Transcript Lecture Slides – Week 3

Introduction to Investments
TOP DOWN OR BOTTOM UP ANALYSIS?
 The usual practice as recommended by the CFA Institute is a top-down approach to analyzing
equities.
 First is a look at macro-economic conditions (usually local, increasingly global) to get a sense of the
state of the world.
 Second is to look at industry-level information.
 Third is company level (technical and fundamental analysis).
 This is the approach we follow.
US GDP Growth (total production of goods and services).
 Long-term US GDP growth rate of
about 3% (pretty spectacular for a
large mature economy). Last 5 years
about 2%, going forward?
 India GDP measurement underwent a
dramatic revision in 2015 to bring
more in line with peers.
Look at GDP per capita (tied to population growth).
 Japan has a declining GDP and a
declining population but is better
than US per capita! Somewhat the
same story in Germany.
 Story for India, historically at 6.8%
versus China (10.2%), the disparity is
not so evident in GDP growth.
Forward looking from 2015, India at
7:5%, China?
Components of US GDP (varies across countries).
 This is why there is so much
worry about consumers!
US unemployment rates.
 Unemployment rate is a lagging
indicator. Seems to spike during
recessions (shaded), not a
smooth response to slowing
growth. Productive resources
become idle and fairly quickly. So
recessions do matter, despite the
long-term trend of growth.
Inflation.
US Consumer Price Index components.
Component
Weight In
CPI
Calculation
Housing
Food
Transportation
Energy
Medical
Education/Communication
Recreation
38.0%
17.2
12.9
8.7
6.3
6.0
5.5
 Core rate excludes food and energy (hangover of 70’s oil crisis). Long run, these are more likely to be
transitory, why should the Fed be heavy handed if that is the case?
Other considerations.
 Hedonic adjustments take out the value of quality improvements to goods and services to more
“accurately” capture a price change. Compounded by a heavier weighting attached to items
dropping in price as people will substitute? Together understate inflation.
 Some efforts at using median or mean CPI, trimmed to eliminate outliers. PCE (personal consumption
expenditure deflator). Updated more frequently than Core CPI, very popular with the Fed.
 Housing prices are measured as rent equivalents. In the 2000’s as people bought houses, rents were
low so measuring housing costs as rent equivalents kept inflation numbers down. Today, the reverse
is true perhaps even distorting upwards !!!
Deflation.
 The good kind=> supply side, prices fall due to oversupply, cost –cutting and productivity increases.
 The bad kind=> demand side, consumer spending and confidence decline, business investment
suffers (Japan in the 2000s)
 Stagflation: slowing growth, higher inflation, high unemployment.
INTEREST RATES, DEMAND AND SUPPLY
 There are many interest rates, prime rates, treasury rates, mortgage rates, some are long-term some are short
term, generally tend to move together locally and now globally. For now, focus on how policy affects these.
 Supply of funds: savers will increase if real interest rates are higher, i.e. benefits to deferring consumption into the
future. Implication of central bank liquidity and low rates on propensity of people to save.
 Demand for funds from business - will borrow if real interest rates are lower.
 Government : will affect both: higher budget deficits increase the demand for funds and therefore interest rates. Fed
policy offsets these by increasing money supply which adjusts nominal rates.
 Inflation increases if demand levels are beyond the productive capacity of the economy.
 Demand shocks are: reduced taxes, export demand, budget deficits.
 Supply shocks are: oil prices, commodity prices both reduce productive capacity.
US Monetary policy (easy to implement/reverse, takes time).
 Increases (decrease) in growth of money supply.
 Adjust short-term rates via open market transactions in T-bonds.
 The US Fed has historically embarked on a gradual program of increasing (decreasing) rates. Evidence of the
1975, 1982, 1991, suggests this worked well, typically preceding business expansions (contractions) by 8 (20)
months. In fact, it worked so well that growth/employment targets get ambitious, triggering possible inflation.
So Fed became pro-active, raising rates to slow economy to head off inflation.
