Chapter 17 investments-5th_ed_-volume_i_-_bodie-_kane-_marcus


Published on

1 Like
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Chapter 17 investments-5th_ed_-volume_i_-_bodie-_kane-_marcus

  1. 1. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 537 Investments, Fifth Edition Industry Analysis Companies, 2001 C H A P T E R S E V E N T E E N MACROECONOMIC AND INDUSTRY ANALYSIS To determine a proper price for a firm’s stock, the security analyst must forecast the dividend and earnings that can be expected from the firm. This is the heart of fun- damental analysis—that is, the analysis of the determinants of value such as earn- ings prospects. Ultimately, the business success of the firm determines the dividends it can pay to shareholders and the price it will command in the stock market. Be- cause the prospects of the firm are tied to those of the broader economy, however, fundamental analysis must consider the business environment in which the firm operates. For some firms, macroeco- nomic and industry circumstances might have a greater influence on prof- its than the firm’s relative performance within its industry. It often makes sense to do a “top-down” analysis of a firm’s prospects. One starts with the broad economic environment, examining the state of the aggregate economy and even the international economy. From there, one considers the implications of the outside environment on the industry in which the firm operates. Finally, the firm’s position within the industry is examined. This chapter treats the broad-based aspects of fundamental analysis— macroeconomic and industry analysis. The two chapters following cover firm-spe- cific analysis. We begin with a discussion of international factors relevant to firm performance, and move on to an overview of the significance of the key variables usually used to summarize the state of the macroeconomy. We then discuss 532
  2. 2. 538 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 533 government macroeconomic policy. We conclude the analysis of the macroenviron- ment with a discussion of business cycles. Finally, we move to industry analysis, treating issues concerning the sensitivity of the firm to the business cycle, the typical life cycle of an industry, and strategic issues that affect industry performance. 17.1 THE GLOBAL ECONOMY A top-down analysis of a firm’s prospects must start with the global economy. The interna- tional economy might affect a firm’s export prospects, the price competition it faces from competitors, or the profits it makes on investments abroad. Certainly, despite the fact that the economies of most countries are linked in a global macroeconomy, there is considerable vari- ation in the economic performance across countries at any time. Consider, for example, Table 17.1, which presents data on several so-called emerging economies. The table documents striking variation in growth rates of economic output in 1999. For example, while the South Korean economy grew by 12.3%, Venezuelan output fell by 9.6%. Similarly, there was con- siderable variation in stock market returns in these countries in 1999, ranging from a 25.8% loss in Colombia (in dollar terms) to a 203.8% gain in Russia. These data illustrate that the national economic environment can be a crucial determi- nant of industry performance. It is far harder for businesses to succeed in a contracting economy than in an expanding one. In addition, the global environment presents political risks of far greater magnitude than are typically encountered in U.S.-based investments. In the last decade, we have seen sev- eral instances where political developments had major impacts on economic prospects. For example, in 1992 and 1993, the Mexican stock market responded dramatically to changing assessments regarding the prospect of the passage of the North American Free Trade Asso- ciation by the U.S. Congress. In 1997, the Hong Kong stock market was extremely sensitive Table 17.1 Stock Market Return Economic Performance in Growth in Real GDP Local Currency $ Terms Selected Emerging Markets China 7.0 22.8 22.8 Hong Kong 4.5 57.7 57.1 India 5.5 75.3 71.3 Indonesia 0.5 70.4 88.2 Singapore 6.7 71.7 71.0 South Korea 12.3 75.4 85.9 Taiwan 5.1 37.9 44.6 Brazil 0.3 139.5 55.7 Colombia 4.6 7.9 25.8 Mexico 4.6 70.8 76.6 Venezuela 9.6 12.2 2.7 Greece 3.5 96.1 71.6 South Africa 1.7 55.1 50.2 Turkey 5.6 551.8 283.0 Russia 1.8 284.2 203.8 Source: The Economist, January 8, 2000.
