Chapter 12 – Macroeconomic and Industry Analysis
CHAPTER TWELVE
MACROECONOMIC AND INDUSTRY ANALYSIS
CHAPTER OVERVIEW
This is the first of three chapters that cover fundamental security valuation. This chapter
introduces a top-down approach to fundamental security analysis. It covers the first two
components: macroeconomic and industry analysis. The text begins with a global analysis,
particularly with respect to how the performance of domestic firms is influenced by international
LEARNING OBJECTIVES
Upon reading this chapter, the student should have a basic understanding of some of the
macroeconomic factors that affect security prices. The student should understand the roles of
fiscal and monetary policy in influencing interest rates and security prices. The student should
CHAPTER OUTLINE
The top-down approach to fundamental analysis begins with analyzing the economy. Expected
economic performance will influence the choice of industry and the specific firm chosen as an
investment.
1. The Global Economy
PPT 12-2 through PPT 12-4
A top–down analysis of a company begins with an examination of global economic prospects.
Factors that may have relevance include political risk and exchange-rate risk. Exchange-rate risk
has several elements that are important to global economic analysis. Unfavorable movements in
exchange rates will affect a firm’s sales and profits and can change relative competitive positions
2. The Domestic Macroeconomy
PPT 12-5 through PPT 12-7
This section will present some of the key economic statistics used to describe the state of the
macroeconomy. Key economic variables used in assessing the economy include gross domestic
product, unemployment rates, interest rates, inflation, budget deficits, and consumer sentiment.
The relationship between earnings and the price level of the S&P 500 is presented in the PPT.
Stock prices tend to rise and fall with earnings. The graph data implies a P/E ratio of between 12
and 25 which may be used as a ‘normal’ (non-bubble, non-depressed) range for the P/E ratio. In
doing so we would be relying on historical data. GDP data is published quarterly, and is often
revised. Forecasts of GDP abound and can be found at the Philadelphia Federal Reserve website
or in the Economist Magazine or at the IMF website.
Chapter 12 – Macroeconomic and Industry Analysis
3. Interest Rates
PPT 12-8 through PPT 12-9
Forecasting interest rates is one of the most difficult areas of applied macroeconomics and yet is
perhaps the most important to consider in analyzing investments. A very simple supply-and-
demand framework is presented along with a graphic display of supply and demand. While the
4. Demand and Supply Shocks
Chapter 12 – Macroeconomic and Industry Analysis
PPT 12-10
Analysis of the economy will often distinguish between demand and supply shocks. A demand
shock is an event that affects demand for goods and services. A tax cut is a policy action
designed to influence the demand from economic participants. A supply shock influences
production capacity or production costs. Higher levels of education for the work force should
have the effect of increasing productivity or reducing production costs. A change in the price
and/or availability of oil is another example of a supply shock.
PPT 12-11
Fiscal policy involves government spending and taxing actions. Fiscal policy is an attempt to
influence the economy in a direct fashion. Monetary policy involves manipulation of the money
supply to influence economic activity. Market participants pay substantial attention to monetary
policy. Tools that are used by the Federal Reserve to influence the money supply and interest
rates include open market operations, the discount rate and reserve requirements. Supply-side
policies focus on incentives and marginal tax rates.
Fiscal policy is comprised of government spending and taxing actions to stabilize or spur growth
in the economy. This is the most direct policy method in terms of its effect on the economy
(Keynesian policy). However it is often implemented too slowly due to the political process
Monetary policy has its own limitations. The Fed can increase the money supply and lower
interest rates in the short term (albeit with lags up to 18 months to fully affect policy), but many
believe money-supply creation is inflationary in the long run and inflation will push interest rates
back up. This is the expectations problem of monetary policy and it can be self-fulfilling. In the
inflationary periods of the 1970s the Fed increased the money supply and interest rates fell, but
quickly began to rise again due to inflationary expectations in the economy. For this reason the
Fed tries to keep inflation out of the system.
Chapter 12 – Macroeconomic and Industry Analysis
Monetary policy is an attempt to change the incentives to purchase and invest, but changing the
money supply and interest rates still may not lead to the desired effect on demand. Japan went
through several years of deflation. Deflation increases the real rate of interest above the nominal
rate and increases the real debt burdens of borrowers. Incomes don’t rise in this situation and
may even fall, making it more difficult to pay down debts, much less engage in capital
purchases.
Supply-siders focus on investment incentives invest, wealth generation and marginal tax rates.
Lowering tax rates tends to encourage more investment and improve incentives to work.
6. Business Cycles
PPT 12-12 through PPT 12-20
A business cycle refers to periods of expansion and contraction. A peak is the high point
following a period of economic expansion. A trough is the low point following a period of
economic decline. Some companies’ performance is very sensitive to the cycle while others are
7. Industry Analysis
PPT 12-21 through PPT 12-33
Industry analysis is used to identify industries that are expected to perform well in the future.
The variability of return on equity, and industry stock-price performance are displayed in the
PPT. Note that performance can vary widely among industries. It can be difficult to find a high-
performing stock in a poorly-performing industry. Also, understanding the industry helps the
analyst forecast future profitability and understand the level of competition faced by a firm in
that industry. One may be able to find a good value stock in a poorly-performing industry. In
fact this is Warren Buffet’s and Peter Lynch’s preferred strategy.
Defining an industry can be difficult. Where does one draw the line between one industry and
another? Many industries are closely related. The North American Industry Classification
Chapter 12 – Macroeconomic and Industry Analysis
Sector rotation is a strategy that can be used to select companies that should perform well in for
various stages of the business cycle. This strategy is referred to as sector rotation and some
example investment types are provided for the phases of the business cycle. It is difficult to
achieve above average returns this way however, as often we don’t know which phase of the
cycle we are in until later and the duration of each phase is also unknown.
Determinants of Industry Competition and Profitability
1. Threat of Entry
• New entrants reduce profitability
• Barriers to entry preserve profitability, examples of barriers include
2. Rivalry between existing competitors
a. Equal competitors reduce profitability
3. Pressure from substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers
Appendix A: Table 12.3 Economic Calendar