Transcript Equity Markets and Business Cycles

Business Cycles
Chapter 15
Stabilization Theory
Chapter 16
Equity Markets
Chapter 21
Corporate Profits



We find that corporate profits are
strongly pro-cyclical and volatile.
When the economy is doing well,
corporations tend to earn high real
profits.
Corporate profits fluctuate far more than
the economy as a whole.
HK Corporate Earnings & the
Business Cycle
.4
% Deviation from Trend
.3
.2
.1
.0
-.1
-.2
-.3
-.4
-.5
86
88
90
92
94
96
Real Corporate Earnings
98
00
Real GDP
02
Objectives




Use the Gordon model to characterize dividend
yields.
Analyze the characteristics of business cycles
Use the AS-AD model to understand the
events that drive short and medium run
fluctuations and stabilization policy.
Use the CAPM model to characterize expected
returns of individual stocks (if time)
Equity Markets
Chapter 21
Stocks for the Long Run




Over time, stocks pay consistently higher
returns than other types of financial investment
like bonds or gold.
Stocks can also be risky. For relatively long
periods, stocks can under-perform bonds or
even lose money.
What are stocks and where does this risk
come from?
Equities (or shares or stocks) Paper asset
reflecting part ownership of company and the
future stream of income that it earns.
Stocks






Equities like common or ordinary stocks are a claim to the profits of a
corporation
Stocks have no maturity date. Firms may buy back stock at market
prices as they choose.
Stock owners receive periodic but not fixed payments called dividends.
Dividends reflect the profitability of the business and are not known in
advance.
Stock owners are the owners of the firms. Holders of shares vote for
the directors of firms on a one share-one vote basis.
Stock owners are the residual claimants to a firms income meaning a
firm that goes out of business must repay all debt before stock owners
get any income.
Stock owners enjoy limited liability. Unlike the owners of private firms,
stock owners cannot lose more than the value of their stock.
Stock Markets in Hong Kong



Stocks in HK are traded at the HK Stock
Exchange.
Stock Index: A stock index is a price aggregate
for stocks. Calculate the weighted sum of the
prices of a set of stocks which represent an
average of the market.
Hang Seng Index is a weighted average of
prices of the equities of major (“blue chip”,
“large cap”) stocks in HK
Economic Function of the Stock
Market


Stock markets can be an important
means for companies to raise funds to
finance investment.
Stock markets are a liquid market in
which assets can be traded.
• Stock markets allow savers to efficiently
•
diversify assets.
Stock markets allow for efficient corporate
ownership of assets.
Stocks and Business Cycles

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The payoff to stocks represent a share of
the profits of firms in an economy.
In general terms, as an asset class,
stocks will generate payments that
reflect the profits generated by the
economy.
Profits which are a share of income are
volatile over the business cycle.
Risk of stocks may also vary over
business cycles.
Stock Returns


Gross returns on any asset are the payoff
divided by the initial price.
Stocks pay-off of stocks is dividend plus
price next period
PAYOFFt  Pt 1  Dt 1
1  Rt 

Pt 1  Dt 1
Pt
Gross Return for Stocks Capital Gain +
Dividend Yield
P P
D
Rt 
t 1
Pt
t

t 1
Pt
Required Return


Define req as the return required by
investors to get them to hold a share of
stock.
Stocks may be volatile and risky.
Typically required returns will be equal to
the risk free interest rate plus a risk
premium
req = rrf + heq
Fundamental Value of Stock
Pt e1  Dte1
Dte1
Pt e1


1  r eq
1  r eq 1  r eq
e
D
Pe
Pt e1  t  2eq  t  2eq
1 r
1 r
Dte 2
Pe
 t  2eq
e
e
e
eq
D
1  r  Dt 1  Dt  2
Pt 1  t 1eq  1  r
1 r
1  r eq
1  r eq 1  r eq
Pt 