  3. 3. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 539 Investments, Fifth Edition Industry Analysis Companies, 2001 534 PART V Security Analysis Figure 17.1 Change in real 18.4% United Kingdom exchange rate: dollar versus 5.8% Italy major currencies, 14.6% Germany 1986–1999. 9.3% France 11.5% Japan Canada 14.9% 25% 20% 15% 10% 5% 0% 5% 10% 15% 20% to political developments leading up to the transfer of governance to China. The biggest in- ternational economic story in late 1997 and 1998 was the turmoil in several Asian economies, notably Thailand, Indonesia, and South Korea. The close interplay between pol- itics and economics was also highlighted by these episodes, as both currency and stock val- ues swung with enormous volatility in response to developments concerning the prospects for aid from the International Monetary Fund. In August 1998, the shockwaves following Russia’s devaluation of the ruble and its default on some of its debt created havoc in world security markets, ultimately requiring a rescue of the giant hedge fund Long Term Capital Management to avoid further major disruptions. In the immediate future, the degree to which the European Monetary Union is successful will again illustrate the important inter- action between the political and economic arenas. Other political issues that are less sensational but still extremely important to economic growth and investment returns include issues of protectionism and trade policy, the free flow of capital, and the status of a nation’s work force. One obvious factor that affects the international competitiveness of a country’s indus- tries is the exchange rate between that country’s currency and other currencies. The ex- change rate is the rate at which domestic currency can be converted into foreign currency. For example, in late 2000, it took about 106 Japanese yen to purchase one U.S. dollar. We would say that the exchange rate is ¥106 per dollar or, equivalently, $.0094 per yen. As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly fluctuates. For example, in 1980, the dollar–yen exchange rate was about $.0045 per yen. Be- cause the exchange rate today is $.0094 per yen, a U.S. citizen would need more than twice as many dollars in 2000 to buy a product selling for ¥10,000 than would have been required in 1980. If the Japanese producer were to maintain a fixed yen price for its product, the price expressed in U.S. dollars would have to double. This would make Japanese products more ex- pensive to U.S. consumers, however, and result in lost sales. Obviously, appreciation of the yen creates a problem for Japanese producers that must compete with U.S. producers. Figure 17.1 shows the change in the purchasing power of the U.S. dollar relative to the purchasing power of the currencies of several major industrial countries in the period between 1986 and 1999. The ratio of purchasing powers is called the “real,” or inflation-adjusted, ex- change rate. The change in the real exchange rate measures how much more or less expensive foreign goods have become to U.S. citizens, accounting for both exchange rate fluctuations and inflation differentials across countries. A positive value in Figure 17.1 means that the dol- lar has gained purchasing power relative to another currency; a negative number indicates a depreciating dollar. Therefore, the figure shows that goods priced in terms of the British pound have become far more expensive to U.S. consumers, but that goods priced in Canadian dollars have become cheaper. Conversely, goods priced in U.S. dollars have become more af- fordable to British consumers, but more expensive to Canadian consumers.
  4. 4. 540 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 535 Figure 17.2 S&P 500 index versus earnings per share forecast. 1,745 1,681 1,617 1,553 1,489 1,425 1,361 1,297 EPS x 26 1,233 1,168 1,104 EPS x 23 1,040 976 EPS x 17 912 848 EPS x 20 784 720 EPS x 14 656 592 528 EPS x 11 464 400 EPS x 8 336 272 208 144 80 12/78 12/80 12/82 12/84 12/86 12/88 12/90 12/92 12/94 12/96 12/98 12/00 S&P 500 Index Source: I/B/E/S Inc., September 2000. 17.2 THE DOMESTIC MACROECONOMY The macroeconomy is the environment in which all firms operate. The importance of the macroeconomy in determining investment performance is illustrated in Figure 17.2, which compares the level of the S&P 500 stock price index to forecasts of earnings per share of the S&P 500 companies. The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock price to earnings varies with factors such as interest rates, risk, inflation rates, and other variables, the graph does illustrate that as a general rule the ratio has tended to be in the range of 10 to 20. Given “normal” price–earnings ratios, we would expect the S&P 500 index to fall within these boundaries. Although the earnings- multiplier rule clearly is not perfect—note the dramatic increase in the price-earnings mul- tiple in recent years—it also seems clear that the level of the broad market and aggregate earnings do trend together. Thus the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole. The ability to forecast the macroeconomy can translate into spectacular investment per- formance. But it is not enough to forecast the macroeconomy well. You must forecast it better than your competitors to earn abnormal profits. In this section, we will review some of the key economic statistics used to describe the state of the macroeconomy. Some of these key variables are: Gross Domestic Product. Gross domestic product, or GDP, is the measure of the economy’s total production of goods and services. Rapidly growing GDP indicates an expanding economy with ample opportunity for a firm to increase sales. Another popular measure of the economy’s output is industrial production. This statistic provides a measure of economic activity more narrowly focused on the manufacturing side of the economy.
  5. 5. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 541 Investments, Fifth Edition Industry Analysis Companies, 2001 536 PART V Security Analysis Employment. The unemployment rate is the percentage of the total labor force (i.e., those who are either working or actively seeking employment) yet to find work. The unemployment rate measures the extent to which the economy is operating at full capacity. The unemployment rate is a factor related to workers only, but further insight into the strength of the economy can be gleaned from the unemployment rate for other factors of production. Analysts also look at the factory capacity utilization rate, which is the ratio of actual output from factories to potential output. Inflation. Inflation is the rate at which the general level of prices is rising. High rates of inflation often are associated with “overheated” economies, that is, economies where the demand for goods and services is outstripping productive capacity, which leads to upward pressure on prices. Most governments walk a fine line in their economic policies. They hope to stimulate their economies enough to maintain nearly full employment, but not so much as to bring on inflationary pressures. The perceived trade-off