 11 cuts in 2001-2002, from 6.5%. After Sep 11, Fed provided more liquidity via repos. Effective overnight rates
were close to 0.
 Since then 12 hikes in the mid 2000s.
 Since the global financial crisis, rates have been kept low. The first hike of the current cycle started December
2015. Market participants are not convinced that the US economy can handle more of these.
Fiscal policy (hard to implement/reverse, works quickly).
 Tax relief (been there, done that).
 Deficit spending, keeps long-term interest rates high.
Supply side –policies
 Both above policies are demand-side to push economy to achieve full employment equilibrium.
 In contrast, supply side policies address the economy’s productive capacity and devise incentive
schemes to encourage growth.
Business Cycles
Bonds
prices
Wages
cost > price
growth
stock
defensive
sales
profits
low inventory, overcap.
 Seven years of plenty and seven years of lean!
 Its death has been proclaimed several times, most recently in the late 1990’s. (post WW-II boom caused the
Commerce department to rename the Business Cycle Digest to the Business Conditions digest)
 Has been more subdued in the last 20 years (10% of the time in recessions versus 40% of the time in the
previous 90 years due to a) decreasing variability of output: agriculture => manufacture => services. b)
inventory control, c) globalization, d) better monetary and fiscal control, e) financial and banking
deregulation.
Why cyclical downturns even if periodicity not predictable?
 Exogenous (rising oil prices in 9 out of last 10 post-war, 9-11)
 Animal spirits (Keynes, insufficient demand, market failure as business investment swings from
optimism to pessimism, jobs and incomes fall amplifying the above, unemployment rises, need
government).
 Excessive supply, overinvestment, mismatch with savings.
 Policy mistakes (Fed actions first allow economies to overheat and then apply the brakes too hard).
Macroeconomic Indicators (NBER).
 Leading, lagged and coincident. Common convention that GDP decreases in 2 consecutive quarter
implies recession! Recently dated as 2 quarters of 2001.
 Generally, leading indicators appear to increase 3-4 months prior to a recovery and decrease 7-8
months prior to a downturn. Sceptics claim ‘stock prices forecast 9 of the last 5 recessions.”
 Diffusion indexes focus on the number of indicators that are up (or down) rather than the
magnitude.
INDICATORS FROM FINANCIAL MARKETS.
PEOPLE HAVE BEEN BUYING STOCKS!
INDICATORS FROM FINANCIAL MARKETS.
BUT HOW LONG ARE THEY HOLDING THEM?
VALUATION CHARTS FROM FINANCIAL MARKETS.
VALUATION CHARTS FROM FINANCIAL MARKETS.
VALUATION CHARTS FROM FINANCIAL MARKETS.
INDUSTRY ANALYSIS.
 Can do a life-cycle analysis of the industry to isolate likelihood of dividend payments:
Growth phase
= no dividends
Consolidation
= growing dividends
Maturity phase = steady/constant dividends
INDUSTRY ANALYSIS.
Sectors and the economy (again each time a little different)
a) Most correlated with expansions and contractions
Capital goods (factory machinery, aircraft)
Consumer cyclical
(auto, housing)
Technology (computers, telecom)
Transportation (airlines, shipping)
Best time to buy: growth has slowed and rates
falling
Worst time to buy: as fast growing economy
slows
b) Sectors that do well at end of expansions
Basic materials (steel, aluminium)
Energy (oil, natural gas)
c) Sectors that do well when the economy slows
Financial services
Utilities
d) Sectors best when heading into a recession
Consumer staples (food, toothpaste)
Healthcare (drugs, HMOs)
Longer term: focus on whether earnings estimates are likely to be cut, maintained, or will go but up.
Shorter term: are earnings surprises priced in?
EFFICIENT MARKETS-1.
 Random walks: no predictable pattern in stock prices.
Q: What if prices were predictable?
A: They would adjust immediately (who would wait around).
 So, market prices should reflect available information.
Q: Why do prices move then?
A: must move when there is new (unexpected) information.
Q: Is new information predictable?