Pt e 2 
Pt 

2

Pt e 2
(1  r eq ) 2
Dte3
Pe
 t 3eq
eq
1 r
1 r
e
t 1
eq
D
1 r
e
t 1
eq

e
t 2
D
1  r 
eq 2
e
t 2
Pt 
D
1 r
Pt 
Dte1
Dte 2

eq
1 r
1  r eq

D
1  r 
eq 2


2
Dte3
Pe
 t 3eq
e
e
eq
1  r  Dt 1  Dt  2
 1 r
(1  r eq ) 2
1  r eq 1  r eq

Dte3
Pe
 t 3eq
e
e
eq
1  r  Dt 1  Dt  2
 1 r
(1  r eq ) 2
1  r eq 1  r eq

 ....
Dte 
1  r 
eq 

Dte3

Pt e3
 1  r  1  r 
2

2
 ....
eq 3
DteT
eq 3

Pt eT
1  r  1  r 
eq T
eq T
Dividend Yields: Gordon Equation

Assume that dividends grow at a constant rate g . This implies
Dt+j = (1+g)j Dt
Dte1
Dte 2
Pt 

1  r eq
1  r eq


2
 .... 
1  g 
(1  g )
Pt 
Dt 
eq
1 r
1  r eq



If x < 1,
For price,
1  r 
2

2
Dte
eq

1  g 
3
Dt 

1  r eq

3
Dt  .... 
1  g 

1  r eq



Dt
x  (1  xT )
1 x
x  (1  x  )
x
x  x 2  x 3  x 4  ......x  

1 x
1 x

x 0
x  x 2  x 3  x 4  ......xT 
 (1  g )
1  g 2  1  g 3  .... 1  g 
Pt  Dt  

2
3

eq
1  r eq
1  r eq
1  r eq

1 r
(1  g )
eq
D
1 g
 Dt  1  r
 Dt  eq
 eq t 1
(1  g )
r g
r g
1
1  r eq
Dt 1
 r eq  g  r rf  heq  g
Pt










Determinants of the Dividend Yield
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The dividend yield plus capital gains is like an
interest rate earned on stocks which in a free
market must be equal to interest rates on other
assets (adjusted for the risk of owning stocks).
In the long run, the growth rate in stock prices
(capital gains) will be equal to growth rate of
dividends which will be equal to the growth rate
of corporate profits which will be equal to the
growth rate of the economy.
What determines the risk premium on
individual stocks?
FAQ
What are the implications of the Gordon Growth
model for stock prices?
Relative to current dividends, stock prices will be
high when

•
•
•

expected growth of dividends is high.
interest rates are low (the return on other assets are low.
the risk premium is low..
Is the Gordon Growth Model a nominal model or a
real model? It works either way.
Business Cycles
Chapter 15
Business Cycles

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
Business cycles are medium term fluctuations
in real output and other variables.
Business cycles are characterized by comovement. All expenditure, production and
income categories move with business cycle.
Degree of business cycle co-movement varies
across sectors which is important for asset
pricing.
Recessions and Booms


Business cycle positions are sometimes
characterized as booms and recessions.
These names have many definitions but
a boom occurs roughly when real output
is above the trend growth path
(detrended output is positive). A
recession occurs roughly when real
output is below trend growth.
HK Booms & Recessions
% Deviations from Trend
.08
.04
Oil Shocks
.00
6-4 Incident
-.04
Handover Talks
-.08
Asian Crisis
-.12
1975
1980
1985
1990
1995
Hong Kong GDP
2000
Business Cycles & Co-movement
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
Business cycles are fluctuations in the
economy as a whole.
Different sub-categories of GDP tend to
co-move with business cycles though to
different degree.
Business cycles tend to co-move across
countries though not as strongly as
within countries.
Business Cycles & Sub-Categories
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Expenditure. Consumption and Investment comove with output. Investment is more volatile
than consumption. Consumer durables are
most volatile part of consumption.
Production – Production sectors co-move with
business cycles. Manufacturing & Construction
most volatile. Services least volatile.
Income – Worker Compensation & Capital
Income are both pro-cyclical. Capital Income
tends to be more volatile.
Hong Kong Expenditure Cycles
.20
.15
.10
.05
.00
-.05
-.10
-.15
1975
1980
1985
1990
1995
GDP
Household Consumption
Fixed Investment
2000
AS-AD Framework
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Microeconomists use supply/demand
framework for thinking about markets.
Macroeconomists use Aggregate Supply/
Aggregate Demand as the central framework
for thinking about business cycles.
AS/AD framework examines the relationship
between the level of output (real GDP) and the
aggregate price level (GDP deflator).
We use the AS/AD to show how different
events will affect output & prices in the medium
and long run.
Long Run Aggregate Supply