between inflation and unemployment is at the heart of many macroeconomic policy disputes. There is considerable room for disagreement as to the relative costs of these policies as well as the economy’s relative vulnerability to these pressures at any particular time. Interest Rates. High interest rates reduce the present value of future cash flows, thereby reducing the attractiveness of investment opportunities. For this reason, real interest rates are key determinants of business investment expenditures. Demand for housing and high-priced consumer durables such as automobiles, which are commonly financed, also is highly sensitive to interest rates because interest rates affect interest payments. (In Chapter 5, Section 5.1, we examined the determinants of interest rates.) Budget Deficit. The budget deficit of the federal government is the difference between government spending and revenues. Any budgetary shortfall must be offset by government borrowing. Large amounts of government borrowing can force up interest rates by increasing the total demand for credit in the economy. Economists generally believe excessive government borrowing will “crowd out” private borrowing and investing by forcing up interest rates and choking off business investment. Sentiment. Consumers’ and producers’ optimism or pessimism concerning the economy is an important determinant of economic performance. If consumers have confidence in their future income levels, for example, they will be more willing to spend on big-ticket items. Similarly, businesses will increase production and inventory levels if they anticipate higher demand for their products. In this way, beliefs influence how much consumption and investment will be pursued and affect the aggregate demand for goods and services. Consider an economy where the dominant industry is automobile production for domestic con- CONCEPT sumption as well as export. Now suppose the auto market is hurt by an increase in the length of CHECK QUESTION 1
  6. 6. time people use their cars before replacing them. Describe the probable effects of this change on (a) GDP, (b) unemployment, (c) the government budget deficit, and (d) interest rates. 17.3 DEMAND AND SUPPLY SHOCKS A useful way to organize your analysis of the factors that might influence the macroecon- omy is to classify any impact as a supply or demand shock. A demand shock is an event that affects the demand for goods and services in the economy. Examples of positive demand shocks are reductions in tax rates, increases in the money supply, increases in government spending, or increases in foreign export demand. A supply shock is an event that influences
  7. 7. 542 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CONFLICTING ECONOMIC SIGNALS Despite last week’s return to optimism in the stock mar- Emphasizing Financial Stocks ket, nagging recession concerns continue to confound The divergent views play a crucial role in near-term in- Wall Street. vesting decisions. Mr. Clough has trimmed his exposure With conflicting economic signals, investors find to the stock market in favor of bonds and emphasizes fi- themselves in a quandary. Is the economy rapidly drop- nancial stocks, which would benefit in a low-rate envi- ping into recession, or close to one? Or is it simply taking ronment. a modest breath before strengthening later this year? Ms. Cohen, conversely, maintains a healthy exposure The recession quandary has split Wall Street strate- to the stock market and emphasizes not just financials, gists. One camp, which includes Charles Clough, chief but also economically sensitive stocks such as autos and strategist at Merrill Lynch & Co., argues that the econ- housing-related stocks. She further expects to emphasize omy is slowing much faster than realized. He says rising later-cyclical commodity stocks as the year unfolds and corporate inventories and a spent consumer are con- the economic pace quickens. tributing to a steepening slowdown. Moreover, the Fed- James Weiss, deputy chief investment officer for eral Reserve is moving too slowly to stave off a period of growth equities at State Street in Boston, and David extended sluggishness, and earnings will probably suffer Shulman, chief strategist at Salomon Brothers, concur more than anticipated this year. with much of Mr. Clough’s analysis of the economy. Mr. The other camp, which includes Abby J. Cohen, mar- Weiss says the recent uptick in cyclical stocks should be ket strategist at Goldman, Sachs & Co., believes that the mostly ignored, and he favors steadier growth in defen- economy will rebound later this year. sive sectors like health care and beverages. Source: Dave Kansas, “Conflicting Economic Signals Are Dividing Strategists,” The Wall Street Journal, February 26, 1996. Excerpted by permission of The Wall Street Journal, © 1996 Dow Jones & Company, Inc. All Rights Reserved Worldwide. production capacity and costs. Examples of supply shocks are changes in the price of im- ported oil; freezes, floods, or droughts that might destroy large quantities of agricultural crops; changes in the educational level of an economy’s work force; or changes in the wage rates at which the labor force is willing to work. Demand shocks are usually characterized by aggregate output moving in the same di- rection as interest rates and inflation. For example, a big increase in government spending will tend to stimulate the economy and increase GDP. It also might increase interest rates by increasing the demand for borrowed funds by the government as well as by businesses that might desire to borrow to finance new ventures. Finally, it could increase the inflation rate if the demand for goods and services is raised to a level at or beyond the total produc- tive capacity of the economy. Supply shocks are usually characterized by aggregate output moving in the opposite di- rection of inflation and interest rates. For example, a big increase in the price of imported oil will be inflationary because costs of production will rise, which eventually will lead to in- creases in prices of finished goods. The increase in inflation rates over the near term can lead to higher nominal interest rates. Against this background, aggregate output will be falling. With raw materials more expensive, the productive capacity of the economy is reduced, as is the ability of individuals to purchase goods at now-higher prices. GDP, therefore, tends to fall. How can we relate this framework to investment analysis? You want to identify the in- dustries that will be most helped or hurt in any macroeconomic scenario you envision. For example, if you forecast a tightening of the money supply, you might want to avoid indus- tries such as automobile producers that might be hurt by the likely increase in interest rates. We caution you again that these forecasts are no easy task. Macroeconomic predictions are notoriously unreliable. And again, you must be aware that in all likelihood your forecast will be made using only publicly available information. Any investment advantage you have will be a result only of better analysis—not better information.
