chapter

13
Economy/
Market
Analysis

I t is apparent to most everyone that a poorly performing economy does not bode well for stocks. The recession that
started in 2001 corresponded with a severe stock market decline that occurred during 2000–2002. Likewise, the
December 2007–June 2009 recession was associated with the dramatic market decline in 2008. Clearly, to be a suc-
cessful investor, it is worthwhile to know something about the overall tone of the economy and market and at least be
able to intelligently consider investment strategies that incorporate economic conditions.
The recognized importance of the economy in investment management manifests itself in the widespread use
of the top‐down approach to security analysis. Evaluating conditions in the overall economy is the starting point in
the top‐down approach because it recognizes the crucial role that the economy/market plays in determining stock
returns.
Exhibit 13‐1 illustrates the top‐down approach to fundamental security analysis, which is covered in Chapters 13–15.

AFTER READING THIS CHAPTER YOU WILL BE ABLE TO:

▶ Understand the relationship between the stock ▶ Make some basic forecasts of possible changes in
market and the economy. the level of the market.
▶ Analyze conceptually the determinants of the stock
market.

Introduction
Investors want to make intelligent judgments about the current state of the financial markets
as well as changes that are likely to occur in the future. Are specific markets at unusually high
or low levels, and what are they likely to do in the next year or next few years? Understanding
the current and future condition of the economy is the first step in a top‐down analysis.
In this chapter, we apply the valuation concepts discussed in Chapter 10 to understand-
ing the aggregate stock market. We also consider forecasts of changes in the stock market.
Although investors cannot possibly hope to be consistently correct in their forecasts of the stock mar-
ket, they can reasonably expect to make some intelligent inferences about major trends in the
market. Because of the market’s impact on investor success, investors should consider the
market’s likely future direction.

c13.indd 339 1/23/2016 4:32:07 PM

 340 CHAPTER 13 ECONOMY/MARKET ANALYSIS

EXHIBIT 13-1
The Top‐Down Approach to Fundamental Security Analysis

Analyze the economy/market

Step 1

Focus on sectors/industries that appear attractive

Step 2

Analyze and value individual companies

Step 3

Taking a Global Perspective

As noted throughout this text, investors must think globally. U.S. investors can choose equi-
ties from numerous countries, and foreign equities comprise approximately two‐thirds of the
world’s market capitalization and gross domestic product (GDP). Therefore, investors should
think about global economies when forming and managing their portfolios.
Multinational corporations have often led in restructuring traditional processes and
embracing new technologies. Therefore, as a general rule, the analysis we consider in this
chapter of the U.S. market and economy applies to other countries as well. Foreign equity
markets are driven by earnings growth and interest rate changes, just as U.S. markets are. By
understanding the U.S. equity markets, investors are in a better position to understand foreign
equity markets despite the cultural, economic, and political differences that exist.
Another reason why investors must consider the global perspective is currency changes.
For example, near the end of 2005, the Euro was worth approximately $1.2; however, about
three years later, the rate had risen to approximately $1.6 before dropping back again to the
$1.2 range in mid‐2010. Since 2010, the rate has fluctuated between a low of approximately
$1.2 and a high of $1.4, ending 2014 near its $1.2 low. Thus, over this 10‐year period, the
currency exchange rate has fluctuated by approximately 30 percent between its high and low
rates. The wide swings in currency values have a large impact on the returns from foreign
investments. U.S. investors in foreign securities benefit when the dollar declines relative to the
respective foreign currency but are harmed when the dollar appreciates.