Central pillar of AS-AD framework is the
assumption that there is no long run
relationship between prices and firms
willingness to produce goods.
In the long run, output may change but it
is not affected by nominal level of the
economy.
Long run AS is decided outside the ASAD framework and is thus, exogenous.
LRAS
P
Y
YLR
Why is Supply Exogenous in the Long
Run?


Output is determined by labor (workers),
capital (structures & equipment) and
technology.
These factors are determined in the long
run by relative prices like the real wage
rate (dollar wages divided by the price
level) and the real interest rate which are
assumed to be exogenous to the
nominal level of the economy in the long
run.
Short Run Aggregate Supply
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
In the short-run, there is thought to be a
positive relationship between the aggregate
price level and firms willingness to supply
goods.
Central element in this story is that dollar
wages that firms pay workers are determined
by formal and informal wage contracts.
If wages are fixed, a rise in the price level
reduces the relative cost of labor for firms.
Firms hire more workers, work their existing
employees longer hours and produce more
output.
LRAS
P
SRAS
PE
Y
YLR
FAQ
Q: Why is the SRAS
upward sloping?
A: Given wages, an
increase in prices
reduces real wages
for firms. Firms
increase
employment and
production.
Q: What shifts the
SRAS curve?
A: If wages rise the
real wage rate will
increase at any price
level. A rise in the
real wage causes
firms to cut back on
employment and
production.
SRAS’
Wages
LRAS
P
SRAS
PE
Y
YLR
↑
Expected Price Level
Q: What is PE?
A: PE is where SRAS crosses LRAS
Q: What is the significance of PE?
A: PE is the expected price level. If the actual price were
equal to the expected price level, real wages would be as
expected and output would be at its long run level.
Q: How does PE affect the business cycle.
A: When actual prices are above PE , price expectations will
tend to move upward over time. When wages are
renegotiated, they change in the same direction as price
expectations. When
The aggregate demand curve maps a negative
relationship between the price level and demand
for goods.


The AD curve
embodies the
negative relationship
between the nominal
price level and the
amount of goods that
will want to buy.
The underlying basis
of this is a fixed
monetary policy
Q: Why is the AD curve
downward sloping?
A: Under a Fixed
Exchange rate, a
rise in prices
causes a real
exchange rate
appreciation
reducing net export
demand.
FAQ
Q: Why is the AD curve downward sloping?
A: It depends on the exact monetary policy.
1.
2.
In most large economies, interest rate targets rise
when prices rise. This reduces investment &
consumption and an exchange rate appreciation (net
exports decline).
If central bank sets a fixed level of money supply, a
rise in prices reduces the purchasing power of cash
held by shoppers. They withdraw funds from banks.
In order to meet their own liquidity needs, banks raise
interest rates to attract deposits. The interest rate rise
in reduces consumption & investment spending and
an exchange rate appreciation (net exports decline).
P
AD
Y
YLR
What shifts the AD curve?:
Event
Category
1.
2.
Stock Market/Real Estate Prices Fall
C ↓, I↓
C↓
AD
←
←
3.
Uncertainty & Precautionary Savings
Rise
C ↓,
←
4.
5.
6.
7.
Expected Yt+1/Kt+1 Falls
I↓
C↓,I↓
G↓
C↓
←
←
←
←
Expectation of Future Income
Falls
Foreign Interest Rates Rise
Government Spending Fall
Taxes Rise
What shifts the AD curve? Pt. 2
8.
9.
10.
11.
Event
Category
Foreign Economy Contracts
NX ↓
NX↑
NX↑,
C,I ↓
Devaluation of Currency
Tariffs Rise
Currency Risk Premium
Rises
AD
←
→
→
←
Spillovers