  8. 8. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 543 Investments, Fifth Edition Industry Analysis Companies, 2001 538 PART V Security Analysis An example of how investment advice is tied to macroeconomic forecasts is given in the nearby box. The article focuses on the different advice being given by two prominent ana- lysts with differing views of the economy. The relatively bearish strategists believe the economy is about to slow down. As a result, they recommend asset allocation toward the fixed-income market, which will benefit if interest rates fall in a recession. Within the stock market, they recommend industries with below-average sensitivity to macroeconomic con- ditions. Two recession-resistant, or “defensive,” investments specifically cited are bever- age and health care stocks, both of which are expected to outperform the rest of the market as investors become aware of the slowdown in growth. Conversely, the optimistic analysts recommend investments with greater sensitivity to the business cycle. 17.4 FEDERAL GOVERNMENT POLICY As the previous section would suggest, the government has two broad classes of macro- economic tools—those that affect the demand for goods and services and those that affect the supply. For much of postwar history, demand-side policy has been of primary interest. The focus has been on government spending, tax levels, and monetary policy. Since the 1980s, however, increasing attention has been focused on supply-side economics. Broadly interpreted, supply-side concerns have to do with enhancing the productive capacity of the economy, rather than increasing the demand for the goods and services the economy can produce. In practice, supply-side economists have focused on the appropriateness of the in- centives to work, innovate, and take risks that result from our system of taxation. However, issues such as national policies on education, infrastructure (such as communication and transportation systems), and research and development also are properly regarded as part of supply-side macroeconomic policy. Fiscal Policy Fiscal policy refers to the government’s spending and tax actions and is part of “demand- side management.” Fiscal policy is probably the most direct way either to stimulate or to slow the economy. Decreases in government spending directly deflate the demand for goods and services. Similarly, increases in tax rates immediately siphon income from con- sumers and result in fairly rapid decreases in consumption. Ironically, although fiscal policy has the most immediate impact on the economy, the formulation and implementation of such policy is usually painfully slow and involved. This is because fiscal policy requires enormous amounts of compromise between the executive and legislative branches. Tax and spending policy must be initiated and voted on by Con- gress, which requires considerable political negotiations, and any legislation passed must be signed by the president, requiring more negotiation. Thus, although the impact of fiscal policy is relatively immediate, its formulation is so cumbersome that fiscal policy cannot in practice be used to fine-tune the economy. Moreover, much of government spending, such as that for Medicare or social security, is nondiscretionary, meaning that it is determined by formula rather than policy and cannot be changed in response to economic conditions. This places even more rigidity into the for- mulation of fiscal policy. A common way to summarize the net impact of government fiscal policy is to look at the government’s budget deficit or surplus, which is simply the difference between revenues and expenditures. A large deficit means the government is spending considerably more than it is taking in by way of taxes. The net effect is to increase the demand for goods (via spending) by more than it reduces the demand for goods (via taxes), thereby stimulating the economy.
  9. 9. 544 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 539 Monetary Policy Monetary policy refers to the manipulation of the money supply to affect the macroecon- omy and is the other main leg of demand-side policy. Monetary policy works largely through its impact on interest rates. Increases in the money supply lower short-term inter- est rates, ultimately encouraging investment and consumption demand. Over longer peri- ods, however, most economists believe a higher money supply leads only to a higher price level and does not have a permanent effect on economic activity. Thus the monetary authorities face a difficult balancing act. Expansionary monetary policy probably will lower interest rates and thereby stimulate investment and some consumption demand in the short run, but these circumstances ultimately will lead only to higher prices. The stimulation/inflation trade-off is implicit in all debate over proper monetary policy. Fiscal policy is cumbersome to implement but has a fairly direct impact on the economy, whereas monetary policy is easily formulated and implemented but has a less direct impact. Monetary policy is determined by the Board of Governors of the Federal Reserve System. Board members are appointed by the president for 14-year terms and are reasonably insu- lated from political pressure. The board is small enough, and often sufficiently dominated by its chairperson, that policy can be formulated and modulated relatively easily. Implementation of monetary policy also is quite direct. The most widely used tool is the open market operation, in which the Fed buys or sells bonds for its own account. When the Fed buys securities, it simply “writes a check,” thereby increasing the money supply. (Un- like us, the Fed can pay for the securities without drawing down funds at a bank account.) Conversely, when the Fed sells a security, the money paid for it leaves the money supply. Open market operations occur daily, allowing the Fed to fine-tune its monetary policy. Other tools at the Fed’s disposal are the discount rate, which is the interest rate it charges banks on short-term loans, and the reserve requirement, which is the fraction of deposits that banks must hold as cash on hand or as deposits with the Fed. Reductions in the dis- count rate signal a more expansionary monetary policy. Lowering reserve requirements allows banks to make more loans with each dollar of deposits and stimulates the economy by increasing the effective money supply. Monetary policy affects the economy in a more roundabout way than fiscal policy. Whereas fiscal policy directly stimulates or dampens the economy, monetary policy works largely through its impact on interest rates. Increases in the money supply lower interest rates, which stimulates investment demand. As the quantity of money in the economy in- creases, investors will find that their portfolios of assets include too much money. They will rebalance their portfolios by buying securities such as bonds, forcing bond prices up and interest rates down. In the longer run, individuals may increase their holdings of stocks as well and ultimately buy real assets, which stimulates consumption demand directly. The ultimate effect of monetary policy on investment and consumption demand, however, is less immediate than that of fiscal policy. CONCEPT Suppose the government wants to stimulate the economy without increasing interest rates. What CHECK QUESTION 2
  10. 10. combination of fiscal and monetary policy might accomplish this goal? Supply-Side Policies Fiscal and monetary policy are demand-oriented tools that affect the economy by stimulat- ing the total demand for goods and services. The implicit belief is that the economy will not by itself arrive at a full employment equilibrium, and that macroeconomic policy can push