Assessing the Economy

Gross Domestic Product A basic measure of economic activity is Gross Domestic Product (GDP), which is defined
(GDP) A measure as the market value of final goods and services produced by an economy for some time
of a country’s output
occurring within its
period (typically a year). It consists of the sum of consumption spending, investment spend-
borders by nationals and ing, government spending, and net exports. Consumption now comprises 70 percent or
foreigners more of GDP.

c13.indd 340 1/23/2016 4:32:07 PM

 Assessing the Economy 341

GDP measures the value of goods and services produced within a country’s borders even
Gross National Product if they are produced by foreign entities. In contrast, Gross National Product (GNP) is the
(GNP) A measure of the value of goods and services produced by domestic entities even if they occur outside the
output of the citizens of
country. Thus, the value of goods produced by foreign‐owned businesses on U.S. land is part
a country on its land or
foreign land of U.S. GDP but not part of U.S. GNP. In contrast, profit earned on a foreign investment by a
U.S. resident is part of U.S. GNP but not part of U.S. GDP.
Most analysts believe that GDP more accurately reflects the health of an economy, and
thus, GDP tends to receive more attention from economists than GNP. GDP numbers are pre-
pared quarterly and released a few weeks following the end of the quarter. GDP constitutes a
basic measure of the economic health and strength of the economy. GDP can be measured on
both a nominal and real (inflation‐adjusted) basis. Figure 13‐1 shows the annual percent
change for real GDP since 1994. Note the ups and downs since 1994, and the upward move-
ment from 1994 to 2000, and the much smaller changes since 2000. The impact of the reces-
sions of 2001 and 2008–2009 are clearly visible in the figure.

✓ Real GDP is the single best measure of overall economic activity.

The Bureau of Economic Analysis releases an advance estimate of quarterly GDP in the
first month following quarter end. In the second month, it provides a preliminary estimate,
and in the third month, it provides a final estimate (however, even this estimate is subject to
annual revisions).1 The average revision of GDP growth from the advance to the final estimate
has been about 2/3 of a percentage point. It should be noted that almost 90 percent of the time
the advance estimate correctly predicts the direction of quarterly change in real GDP growth.
Investors are very concerned about whether the economy is experiencing an expansion
or a contraction because employment, interest rates, and inflation are clearly affected. Of more
immediate interest to investors, GDP changes directly affect company financials. The mecha-
nism with respect to stock prices is relatively straightforward—if growth in GDP slows, as it
did by the end of 2000 and 2007, corporate revenues and profits slow. The stock market
reacts negatively to the prospect of diminished economic activity.

✓ The recurring pattern of expansion and contraction in economic activity is referred to as

Business Cycle The the business cycle.
recurring patterns
of expansion, boom,
contraction, and recession
in the economy THE BUSINESS CYCLE
The business cycle reflects movements in economic activity as a whole; however, economic
activity is comprised of many diverse parts. The diversity of parts ensures that business cycles
are unique. However, cycles do have a common framework, with a beginning (they start from

Figure 13-1 Real gross domestic product

Annual percent change
Percent Change in 6
Real Gross Domestic
3
Product (GDP),
0
1994–2011
–3
SOURCE: Monetary Trends,
The Federal Reserve Bank of –6
St. Louis, February 2012, p. 13.
19
19
19
19
19
19
20
20
20
20
20
20
20
20
20
20
20
20
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11

1
This discussion is based on Abbigail J. Chiodo and Michael T. Owyang, “Subject to Revision,” National Economic
Trends, The Federal Reserve Bank of St. Louis, June 2002, p. 1.

c13.indd 341 1/23/2016 4:32:07 PM

 342 CHAPTER 13 ECONOMY/MARKET ANALYSIS

a trough), a peak, and an ending (a new trough). Thus, economic activity starts in depressed
conditions, builds up in the expansionary phase, and ends in a downturn, only to start again.
The word “trough” is used to indicate when the economy has hit bottom.

◨ The period from a peak to a trough is a recession.

◨ The period from a trough to a peak is an expansion.

The typical business cycle in the United States since the end of World War II (WWII)
consists of an expansion averaging about 57 months. Contractions since the war average
about 10 months in duration. Obviously, however, these are only averages, and we cannot rely
on them exclusively to interpret current or future situations. For example, the March 1991
expansion became the longest peacetime expansion, ending in March 2001. Business cycles
cannot be neatly categorized as to length and turning points at the time they are occurring;
only in hindsight can such precise distinctions be made. The National Bureau of Economic
Research (NBER), a private nonprofit organization, measures business cycles and officially
decides on the economic “turning points,” the dates at which the economy goes from an
expansion mode to a contraction mode, and vice versa.2

✓ The turning points of the business cycle typically are determined well after the fact, so
that observers do not know on a current basis, at least officially, when a peak or trough
has been reached.

