasts of the economy from various sources. Some of these are what are referred to as
“consensus” forecasts, in the same way that is talk about consensus earnings forecasts for
stocks. For example, Blue Chip Economic Indicators is a publication that compiles
consensus forecasts from well-known economic forecasters of such important economic
variables as real GDP, consumer prices, and interest rates. Thus, investors can find
reputable, consistently done forecasts of the economy for at least the year ahead. Because
of its vital role in the economy, monetary policy traditionally has been assumed to have an
important effect on the economy, stock prices, and interest rates.

Insights from Yield Curve

The yield curve depicts the relationship between bond yields and time, holding the issuer
(typically, the U.S. government) constant, and in effect shows how interest rates vary across
time on any given day. It should contain valuable information, because it reflects bond
traders’ views about the future of the economy. Several studies suggest that the yield curve
is very useful in making economic forecasts. It has long been recognized that the shape of
the yield curve is related to the stage of the business cycle. In the early stages of an
expansion yield curves tend to be low and upward- sloping, and as the peak of the cycle
approaches yield curves tend to be high and down-ward sloping. More specifically,
 1. A steepening yield curve suggests that the economy is accelerating in terms of activity
as monetary policy stimulates the economy.
2. When the yield curve becomes more flat, it suggests that economic activity is slowing
down.
3. An inverted yield curve carries an ominous message, however—expectations of an
economic slowdown (every recession since World War II has been preceded by a
downward-sloping yield curve)

The top panel of Figure 13-2 shows some Treasury yield curves for 2011 and 2012 as the
economy struggled to grow. They were upward-sloping, which is the normal shape of the
yield curve. The middle panel of Figure 13-2 shows an upward-sloping yield curve in
January 2005 which had become basically flat by January 2006. The bottom panel shows
yield curves in 2000, which went from flat in January to clearly downward-sloping in June
and July. As we now know, a recession officially began in March 2001.

03. THE STOCK MARKET AND THE ECONOMY

The stock market is an important and vital part of the economy. If the economy is
underperforming, most companies will underperform too, as will the stock market.
Conversely, if the economy is prosperous, most companies will also develop, and the stock
market will reflect the strength of this economy.
 The relationship between the stock market and the business cycle, although generally
considered reliable, it is widely recognized that the market has given the wrong signal about
future economic activity, especially with regard to recessions. The real market doesn't
always lead the economy in predictable ways.

Recognizing that the market does not always lead the economy in the predicted manner,
consider what an examination of the historical record shows:
1) Stock prices often peak approximately one year before the start of a recession.
2) A typical stock price contraction is 25 percent from its peak. However, with the
recent recession, the figure has reached 40 percent or more. For example, in
2000–2002 the S&P 500 Index fell about 45 percent from its peak.
3) The ability of the market to predict recoveries has been remarkably good.
4) Stock prices almost always turn up three to five months before a recovery, with
four months being very typical.

After World War II, and before the 2001 recession, there were nine periods of recovery. In
each of these, the market (S&P 500) rose before the trough of the recession, and continues
to advance as expansion enters its early stages. Six months after the recovery, stock prices
are on average more than 25 percent higher than in the previous year.

In short, although the main relationship between the stock market and the economy is far
from perfect, investors should take it into account. Typically, when investors clearly
recognize what the economy is doing, such as entering a recession or getting out of a
recession, the stock market anticipates the event and reacts.

04. THE ECONOMY AND STOCK MARKET BOOMS

Economic slowdowns and bear markets
An economic slowdown occurs when the rate of economic growth slows in an economy.
Bear market is a downward trend in the stock market.
Relating the bond market and interest rates to the stock market
What is the relationship between the bond market and the stock market? Bond prices and
interest rates are opposite sides of the coin—if bond prices move up (down), interest rates
move down (up).
05. UNDERSTANDING THE STOCK MARKET
To value the stock market using the fundamental analysis approach, we use as our
foundation the P/E ratio or multiplier approach because a majority of investors focus on
earnings and P/E ratios. Estimates of index earnings and the earnings multiplier are used
in Equation:

06. MAKING MARKET FORECASTS

Ideally, investors need earnings estimates and the P/E ratio for next year for the market. As
we have seen, however, accurate estimates are difficult to obtain, given the various
constructs that are available. What, then, can investors do in trying to assess future
movements in the market?