  11. 11. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 545 Investments, Fifth Edition Industry Analysis Companies, 2001 540 PART V Security Analysis the economy toward this goal. In contrast, supply-side policies treat the issue of the produc- tive capacity of the economy. The goal is to create an environment in which workers and owners of capital have the maximum incentive and ability to produce and develop goods. Supply-side economists also pay considerable attention to tax policy. Whereas demand siders look at the effect of taxes on consumption demand, supply siders focus on incentives and marginal tax rates. They argue that lowering tax rates will elicit more investment and im- prove incentives to work, thereby enhancing economic growth. Some go so far as to claim that reductions in tax rates can lead to increases in tax revenues because the lower tax rates will cause the economy and the revenue tax base to grow by more than the tax rate is reduced. CONCEPT Large tax cuts in the 1980s were followed by rapid growth in GDP. How would demand-side and CHECK QUESTION 3
  12. 12. supply-side economists differ in their interpretations of this phenomenon? 17.5 BUSINESS CYCLES We’ve looked at the tools the government uses to fine-tune the economy, attempting to maintain low unemployment and low inflation. Despite these efforts, economies repeatedly seem to pass through good and bad times. One determinant of the broad asset allocation de- cision of many analysts is a forecast of whether the macroeconomy is improving or deteri- orating. A forecast that differs from the market consensus can have a major impact on investment strategy. The Business Cycle The economy recurrently experiences periods of expansion and contraction, although the length and depth of those cycles can be irregular. This recurring pattern of recession and re- covery is called the business cycle. Figure 17.3 presents graphs of several measures of pro- duction and output for the years 1967–1998. The production series all show clear variation around a generally rising trend. The bottom graph of capacity utilization also evidences a clear cyclical (although irregular) pattern. The transition points across cycles are called peaks and troughs, labeled P and T at the top of the graph. A peak is the transition from the end of an expansion to the start of a con- traction. A trough occurs at the bottom of a recession just as the economy enters a recov- ery. The shaded areas in Figure 17.3 all represent periods of recession. As the economy passes through different stages of the business cycle, the relative per- formance of different industry groups might be expected to vary. For example, at a trough, just before the economy begins to recover from a recession, one would expect that cyclical industries, those with above-average sensitivity to the state of the economy, would tend to outperform other industries. Examples of cyclical industries are producers of durable goods such as automobiles or washing machines. Because purchases of these goods can be de- ferred during a recession, sales are particularly sensitive to macroeconomic conditions. Other cyclical industries are producers of capital goods, that is, goods used by other firms to produce their own products. When demand is slack, few companies will be expanding and purchasing capital goods. Therefore, the capital goods industry bears the brunt of a slowdown but does well in an expansion. In contrast to cyclical firms, defensive industries have little sensitivity to the business cycle. These are industries that produce goods for which sales and profits are least sensitive to the state of the economy. Defensive industries include food producers and processors,
  13. 13. 546 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 541 Figure 17.3 Cyclical indicators 1967–1998. Source: The Conference Board, Business Cycle Indicators, February 1999. pharmaceutical firms, and public utilities. These industries will outperform others when the economy enters a recession. The cyclical/defensive classification corresponds well to the notion of systematic or market risk introduced in our discussion of portfolio theory. When perceptions about the health of the economy become more optimistic, for example, the prices of most stocks will increase as forecasts of profitability rise. Because the cyclical firms are most sensitive to such developments, their stock prices will rise the most. Thus firms in cyclical industries will tend to have high-beta stocks. In general, then, stocks of cyclical firms will show the best results when economic news is positive but the worst results when that news is bad.
  14. 14. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 547 Investments, Fifth Edition Industry Analysis Companies, 2001 542 PART V Security Analysis Table 17.2 A. Leading indicators Indexes of 1. Average weekly hours of production workers (manufacturing) Economic Indicators 2. Initial claims for unemployment insurance 3. Manufacturers’ new orders (consumer goods and materials industries) 4. Vendor performance—slower deliveries diffusion index 5. New orders for nondefense capital goods 6. New private housing units authorized by local building permits 7. Yield curve slope: 10-year Treasury minus federal funds rate 8. Stock prices, 500 common stocks 9. Money supply (M2) 10. Index of consumer expectations B. Coincident indicators 1. Employees on nonagricultural payrolls 2. Personal income less transfer payments 3. Industrial production 4. Manufacturing and trade sales C. Lagging indicators 1. Average duration of unemployment 2. Ratio of trade inventories to sales 3. Change in index of labor cost per unit of output 4. Average prime rate charged by banks 5. Commercial and industrial loans outstanding 6. Ratio of consumer installment credit outstanding to personal income 7. Change in consumer price index for services Source: The Conference Board, Business Cycle Indicators, February 2000. Conversely, defensive firms will have low betas and performance that is relatively unaf- fected by overall market conditions. If your assessments of the state of the business cycle were reliably more accurate than those of other investors, you would simply choose cyclical industries when you are rela- tively more optimistic about the economy and defensive firms when you are relatively more pessimistic. Unfortunately, it is not so easy to determine when the economy is pass- ing through a peak or a trough. It if were, choosing between cyclical and defensive indus- tries would be easy. As we know from our discussion of efficient markets, however, attractive investment choices will rarely be obvious. It usually is not apparent that a reces- sion or expansion has started or ended until several months after the fact. With hindsight, the transitions from expansion to recession and back might be apparent, but it is often quite difficult to say whether the economy is heating up or slowing down at any moment. Economic Indicators Given the cyclical nature of the business cycle, it is not surprising that to some extent the cycle can be predicted. A set of cyclical indicators computed by the Conference Board helps forecast, measure, and interpret short-term fluctuations in economic activity. Lead- ing economic indicators are those economic series that tend to rise or fall in advance of the rest of the economy. Coincident and lagging indicators, as their names suggest, move in tandem with or somewhat after the broad economy. Ten series are grouped into a widely followed composite index of leading economic in- dicators. Similarly, four coincident and seven lagging indicators form separate indexes. The composition of these indexes appears in Table 17.2.