Some Practical Advice

What exactly is the definition of a recession, and how The official declaration that a recession has occurred
do we know when we are in one? This was a hotly comes from the NBER’s dating committee. Unfor-
debated topic in early 2008 as the economy appeared tunately, in either case you won’t know about it
to be weakening rapidly. A commonly accepted until after it has started. With the GDP definition,
definition of a recession among the general public is you must wait until the data for the two consecu-
two consecutive quarters in which real GDP declines. tive quarters have been released. In the NBER case,
However, the NBER defines a recession as a “significant the committee usually declares that a recession has
decline in activity spread across the economy, started some 6–18 months after economic activity
lasting more than a few months, visible in industrial has peaked (it took 12 months in the case of the 2008
production, real income, and wholesale‐retail sales.” recession).

Standard practice is to separate economic indicators into three categories: leading, coin-
Composite Economic cident, and lagging. Composite economic indexes are formed for each of the three categories.
Indexes Leading, The leading indicators tend to move prior to a transition in economic conditions and consist
coincident, and lagging
of variables such as stock prices, an index of consumer expectations, money supply, and
indicators of economic
activity interest rate spreads. The coincident indicators consist of four variables, including industrial
production, employment figures, manufacturing activity, and trade sales. The lagging indicators
move after economic activity and consist of seven variables such as duration of unemployment,
bank prime rate, labor costs, and commercial and industrial loans outstanding.3

2
The NBER’s Business Cycle Dating Committee determines the turning points of the business cycle.
3
The Conference Board, a business membership and research network founded in 1916, assumed the responsibility
for computing the composite indexes from the Department of Commerce.

c13.indd 342 1/23/2016 4:32:07 PM

 Assessing the Economy 343

The composite indexes are used to indicate peaks and troughs in the business cycle. The
intent of using all three is to better summarize and reveal turning point patterns in economic
data. Note that a change in direction in a composite index does not automatically indicate a
cyclical turning point. The movement must be of sufficient size, duration, and scope.4

In March 2001, following the stock market plunge and weakening of the economy, it was
Example 13-1 reported that the index of leading economic indicators declined in February for the fourth
time in five months. In November 2001, the NBER declared that a recession began in March
2001. In 2007, there was widespread weakness among the leading indicators. We now know
that the 2008–2009 recession officially started in December 2007.

Some Practical Advice

In the last half of 2011, many people were worried that recession under these conditions. While this is not in
the United States would suffer another recession—a any way a guarantee, it is about as good an assurance
double dip. However, the leading economic indicator as we can get about the economy from any single
index was at a high level and had been rising for piece of information.
five months. The United States has not suffered a

The Global Perspective The most recent downturns in U.S. economic activity
occurred as other countries were experiencing the same conditions, thus, there was a synchro-
nized global downturn. As we noted in Chapter 1, economies around the world are now more
integrated due to increased trade and capital flows among countries. However, the most
important reason for synchronized recessions among many countries is a common shock that
is felt around the world. For example, in the 1970s, there was an oil price shock, and it
affected numerous countries. The collapse of the technology sector, and with it the technology
stocks, was the common shock that occurred in several countries in 2000–2001. In 2008, the
subprime mortgage fiasco and the related liquidity problems with financial institutions con-
stituted a common shock to a number of countries.
Keep in mind the potential importance of foreign trade to GDP. While the growth rate
of real GDP may be positive, the growth rate of gross domestic spending (which excludes net
foreign trade) can be negative. In the same manner, an increase in overseas corporate profits
for U.S. companies can offset (partially or totally) a decrease in domestic corporate profits.