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
A decrease in demand will tend to decrease
the level of output and production which will
decrease household income which will put
downward pressure on consumption.
A decrease in demand will reduce the level of
output per unit of capital so this will tend to
diminish profit maximizing level of capital
putting downward pressure on investment.
A decrease in demand will reduce import
demand partially offsetting the multiplier effect
on consumption.
AS-AD



The AS-AD model determines the
position of nominal prices and real
output over time.
Equilibrium output and price level are
defined as the intersection between
SRAS and AD.
LRAS exists in the background exerting
a gravitational pull.
SRAS
P
[P*,Y*]
AD
Y
YLR
Gravitational Pull:

Whenever the AD curve and the SRAS cross each
other away from the LRAS curve, P* will not equal
PE.

If the prices that workers and firms observe (P*)
are different than the prices they expected when
they negotiated labor contracts (PE), real wages
are different than long-term levels.
•
•
If P* > PE real wages are lower than long-term
If P* < PE real wages are higher than long-term
Gravitational Pull Cont.



If actual prices (P*) are different from expected prices
(PE), expectations will be updated for future labor
contracts.
If P* > PE, PE will rise over time and workers will demand
higher wages. This will cause the SRAS curve to shift
upward as firms charge higher prices for their output.
Wages rise until P* = YE and Y* = YLR.
If P* > PE, PE will fall over time and firms will demand
workers take pay cuts. This will cause the SRAS curve to
shift downward. Wages rise until P* = PE and Y* = YLR.
SRAS’
SRAS
P
[P*,Y*]
AD
Y
YLR
Business Cycles as Shocks



Business Cycles are thought of as being driven
by “random” events which destabilize the
economy from its long-term path and set in
motion a train in events.
These events are separated into those that
affect demand (exogenously shift the demand
curve) and those that affect supply
(exogenously shift the supply curve).
AS-AD theory is set up to examine demand
driven shocks.
• Contractionary Shock & Recession
SRAS
P
[P*,Y*]
[P**,Y**]
AD
AD’
YLR
Y
Short Run


Some Event causes a contraction in
Aggregate Demand.
Demand for Goods falls as do
equilibrium market prices. This increases
real wages and reduces demand for
labor. Unemployment rises and
production decreases.

Medium: Wage Renegotiation
SRAS
SRAS’
P
PE
[P***,Y***]
AD’
YLR
Y
Medium Run



After shift in demand curve, P** < PE. When
employers have a chance to renegotiate
salaries, they will offer lower wages.
Reduced wage costs will reduce production
costs. Reduced production costs will reduce
the price charged by firms at every level of
production.
This is equivalent to a downward shift in SRAS
curve.

Return to Long Run
P
SRAS’’
PE
[P****, Y****]
AD’
Y
YLR
Return to Long Run


Wages continue to be bid down as long
as prices are below expected prices.
This is equivalent to saying that the
SRAS continues to shift downward until
it crosses the new AD curve where the
AD curve crosses the LRAS curve.
Demand Driven Recessions

Recession Caused By Contraction in Demand
is Characterized by
•
•
•

Lower than Expected Inflation (in some cases even
deflation)
High Unemployment
High Real Wages
Boom Caused By Expansion in Demand is
Characterized By
•
•
•
Higher than Expected Inflation
Low Unemployment
Low Real Wages.
Real Wages & Business Cycles in
Hong Kong
HK: Real Salary Index (A): All Industries
Jun 1995=100
120
115
110
105
100
95
90
1987/88
1989/90
1991/92
1993/94
1995/96
1997/98
1999/00
2001/02
Phillips Curve & Inflation


Relationship between Higher
or Lower than expected
Inflation and higher or lower
than average unemployment
is called the Phillips curve
after Kiwi economist A.W.
Philips.
When inflation is faster than
expected inflation, inflation
will be faster than nominal
wage growth, real wages will
be decreasing. Demand for
workers will be high and
unemployment will be low.