  15. 15. 548 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 543 Figure 17.4 Indexes of leading, coincident, and lagging indicators. CYCLICAL INDICATORS Composite Indexes Index: 1992=100 Apr Apr Feb Dec Nov Nov Mar Jan July July Nov July Mar T P T P T P T P T P T P T 110 110 910. Composite index of 10 leading indicators –6 100 (series 1,5, 8, 19, 27, 29, 32, 83, 106, 129) 100 –9 –15 –3 90 –8 90 80 80 –11 Dec 110 120 120 110 920. Composite index of 4 coincident indicators –1 110 100 (series 41,47, 51, 57) 100 90 100 0 0 0 90 80 0 80 70 90 0 +1 70 –2 60 0 60 80 0 50 50 0 0 Dec 40 40 930. Composite index of 7 lagging indicators +3 –12 110 110 (series 62,77, 91, 95, 27, 101, 109, 120) +2 +3 +13 100 100 +3 +6 +21 +15 +22 90 +3 90 +9 Dec 80 80 110 940. Ratio, coincident index to lagging index 110 100 0 100 90 90 –10 –8 –2 80 80 –11 70 –10 70 –2 –2 60 0 60 –11 –4 –10 50 Dec 50 59 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 Note — Series 910,920, 930 and 940 are plotted on a ratio scale Source: The Conference Board, Business Cycle Indicators, February 1999. Figure 17.4 graphs these three series over the period 1958–1998. The numbers on the charts near the turning points of each series indicate the length of the lead time or lag time (in months) from the turning point to the designated peak or trough of the corresponding business cycle. Although the index of leading indicators consistently turns before the rest of the economy, the lead time is somewhat erratic. Moreover, the lead time for peaks is consistently longer than that for troughs. The stock market price index is a leading indicator. This is as it should be, as stock prices are forward-looking predictors of future profitability. Unfortunately, this makes the series of leading indicators much less useful for investment policy—by the time the series
  16. 16. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 549 Investments, Fifth Edition Industry Analysis Companies, 2001 544 PART V Security Analysis Table 17.3 Statistic Release Date* Source Economic Calendar Auto and truck sales 2nd of month Commerce Department Business inventories 15th of month Commerce Department Construction spending 1st business day of month Commerce Department Consumer confidence Last Tuesday of month Conference Board Consumer credit 5th business day of month Federal Reserve Board Consumer price index (CPI) 13th of month Bureau of Labor Statistics Durable goods orders 26th of month Commerce Department Employment cost index End of first month of quarter Bureau of Labor Statistics Employment record 1st Friday of month Bureau of Labor Statistics (unemployment, average workweek, nonfarm payrolls) Existing home sales 25th of month National Association of Realtors Factory orders 1st business day of month Commerce Department Gross domestic product 3rd–4th week of month Commerce Department Housing starts 16th of month Commerce Department Industrial production 15th of month Federal Reserve Board Initial claims for jobless Thursdays Department of Labor benefits International trade balance 20th of month Commerce Department Index of leading economic Beginning of month Conference Board indicators Money supply Thursdays Federal Reserve Board New home sales Last business day of month Commerce Department Producer price index 11th of month Bureau of Labor Statistics Productivity and costs 2nd month in quarter Bureau of Labor Statistics (approx. 7th day of month) Retail sales 13th of month Commerce Department Survey of purchasing 1st business day of month National Association of managers Purchasing Managers *Many of these release dates are approximate. Source: Charter Media, Inc., predicts an upturn, the market his already made its move. Although the business cycle may be somewhat predictable, the stock market may not be. This is just one more manifestation of the efficient markets hypothesis. The money supply is another indicator. This makes sense in light of our earlier discus- sion concerning the lags surrounding the effects of monetary policy on the economy. An expansionary monetary policy can be observed fairly quickly, but it might not affect the economy for several months. Therefore, today’s monetary policy might well predict future economic activity. Other leading indicators focus directly on decisions made today that will affect production in the near future. For example, manufacturers’ new orders for goods, contracts and orders for plant and equipment, and housing starts all signal a coming expansion in the economy. A wide range of economic indicators are released to the public on a regular “economic calendar.” Table 17.3 is an “economic calendar,” listing the public announcement dates and sources for about 20 statistics of interest. These announcements are reported in the financial