Has the Business Cycle Been Tamed? From the end of WWII through the end of
the 20th century, there were nine recessions. A record‐long expansion began in 1991 and
peaked in March 2001. This extended period of prosperity prompted some observers to ask
whether the business cycle was dead. As one CEO noted, “We are in a global economy . . .”
which “has changed the paradigm. . . . We don’t see the cyclical events that characterized the
past.”5 As it turns out, this was an unfortunate observation, given the two subsequent periods
of economic crisis and the accompanying recessions of 2001 and 2008–2009.

4
All of this information is available at the Conference Board website, http://www.conference‐board.org/data/
bciarchive.cfm?cid51.
5
This quote and discussion are based on Jacob M. Schlesinger, “The Business Cycle Is Tamed, Many Say, Alarming
Some Others,” The Wall Street Journal, November 15, 1996, pp. A1, A16.

c13.indd 343 1/23/2016 4:32:07 PM

 344 CHAPTER 13 ECONOMY/MARKET ANALYSIS

The other side of the coin is that as expansions continue, people tend to forget the les-
sons learned from prior recessions. As one researcher noted, “Who can eliminate herding?”—
referring to the tendency of people to get collectively carried away. Expansions typically end
for one of the following reasons: an overheating economy with rising inflation, forcing the
Federal Reserve (Fed) to raise interest rates; an external shock, such as a sharp rise in oil prices;
or a financial crash following a break in a speculative bubble (when speculation pushes asset
Bubble When speculation prices to unsustainable highs). For example, the Japanese economic expansion of the 1980s
pushes asset prices to
was a speculative bubble that drove stock prices and land values to record levels, and the bub-
unsustainable highs
ble burst at the end of the 1980s—the Japanese economy and market have yet to fully recover.
One can argue that a bubble occurred in the U.S. stock market in the late 1990s, peak-
ing in March 2001.6 Regardless of whether a “true” bubble occurred or not and whether such
a bubble caused a recession, this recession was short‐lived and ended eight months later in
November 2001.
While business cycles may be different than they were historically, they will continue to
exist. This was made clear by the start of the 11th recession since WWII in December 2007.
This recession brought new shocks to the U.S. economy not seen since the Great Depression.
Unprecedented events happened in the form of government bailouts, government involvement
in banks and other companies, severe changes on Wall Street, and turbulence in the stock
market that truly frightened many people. Anyone who previously believed that the business
cycle had been tamed was surely cured of that belief in 2008 as unemployment reached levels
not seen in 30 years, numerous financial institutions failed, and at least two automakers were
on the brink of bankruptcy.

FORECASTS OF THE ECONOMY

Good economic forecasts are of significant value to investors, but how good are the forecasts
that are made available? Some research suggests that forecasts made by prominent forecasters
are very similar and that differences in accuracy are very small, suggesting that investors can
use any of a number of such forecasts. Obviously, not all forecasters are equally accurate, and
all forecasters make errors. The good news is that forecast accuracy apparently has increased
over time.
Investors can find forecasts of the economy from various sources. Some of these are
what are referred to as “consensus” forecasts. For example, Blue Chip Economic Indicators is a
publication that compiles consensus forecasts from well‐known economic forecasters of
important economic variables such as real GDP, consumer prices, and interest rates. Thus,
investors can find reputable, consistently done (but not necessarily accurate) forecasts of the
economy for at least the year ahead.

The Impact of the Fed Many investors closely monitor the actions of the Fed because
of its role in monetary policy and its impact on interest rates. When the Fed chairman testifies
before Congress or otherwise makes a public statement, the financial markets scrutinize every
word for clues as to the future of the economy and financial markets. During normal eco-
nomic times, the Fed carries out monetary policy through what is known as its “dual
mandate.”
In 1977, Congress gave formal recognition of the monetary objectives of the Fed by
identifying the Fed’s dual mandate. According to the dual mandate, the Fed is to apply its
policies to promote the goals of maximum employment and stable prices (essentially, low

6
For a discussion of whether the U.S. markets underwent a speculative bubble, see Robert J. Shiller, “Bubbles, Human
Judgment, and Expert Opinion,” Financial Analysts Journal, May/June 2002, pp. 18–26.