Phillips Curve
 t   tE  A (urNR  urt )




π-Inflation Rate
π Expected Inflation Rate
ur-Unemployment Rate
urNR – Natural Rate of
Unemployment
Natural Rate of Unemployment



The unemployment rate is the ratio of adults
looking for work relative to the sum of the
number of adults working and looking for work.
The natural rate of unemployment is the
unemployment rate that will occur hen
economy is at its long-term level of output YLR
due to standard turnover of jobs.
Natural rate of unemployment is sometimes
called NAIRU – Non-accelerating Inflation Rate
of Unemployment (for reasons which will
become apparent).
Uses of the Phillips Curve




Inflation expectations and natural rate cannot be
observed.
Moreover, Phillips curve ignores inflation from supply side
factors like energy prices.
When combined with a theory about the formation of
expectations, Phillips Curve can be used to calculate
additional unemployment that results from disinflationary
paths induced by policy.
For example, HK is experiencing a recession and
deflation. How might unemployment be reduced if the
government used (monetary or fiscal policy) to increase
the inflationary path.
Adaptive Expectations

Simplest theory of inflationary
expectations assumes that people
respond to past events. tE   t 1

In this case, unemployment is a function
of inflation deceleration.NR
 t   t 1  A (ur
 urt )
Example


Government foresees a deflationary path
of -3% this year, -4% next year, and -5%
thereafter. Government can use policy to
change this to inflation of -2%, 1% and
3% respectively.
Assume A = .5 and urNR =4%, what will
be the affect of such a policy on
unemployment.
Example
π
πE
ur
2002 -3%
0
2003 -4%
π
πE
ur
5.5% -2%
0
5%
-3%
4.5% 1%
-2%
2.5%
2004 -5%
-4%
4.5% 3%
1%
3%
2005 -5%
-5%
4%
3%
3%
4%
2006 -5%
-5%
4%
3%
3%
4%
Insights



More quickly that inflation expectations
(and wages) respond to inflation, the
less will unemployment respond.
Unemployment effects of inflation are
temporary.
Only way for government to permanently
reduce employment permanently is to
induce a permanently accelerating
inflation path.
Supply Shocks




Exogenous events like energy prices or natural
disasters may directly effect the production
costs of firms.
Such events can be modeled within the AS-AD
framework.
An event that causes a temporary rise in
production cost is modeled as an exogenous
shift upward in the SRAS curve.
This will lead to a rise in prices and a reduction
in output.
• Contractionary Supply Shock & Stagflation
SRAS’
P
SRAS
[P**,Y**]
[P*,Y*]
AD
AD’
YLR
Y
Theory of Risk


The fundamental insight of the theory of
finance is that the risk of an asset is not
measured by the volatility of the assets
returns, but by the amount that it adds
volatility to your portfolio.
A well diversified portfolio can reduce the
average risk of the assets in the
portfolio.
Example: Coin Flipping Stocks


Consider a portfolio with a 1 million shares of Heads
or Tails Inc. At the end of the year, HoT will flip a coin.
If Heads comes up, the company will pay a dividend
of a dollar per share. If tails comes up, the company
will pay 0. Either way, the company will close down.
Present value of the expected dividend is $.5 million.
However, price that a portfolio investor will pay for
this portfolio should be considerably less than $.5
million because of the high risk of the portfolio.
Well Diversified Portfolio





Consider a portfolio of 1 million shares of stocks in 1
million different coin-flipping companies.
At the end of the year, each company will independently
flip a coin (for a total of 1 million coin flips). If heads come
up, they will pay a dollar. If tails come up, they will pay
nothing.
Each individual share has the same risk characteristics as
share of Heads or Tails Inc. Expected PV = $.5 Million
However, Law of Large Numbers says that if you flip a
coin 1 million times, there is an extremely high probability
that you will come very close to getting .5 million heads.
Perfectly diversified portfolio of independent coin-flipping
stocks has very low risk.
Comovement as Risk