  17. 17. 550 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 545 Figure 17.5 Economic calendar at Yahoo! Economic Calendar Apr. 13–Apr. 16 Last Week Next Week Time Briefing Market Revised Date (ET) Statistic For Actual Forecast Expects Prior From Apr 8:30 am CPI Mar 0.2% 0.4% 0.3% 0.1% 0.1% 13 8:30 am CPI ex-food & energy Mar 0.1% 0.2% 0.2% 0.1% 0.1% 8:30 am Retail Sales Mar 0.2% 0.2% 0.4% 1.7% 0.9% Apr 8:30 am Business Inventories Feb 0.4% 0.4% 0.2% Unch 0.1% 14 Apr 8:30 am Intial Claims 04/10 – 305K 295K 299K – 15 4:30 pm M2 (Money Supply) 04/05 – NA NA $8.8B – Apr 8:30 am Building Permits Mar – 1.730M 1.730M 1.745M – 16 8:30 am Housing Starts Mar – 1.770M 1.750M 1.799M – 9:15 am Capacity Utilization Mar – 80.0% 80.2% 80.3% – 9:15 am Industrial Production Mar – Unch 0.2% 0.2% – 10:00 am Michigan Sentiment Apr – 107.0 106.0 105.7 – press, for example The Wall Street Journal, as they are released. They also are available on the World Wide Web, for example, at the Yahoo! website. Figure 17.5 is an excerpt from the Economic Calendar page at Yahoo! The page gives a list of the announcements to appear during the week. (The page was printed on April 14, so it gives actual values for statistics re- leased on April 13 and 14, but not those to be released later in the week.) Notice that recent forecasts of each variable are provided along with the actual value of each statistic. This is useful, because in an efficient market, security prices already will reflect market expecta- tions. The new information in the announcement will determine the market response. 17.6 INDUSTRY ANALYSIS Industry analysis is important for the same reason that macroeconomic analysis is. Just as it is difficult for an industry to perform well when the macroeconomy is ailing, it is unusual for a firm in a troubled industry to perform well. Similarly, just as we have seen that eco- nomic performance can vary widely across countries, performance also can vary widely across industries. Figure 17.6 illustrates the dispersion of industry performance. It shows projected growth in earnings per share in 2000 and 2001 for several major industry groups. The forecasts for 2001, which come from a survey of industry analysts, range from 5.1% for energy to 37.9% for technology firms. Industry groups show even more dispersion in their stock market performance. Figure 17.7 illustrates the performance of the 10 best- and 10 worst-performing industries in 1999. The spread in performance is remarkable, ranging from an 222% return for the mobile communication industry to a 54.4% loss in the tobacco industry. Even small investors can easily take positions in industry performance using mutual funds with an industry focus. For example, Fidelity offers about 40 Select Funds, each of which is invested in a particular industry.
  18. 18. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 551 Investments, Fifth Edition Industry Analysis Companies, 2001 546 PART V Security Analysis Figure 17.6 Earnings growth estimates in several industries. 60 107.7 2000 2001 50 41.4 40 37.1 37.9 29.3 30 27.1 21.6 22.7 22.8 22.9 20.4 20.2 20.1 20 18.7 13.5 12.5 13.8 12.9 13.3 10 7.1 7.8 6.9 5.1 3.0 0 I/B/E/S* Basic Capital Consumer Consumer Consumer Energy Financial Health Public Technology Transpor- industries goods durables non- services services care utilities tation durables No. of firms: 4762 250 339 163 211 935 198 803 530 198 1042 93 *Institutional Brokers Estimate System. Source: U.S. Comments, Institutional Brokers Estimate System (I/B/E/S), September 2000. Defining an Industry Although we know what we mean by an “industry,” it can be difficult in practice to decide where to draw the line between one industry and another. Consider, for example, the fi- nancial services industry. Figure 17.6 shows that the forecast for 2001 growth in industry earnings per share was 13.3%. But the financial services “industry” contains firms with widely differing products and prospects. Figure 17.8 breaks down the industry into seven subgroups. The forecasted performance on these more narrowly defined groups differs widely, suggesting that they are not members of a homogeneous industry. Similarly, most of these subgroups in Figure 17.8 could be divided into even smaller and more homoge- neous groups. A useful way to define industry groups in practice is given by Standard Industry Clas- sification, or SIC codes. These are codes assigned by the U.S. government for the purpose of grouping firms for statistical analysis. The first two digits of the SIC codes denote very broad industry classifications. For example, the SIC codes assigned to any type of building contractor all start with 15. The third and fourth digits define the industry grouping more narrowly. For example, codes starting with 152 denote residential building contractors, and group 1521 contains single-family building contractors. Firms with the same four-digit SIC code, therefore, are commonly taken to be in the same industry. Many statistics are com- puted for even more narrowly defined five-digit SIC groups. SIC industry classifications are not perfect. For example, both J.C. Penney and Neiman Marcus are in group 5311, Department Stores. Yet the former is a high-volume “value” store, whereas the latter is a high-margin elite retailer. Are they really in the same industry? Still, SIC classifications are a tremendous aid in conducting industry analysis since they provide a means of focusing on very broad or fairly narrowly defined groups of firms.