c13.indd 344 1/23/2016 4:32:07 PM

 Assessing the Economy 345

inflation). The power of the Fed is derived primarily due to its authority over these two
prominent aspects of the economy.
Not surprisingly, relationships between macro variables are imprecise and controversies
exist about the impact of changes in policy variables on the economy. Most economists agree
that monetary policy tightening can slow an overheating economy, whereas monetary expan-
sion can stimulate a weak economy. There is, however, considerable disagreement regarding
the effectiveness of Fed policy and the timing of policy changes and their subsequent economic
impact.
How does the Fed change the money supply? Essentially all changes in the money
supply are initiated via the Fed’s most powerful monetary policy tool—its open market
operations. The Fed executes its open market operations through the Federal Open Market
Committee (FOMC). If the Fed believes that the economy would benefit from monetary
stimulus—that is, an expansion of the money supply—the Fed directs the FOMC to purchase
bonds. The bond purchase replaces bond holdings of financial institutions (banks) with cash,
which the banks then lend to customers who put them to productive use expanding business
operations. Thus, the FOMC’s purchase of bonds results in more money circulating through
the economy, which represents an increase in the money supply. As a response to the 2008
financial crisis, the Fed initiated a program referenced as Quantitative Easing (QE) to shore up
the financial markets. QE is essentially nothing new but rather the Fed’s open market bond
purchase program on steroids.
Following the 2008 financial crisis, monetary easing became the dominant Fed policy,
if, however, the Fed believes that inflation has become the overriding concern, its policy will
likely shift to monetary tightening. To execute this shift, the Fed will direct the FOMC to sell
bonds, thus replacing bank cash holdings with bonds. An increase in the bond holdings of
banks diminishes the money available to create bank loans. This action will help to put the
brakes on the economy. Thus, the ultimate result of FOMC bond sales is a reduction in money
circulating through the economy.7

Insights from the Yield Curve The yield curve depicts the relationship between bond
yields and time to maturity. The curve shows how the yield on short‐term, intermediate‐term,
and long‐term bonds relate to one another.8 It contains valuable information because it reflects
bond traders’ views about the direction of future interest rates and the economy in general. For
example, an upward‐sloping yield curve indicates that bond traders believe that interest rates
will increase in the future. Several studies suggest that the yield curve is very useful in making
economic forecasts.
Many investors believe that the shape of the yield curve is related to the stage of the
business cycle. In the early stages of an expansion, yield curves tend to be low and upward-
sloping, and as the peak of the cycle approaches, yield curves tend to be high and downward-
sloping. More specifically:

◨ A steepening yield curve suggests that the economy is accelerating in terms of activity.
◨ When the yield curve becomes more flat, it suggests that economic activity is slowing.
◨ For many, an inverted yield curve carries an ominous message—the expectation of an
economic slowdown (every recession since WWII has been preceded by a downward‐
sloping yield curve).

7
For a more complete discussion of the relation between Fed policy and markets, see Robert Johnson, Gerald Jensen,
and Luis Garcia‐Feijoo, Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy
(McGraw Hill Inc., 2015).
8
In Chapter 17, we consider the yield curve and its role in understanding interest rates.

c13.indd 345 1/23/2016 4:32:07 PM

 346 CHAPTER 13 ECONOMY/MARKET ANALYSIS

The top panel of Figure 13‐2 shows some Treasury yield curves for 2011 and 2012 as
the economy struggled to grow. They are upward-sloping, which is the normal shape of the
yield curve. The middle panel of Figure 13‐2 shows an upward‐sloping yield curve in January
2005, which had become basically flat by January 2006. At the end of 2006, and early in
2007, the yield curve had a slight downward slope, and by December 2007, the economy was
in recession. The bottom panel shows yield curves in 2000, which went from flat in January
to clearly downward-sloping in June and July. As we now know, a recession officially began in
March 2001.