The individual shares in the first portfolio have
the same properties as the shares in the
second portfolio, but the second portfolio has
more risk overall. Why?
The reason is the pay-offs of the shares in the
first portfolio have a strong mutual covariance
(i.e. statistical co-movement). The shares in the
second portfolio have zero covariance.
A well-diversified portfolio will be composed of
a variety of stocks with as little co-movement as
possible.
Portfolio Risk



A stock will add more volatility to your
portfolio if its return has a high covariance
with the assets in your portfolio than a stock
whose return is independent of the assets.
A stock that is negatively correlated with
your portfolio can reduce the volatility of
your portfolio.
Is it possible to construct a risk-free
portfolio of stocks in the real world? No.
Why not? Systematic Risk.
Systematic Risk





Stock returns in a market tend to move together.
Most companies tend to have common movements in
returns due to business cycles.
Common or systematic risk cannot be diversified
away.
All firms have idiosyncratic risk which is independent
of systematic risk. This risk can be diversified away.
Different firms have different exposure to systematic
risk. Firms whose returns drop especially sharply
when the market as a whole drops, have larger
exposure to market risk. Adding these stocks to your
portfolio adds proportionately more to the volatility to
your portfolio.
Capital Asset Pricing Model



The CAPM takes the point of view that the risk
premium for an individual stock j demanded by
the market as a whole are a function of the
extra volatility added to a diversified portfolio
by the individual stock.
The degree to which an individual stock adds
to the volatility of a diversified portfolio
depends on the co-movement of its return with
the overall market return.
Stocks which have greater exposure to
systematic risk display greater co-movement
with the market portfolio.


The degree to which a stock adds to the risk of a welldiversified portfolio is measured by its beta coefficient
• rf : Risk-free return
• Rm: Return on Market Portfolio (Return on a Broad
Index like Hang Seng)
• Rj : Return on Stock j
• : Correlation of Excess Returns on Stock j (Rj- rf) with
the excess returns on market portfolio (Rm- rf)
• m : Standard Deviation of Excess Returns on Market
Portfolio
• j : Standard Deviation of Excess Returns on Stock j
Model of Equity Premium

Beta is the product of the correlation of the excess returns
on a stock with the excess returns on a market portfolio
and the relative volatility of the stocks returns.
j
  
m

A stocks equity premium is proportional
to its beta e
f
e
Rj  r    (Rm  rf )  h
f
CAPM and Dividend Yield



Stock is forecast to have constant
dividend growth of 4%. The risk-free
interest rate is 5%. The average market
return is 10%. stock has a beta of 1.2.
rj = .05 + 1.2·(.10-.05) = .11
Pt = Dt+1· 1/(.11-.04)
Dt 1
 .11 .04  .07
Pt
Implications for Macroeconomics



For asset pricing, it is not possible to price
individual stocks based on microeconomic
information. We must understand how returns
co-move with the aggregate market.
Business cycles are a key source of systemic
volatility.
We can understand a company’s exposure to
market risk by understanding its exposure to
business cycles.
Equity Premium Puzzle
Why are stock returns so much higher than bond
returns?
 Equity owners (unlike bond owners or workers)
absorb the full risk of economic fluctuations.
 Much of the risk of the overall wealth portfolios
of individual savers comes from equity risk.
Equity as an asset class has a high beta with
the overall wealth portfolio and requires high
returns.
 No economic model, however, has
satisfactorily explained why the equity premium
puzzle is as high as it is.
Equity Premium in Long Run
Perspective



Consider two 35 year old investors. In 1974,
each has $100 dollars two invest. One puts the
money into the HK stock market and keeps it
there. The other puts his money into bonds
and continuously rolls over his funds.
How do the portfolios of these investors
progress through time?
At first Mr. Stocks does not do so well, but…
Portfolios
250
200
HK Dollars
150
Stocks
Bonds
100
50
0
1972
1977
1982
Portfolios
4000
3500
3000
Dollars
2500
Stocks
2000
Bonds
1500
1000
500
0
1972
1977
1982
1987
Year
1992
1997