Focus on the important variables

Buffett was asked to comment on the likely scenario for the market. Buffett argued that
long-term movements in stock prices in the past, and likely in the future, are caused by
significant changes in “two critical economic variables”:
1) Interest rate
2) Expected corporate profit

Corporate Earnings, Interest Rates, and Stock Prices

Interest rates and P/E ratios are generally inversely related. When fixed-income securities
are paying less return, investors are willing to pay more for stocks; therefore, P/E ratios are
higher. Stocks rise strongly as earnings climb and interest rates stay low.
Figure 13-4 shows the three series together—interest rates

The percent change in corporate profits after taxes annually, and the percent change in
total returns annually for the S&P 500 Index for the period 1987–2011. The shaded areas
indicate recessions, as determined by the National Bureau of Economic Research. In
general, in the recessionary periods, interest rates trended upward before the recession,
corporate profit changes were downward, and stock return changes were downward.

“In general, in the recessionary periods, interest rates trended upward before the recession,
corporate profit changes were downward, and stock return changes were downward. Also
notice the similarities in profit changes and stock return changes in terms of highs and
lows, and how rising (falling) interest rates are generally associated with falling (rising)
stock returns”

Interest rates are a basic component of discount rates, with the two usually moving
together. As Figure 13-4 shows, there is a relationship between interest rate movements
and stock prices, just as there is with corporate profits. In this case, however, the
relationship is inverse. As interest rates rise (fall), stock prices fall (rise), other things
equal. “If interest rates rise, the riskless rate of return, RF, rises, because it is tied to interest
rates, and other things being equal, the required rate of return (discount rate) rises because
the riskless rate is one of its two components.”

Using the business cycle to make market forecasts

Stock prices can be helpful in forecasting or ascertaining the position of the business cycle.
Stock prices have almost always risen as the business cycle is approaching a trough. These
increases have been large, so that investors do well during these periods. Furthermore,
stock prices often remain steady or even decline suddenly as the business cycle enters into
the initial phase of recovery. After the previous sharp rise as the bottom is approached, a
period of steady prices or even a decline typically occurs.
Based on the above analysis,
1. If the investor can recognize the bottoming out of the economy before it occurs, a
market rise can be predicted, at least based on past experience, before the bottom is
hit. In previous recessions since World War II, the market started to rise about halfway
between GDP starting to decline and starting to grow again.
2. The market’s average gain over the 12 months following its bottom point is about 36
percent.
3. As the economy recovers, stock prices may level off or even decline. Therefore, a
second significant movement in the market may be predictable, again based on past
experience.
4. Based on the most recent nine economic slumps in the twentieth century, the market
P/E usually rises just before the end of the slump. It then remains roughly unchanged
over the next year.

The E/P ratio and the treasury bond yield

To measure bond yields, one can use the yield on 10-year Treasuries. Of course, this
number can be observed on an updated basis every day. The earnings yield is calculated
as earnings divided by stock price, using the S&P 500 Index. The earnings figure used is
a forward 12-month earnings estimate, based on operating earnings.
This model can be used to formulate decision rules in the following ways:
• When the earnings yield on the S&P 500 is greater than the 10-year Treasury yield,
stocks are relatively attractive.
• When the earnings yield is less than the 10-year Treasury yield, stocks are relatively
unattractive
An alternative way to use this model:
• If the estimated fair value of the market is greater than the current level of the market,
stocks are undervalued.
• If the estimated fair value of the market is less than the current level of the market,
stocks are overvalued.

Other approaches to assessing the market’s likely direction

Ø The Market’s P/E Ratio
Consider the following analysis of annualized total returns over rolling 10-year periods
covering 1900–2010, a total of 102 periods. Thirty-five percent of the time, the
annualized returns exceeded 12 percent. While this is not conclusive proof of the
importance of the starting price-earnings ratio in affecting future market returns, it is
certainly suggestive that investors should pay close attention to the price-earnings ratio.
Ø Interest Rates
Investors attempting to forecast the market’s direction should pay attention to certain
important variables. Interest rates are an obvious variable to watch
Ø Monetary Policy
The results of this study indicated that during periods of restrictive monetary policy the
stock market performed poorly, with stock returns averaging less than 3 percent, and
risk at higher-than-average levels. Conversely, during periods of expansive monetary
policy, returns were higher than average and risk was lower
Ø Volatility
The Chicago Board Options Exchange has a volatility index (VIX). It is often referred
to as a “fear” index, but it is actually an index of expected market volatility. There is
historical evidence that volatile days tend to cluster together rather than occur
randomly. Investors who wish to avoid these volatile days can possibly use the VIX.
Ø January Market Performance
January 2008 showed a decline for the month, and the market suffered a drastic loss for
the year. However, 2009, 2010, and 2011 did not follow this pattern. In January 2009,
the S&P 500 Index declined, but the market performed very well. For 2011, the S&P
500 Index started and ended the year at the exact same level, 1,257.6, although it was
up about 2.3 percent in January. This shows once again the dangers of relying solely on
the past when predicting the future—it does not always work out.