Figure 13-2 Percent

4
Treasury Yield Curves Week ending friday:
09/16/2011
SOURCE: Monetary Trends, 08/17/2012
Federal Reserve Bank of 09/14/2012
St. Louis, September 2012, 3
p. 3; National Economic Trends,
Federal Reserve Bank of
St. Louis, February 2006 p. 7;
Federal Reserve Bank of 2
Cleveland.

0
5y 7y 10y 20y

Treasury yield curve

5.25
Week ending: 01/27/2006
4.75
4.25
January 2006
Percent

3.75
3.25
January 2005
2.75
2.25
1.75
3m 1y 2y 5y 7y 10y

7.00
Yield curves
6.50
January 2000

6.00

5.50
June 30, 2000
Percent

5.00

July 28, 2000

4.50

4.00

3.50

3.00
0 5 10 15 20 25 30
Years to maturity

c13.indd 346 1/23/2016 4:32:07 PM

 The Stock Market and the Economy 347

A prominent model for forecasting recessions relies on the spread between long‐term
and short‐term bonds, that is, the shape of the yield curve. According to the model’s creators,
it was quite successful in predicting recessions four quarters in advance of their start.9

Checking Your Understanding

1. Assume that you observe a downward‐sloping yield curve. As an investor, what signifi-
cance would this have to you? How much confidence would you have in the conclusions
you draw from this?

The Stock Market and the Economy

The stock market is a significant and vital part of the overall economy. If the economy is weak,
most companies will perform poorly, as will the stock market. Conversely, if the economy is
prospering, most companies will do well, and the stock market will reflect this economic
strength. The relationship between the economy and the stock market, however, is not coin-
cident as stock prices generally lead the economy. Historically, the stock market is the most
sensitive indicator of the business cycle (it is one of the leading indicators).

✓ The market and the economy are closely related, but stock prices typically turn before
the economy.

Investments Intuition

Why is the market a leading indicator of the economy? An alternative explanation for stock prices
Basically, investors are discounting the future because leading the economy involves changes in investor
stocks are worth the discounted value of all future cash confidence. A change in investor confidence changes
flows. Current stock prices reflect investor expecta- the required rate of return in the opposite direction.
tions of the future. Stock prices adjust quickly if inves- For example, an increase in investor confidence
tor expectations of corporate profits change. Of course, reduces required returns, which increases stock
the market can misjudge corporate profits, resulting in prices. Psychological elements are sometimes used
a false signal about future movements in the economy. in explaining market movements.

How reliable is this relationship between the stock market and the business cycle? While
it is generally considered reliable, it is widely known that the market has given false signals
about future economic activity, particularly with regard to recessions. The old joke goes some-
thing like this—“The market has predicted nine out of the last five recessions.”
Recognizing that the market does not always lead the economy in the predicted manner,
consider what an examination of the historical record shows:

◨ Prices often peak roughly one year before the start of a recession.
◨ The typical contraction in stock prices is 25 percent from the peak. With recent reces-
sions, however, it has been 40 percent or more. For example, in 2000–2002, the S&P
500 declined some 45 percent from its peak.

9
See Arturo Estrella and Frederic S. Mishkin, “The Yield Curve as a Predictor of U.S. Recessions,” Current Issues in
Economics and Finance, 2 (June 1996): 1–6; and Arturo Estrella and Frederic Mishkin, “Predicting U.S. Recessions:
Financial Variables as Leading Indicators,” Review of Economics and Statistics, 80 (February 1998): 45–61.

c13.indd 347 1/23/2016 4:32:08 PM

 348 CHAPTER 13 ECONOMY/MARKET ANALYSIS

◨ The ability of the market to predict recoveries has been remarkably good.
◨ Stock prices almost always turn up three to five months before a recovery, with four
months being very typical.

Following WWII, and preceding the recession of 2001, there were nine periods of
recovery. In each of these, the market (the S&P 500) rose before the recession’s trough
and continued to rise as the expansion entered its early stages. Six months into recovery,
stock prices were, on average, more than 25 percent higher than they had been a year
earlier.
In summary, although the leading relationship between the stock market and the econ-
omy is far from perfect, investors must take it into account.