  19. 19. 552 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 547 Figure 17.7 Industry stock price performance, 1999. Mobile communication 222.22 Industrial technology 168.01 Aluminum 107.30 Communications technology 102.88 Software 88.93 Cable/broadcasting 79.32 Biotechnology 70.81 Semiconductors 69.42 Advertising 69.31 Specialty retailers 67.68 Clothing/fabric 24.33 Insurance, property 24.85 Savings and loan 26.86 Food retailers 34.46 Home construction 37.04 Drug retailers 38.09 1999 return Tires and rubber 40.79 Office equipment 48.71 Pollution control 50.00 Tobacco 54.40 100 50 0 +50 +100 +150 +200 +250 Percent return Source: The Wall Street Journal, January 3, 1998. © 1998 Dow Jones & Company, Inc. All Rights Reserved Worldwide. Several other industry classifications are provided by other analysts; for example, Stan- dard & Poor’s reports on the performance of about 100 industry groups. S&P computes stock price indexes for each group, which is useful in assessing past investment perfor- mance. The Value Line Investment Survey reports on the conditions and prospects of about 1,700 firms, grouped into about 90 industries. Value Line’s analysts prepare forecasts of the performance of industry groups as well as of each firm. Sensitivity to the Business Cycle Once the analyst forecasts the state of the macroeconomy, it is necessary to determine the implication of that forecast for specific industries. Not all industries are equally sensitive to the business cycle. For example, consider Figure 17.9, which is a graph of automobile production and shipments of cigarettes, both scaled so that 1963 has a value of 100. Clearly, the cigarette industry is virtually independent of the business cycle. Demand for cigarettes does not seem affected by the state of the macroeconomy in any meaningful way. This is not surprising. Cigarette consumption is determined largely by habit and is a small enough part of most budgets that it will not be given up in hard times.
  20. 20. Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill 553 Investments, Fifth Edition Industry Analysis Companies, 2001 548 PART V Security Analysis Figure 17.8 Earnings estimates for financial services industries. 40 37.5 2000 2001 35 30 24.9 24.6 25 18.4 20 16.3 15.3 15 12.9 13.3 12.8 11.7 12.0 10.7 9.5 9.4 10 8.1 5 3.4 0 Financial Banking Finance Financial Insurance Investments Savings Leasing services and Loan Services and Loans No. of firms: 803 261 48 57 144 76 204 11 Source: U.S. Comments, I/B/E/S Inc., September 2000. Auto production, by contrast, is highly volatile. In recessions, consumers can try to pro- long the lives of their cars until their income is higher. For example, the worst year for auto production, according to Figure 17.9, was 1982. This was also a year of deep recession, with the unemployment rate at 9.5%. Three factors will determine the sensitivity of a firm’s earnings to the business cycle. First is the sensitivity of sales. Necessities will show little sensitivity to business condi- tions. Examples of industries in this group are food, drugs, and medical services. Other in- dustries with low sensitivity are those for which income is not a crucial determinant of demand. As we noted, tobacco products are examples of this type of industry. Another in- dustry in this group is movies, because consumers tend to substitute movies for more ex- pensive sources of entertainment when income levels are low. In contrast, firms in industries such as machine tools, steel, autos, and transportation are highly sensitive to the state of the economy. The second factor determining business cycle sensitivity is operating leverage, which refers to the division between fixed and variable costs. (Fixed costs are those the firm in- curs regardless of its production levels. Variable costs are those that rise or fall as the firm produces more or less product.) Firms with greater amounts of variable as opposed to fixed costs will be less sensitive to business conditions. This is because in economic downturns, these firms can reduce costs as output falls in response to falling sales. Profits for firms with high fixed costs will swing more widely with sales because costs do not move to off- set revenue variability. Firms with high fixed costs are said to have high operating lever- age, as small swings in business conditions can have large impacts on profitability.
  21. 21. 554 Bodie−Kane−Marcus: V. Security Analysis 17. Macroeconomics and © The McGraw−Hill Investments, Fifth Edition Industry Analysis Companies, 2001 CHAPTER 17 Macroeconomic and Industry Analysis 549 Figure 17.9 Industry cyclicality. 140 Annual sales (1963 = 100) 120 100 80 60 Cigarette sales 40 Passenger cars sales 20 0 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 Source: Passenger car sales: Ward’s Automobile Yearbook, 1994. Cigarette sales: Department of Alcohol, Tobacco, and Firearms Statistical Releases. An example might help illustrate this concept. Consider two firms operating in the same industry with identical revenues in all phases of the business cycle: recession, normal, and expansion. Firm A has short-term leases on most of its equipment and can reduce its lease expenditures when production slackens. It has fixed costs of $5 million and variable costs of $1 per unit of output. Firm B has long-term leases on most of its equipment and must make lease payments regardless of economic conditions. Its fixed costs are higher, $8 mil- lion, but its variable costs are only $.50 per unit. Table 17.4 shows that Firm A will do bet- ter in recessions than Firm B, but not as well in expansions. A’s costs move in conjunction with its revenues to help performance in downturns and impede performance in upturns. We can quantify operating leverage by measuring how sensitive profits are to changes in sales. The degree of operating leverage, or DOL, is defined as Percentage change in profits DOL Percentage change in sales DOL greater than 1 indicates some operating leverage. For example, if DOL 2, then for every 1% change in sales, profits will change by 2% in the same direction, either up or down. We have seen that the degree of operating leverage increases with a firm’s exposure to fixed costs. In fact, one can show that DOL depends on fixed costs in the following manner:1 Fixed costs DOL 1 Profits As a concrete example of operating leverage, return to the two firms illustrated in Table 17.4 and compare profits and sales in the “normal” scenario for the economy with those in a recession. Profits of Firm A fall by 100% (from $1 million to zero) when sales fall by 16.7% (from $6 million to $5 million): Percentage change in profits 100% DOL(Firm A) 6 Percentage change in sales 16.7% 1 Operating leverage and DOL are treated in more detail in most corporate finance texts.