A: Would expect new information to be random (some good, some bad)
 So, would expect deviations of prices from true value to be random (1/3 of stocks
overpriced, 1/3 under, 1/3 fairly priced…)
 THIS IS WHAT IS MEANT BY MARKET EFFICIENCY.
EFFICIENT MARKETS - 2
Q: If markets are efficient, why search for stocks
THE NOTION OF EFFICIENT MARKETS IS A HYPOTHESIS.
 TO CHECK IT, YOU TEST WHAT TYPES OF INFORMATION IS REFLECTED IN MARKET PRICES
•
Markets are efficient in the weak-form IF information from trading data such as past
price and volume is reflected in prices.
•
Markets are semi-strong form efficient IF all public info, (trading + fundamental) is
reflected in prices.
•
Markets are strong form efficient IF all info (public + private) is reflected in prices.
IMPLICATIONS OF THE EFFICIENT MARKET HYPOTHESIS (EMH).
If prices reflect available information and new information affects prices randomly THEN:
You wouldn’t expect people to generate risk-adjust alpha’s consistently.
A: Technical analysis
Technical analysts look at past trading data, prices, volumes, odd lots, short interest etc to
develop trading strategies.
IF these trading strategies are successful (i.e they generate positive risk adjusted alpha) =>
markets not efficient in the weak form.
IMPLICATIONS OF THE EFFICIENT MARKET HYPOTHESIS (EMH).
If prices reflect available information and new information affects prices randomly THEN:
You wouldn’t expect people to generate risk-adjust alpha’s consistently.
A: Technical analysis
B: Fundamental analysis.
Fundamental analysts look at financial statements, earnings, dividends, interest rates, risk
etc., and develop fair values for stock prices based on some sort of DCF or relative value analysis.
IF their trading strategies are consistently successful THEN
=>markets are not efficient in the semi-strong form.
IMPLICATIONS OF THE EFFICIENT MARKET HYPOTHESIS (EMH).
If prices reflect available information and new information affects prices randomly THEN:
You wouldn’t expect people to generate risk-adjust alpha’s consistently.
A: Technical analysis
B: Fundamental analysis.
C: Portfolio manager, insiders and others with private information
PMs spend resources on information
Insiders often know things that are not public.
IF even these guys cannot consistently generate risk-adjusted alpha,
=> markets are not efficient in the strong form.
SO WHAT IS THE EVIDENCE FOR OR AGAINST THE EMH?
 Insignificant runs and filter rule tests.
 Insignificant daily return auto-correlation (serial correlation)
 Later results positive over short horizons for portfolios (price momentum) but not for individual
stocks;
 Negative over long horizons (fads, overreaction).
 Winner-loser returns and reversals (losers beat winners by a cumulative 25% over 3-years).
 Other results on D/P, P/E, yield spreads appear to predict return
SO, SHORT RUN => MOMENTUM, LONG RUN => REVERSION
Evidence: semi-strong form (notion of event studies and abnormal returns)
 Post-earnings announcement drift (sluggish, slow response)
 January and tax-loss selling
 Small firms (outperform 4.3% risk-adjusted)
 Book-to-market (high performs better).
 Neglected firms
Evidence: Strong form
 Insider trades
 Value line rankings
 Fund manager performance
Alternative Exposition
 No group of investors will consistently beat the market
(T)
 No investor will beat the market consistently over any time period
(F)
 Chances of finding an undervalued stock are 50/50
(T)
 Minimizing trading activity provides superior returns to one that involves trading frequently
(T)
Summary
 The notion of efficient markets is one that is perhaps more pertinent for investors in developed capital
markets. In that context, the key question to ask is: How efficient are markets? NOT
Are markets efficient ?
 Investors in markets that are developing are less concerned with this idea. However, the prevailing view
is that the behavioral paradigm we referred to in past session does apply to both markets. Besides, there
are several issues that merit consideration.
a)
Magnitude issue ($ 5million gain on a $ 5 billion portfolio is a lot in dollar terms, not in
return terms)
b)
Selection bias issue (the good strategies are never made public).
c)
Lucky event issue (Warren Buffett and others like him)