Transcript Leading indicators

Investment Analysis and
Portfolio Management
Frank K. Reilly & Keith C. Brown
CHAPTER 12
BADM 744: Portfolio Management and Security Analysis
Ali Nejadmalayeri
Economies and Markets
• A strong relationship exists between the
economy and the stock market
• Security markets reflect what is going on in
an economy because the value of an
investment is determined by
– its expected cash flows
– required rate of return
Economic Activity and
Security Markets
Stock Market As A Leading Indicator
– Stock prices reflect expectations of earnings,
dividends, and interest rates
– Stock market reacts to various leading indicator
series
– Stock prices consistently turn before the
economy does
Cyclical Indicator Approach to
Forecasting the Economy
This approach contends that the aggregate
economy expands and contracts in
discernable periods
Cyclical Indicator Approach to
Forecasting the Economy
• National Bureau of Economic Research
(NBER)
• Cyclical indicator categories
– leading indicators
– coincident indicators
– lagging indicators
• Composite series and ratio of series
Cyclical Indicator Categories
• Leading indicators – economic series that usually reach
peaks or troughs before corresponding peaks or troughs in
aggregate economy activity
• Coincident indicators – economic series that have peaks
and troughs that roughly coincide with the peaks and
troughs in the business cycle
• Lagging indicators – economic series that experience
their peaks and troughs after those of the aggregate
economy
• Selected series – economic series that do not fall into one
of the three main groups
Cyclical Indicators
• Leading indicators
– Treasury spread, Avg. weekly hours production workers, building
permits, vendor performance, consumer expectations, etc.
• Coincident indicators
– Employment (nonagricultural), personal income, Industrial
production, manufacturing and trade sales
• Lagging indicators
– Manufacturing and trade inventories, prime rate, commercial and
industrial loans, consumer credit to personal income, duration of
unemployment
Cyclical Indicator Approach to
Forecasting the Economy
• Analytical measures of performance
– diffusion indexes
• trends
• rates of change
• direction of change
• comparison with previous cycles
Cyclical Indicator Approach to
Forecasting the Economy
• Limitations of cyclical indicator approach
– high variability
– currency of the data and revisions
– no series reflects the service sector
– no series represents the global economy
– political and international developments are
not factored into a statistical system
Cyclical Indicator Approach to
Forecasting the Economy
• Leading indicators and stock prices
• Other leading indicator series
– CIBCR:
• Long-leading index
• leading employment index
• Leading inflation index
– Analysis of alternative leading indicators of
inflation
– International leading indicator series
– Survey of sentiment and expectations
Monetary Variables, the Economy,
and Stock Prices
• Money supply and the economy
• Money supply and stock prices
• Excess liquidity and stock prices
– year to year percentage change in M2
money supply adjusted for small time
deposits less the year-to-year percentage
change in nominal GDP
Money Supply and the Economy
• Declines in the rate of growth of the money
supply have preceded business contraction
by an average of 20 months
• Increases in the rate of growth of the money
supply have preceded economic expansions
by about 8 months
Monetary Variables, the Economy,
and Stock Prices
• Other economic variables and stock prices
– growth in industrial production
– changes in the risk premium
– twists in the yield curve
– measures of unanticipated inflation
– changes in expected inflation during periods
of volatile inflation
Inflation, Interest Rates,
and Security Prices
• Inflation and interest rates
– generally move together
– investors are not good at predicting inflation
• Inflation rates and bond prices
– negative relationship
– more effect on longer term bonds
• Interest rates and stock prices
– not direct and not consistent
– effect varies over time
Findings
• Flannery and Protopapadakis (2002)
– If reaction to the surprise at the announcement day is
considered, then:
• Market return affected by:
– CPI negatively
– PPI negatively
– M1 negatively
• Market vol. affected by:
– EMPNF positively
– HOMSTART positively
– M1 and M2 positively
Sector Rotation and
Economic Condition
This chart is based on Sam Stovall's S&P's Guide to Sector Rotation and states
that different sectors are stronger at different points in the economic cycle.
Model Performance
• Information Coefficient
– Actual Rank = α + IC Forecasted Rank + ε
• For a set of models use the weighted
average IC method