✓ Typically, by the time investors clearly recognize what the economy is doing, such as
going into recession or coming out of recession, the stock market has already antici-
pated the event and reacted.

THE ECONOMY AND STOCK MARKET BOOMS

It should come as no surprise that in a complex economy such as the U.S. economy, exact
relationships cannot be specified. Nevertheless, based on an analysis of the past, some clear
Bull Market A relatively guidelines have emerged. Stock market booms (bull markets) have generally occurred during
strong upward trend in periods of relatively rapid economic growth.10 Productivity growth is also associated with
the stock market market booms; however, there is little evidence linking stock market performance with unu-
sual growth in the money supply or aggregate credit. Bull markets have occurred during
periods of deflation, price stability, and inflation.

The business cycle–stock‐price relationship is illustrated by what happened in 2000–2001.

Example 13-2 Following a strong run‐up in the late 1990s, the U.S. stock market peaked in March 2000, and
the longest economic expansion in U.S. history—the 10‐year expansion of the 1990s—is
considered to have ended in March 2001.

ECONOMIC SLOWDOWNS AND BEAR MARKETS

What happens to the stock market when economic activity slows, for example in a recession?
Common sense suggests a negative impact on the market, and that is what has happened
historically. By mid‐July 2008, the major market indexes had all declined at least 20 percent,
Bear Market A downward the classic definition of a bear market. And, of course, the economy was in great turmoil from
trend in the stock market the subprime debacle, record oil prices, bank failures, and so forth.
According to Standard & Poor’s, since WWII, 11 bear markets have occurred through
2009. These bear markets lasted an average of 16 months. It took an average of nine months
for the decline to breach the −20 percent mark that defines a bear market.

10
This discussion is based on Michael D. Bordo and David C. Wheelock, “Monetary Policy and Asset Prices: A Look
Back at Past U.S. Stock Market Booms”, Review, Federal Reserve Bank of St. Louis, 86, no. 6 (November/December
2004): 19–44.

c13.indd 348 1/23/2016 4:32:08 PM

 Understanding the Stock Market 349

A reasonable hypothesis to explain the stock market’s decline when the economy slows is
that investors become more risk averse and demand a higher return for holding stocks. Campbell
and Cochrane formalized this idea in a model.11 With an economy going into, or in, a recession,
investors are less willing to bear financial risk. To induce investors to hold stocks rather than
Treasury securities, the equity risk premium must increase, which results in stock cash flows
being discounted at a higher discount rate. Thus, stock prices fall during recessions.

Checking Your Understanding

2. Assume you determine this month that the economy has reached a peak and is headed
downward. What conclusions would you draw about stock prices?

Understanding the Stock Market

A MODEL OF AGGREGATE STOCK PRICES

In Chapter 10, we considered a model to estimate the intrinsic value of stocks, which relied
on a firm’s forecasted earnings and an estimated appropriate P/E for the stock. The same
model can be applied to the aggregate stock market as represented by a market index such as
the S&P 500.
To value the stock market using the multiplier approach, you must estimate index earn-
ings and the earnings multiplier as shown in Equation 13‐1. This model uses an appropriate
P/E ratio, which we call (P0/E1)A. We use the S&P 500 for our example:

P0
P0 E1 13-1
E1 A

where
E1 expected earnings on the S & P 500
P0
the appropriate price-earnings ratio or multiplier
E1 A

We consider each of these variables in turn.

The Earnings Stream Estimating earnings (profits) for purposes of valuing the market
is not easy. Corporate profits are derived from corporate sales, which in turn are related to
GDP. A detailed, top‐down fundamental analysis of the economy/market involves estimating
GDP, then corporate sales, working down to corporate earnings before taxes, and finally to
corporate earnings after taxes. Each of these steps can be time‐consuming and tedious.
However, evidence supports the value of the process as real (inflation‐adjusted) earnings
growth has correlated well with real GDP growth over the long run.

✓ When estimating real earnings growth for the future, the best guide may be expected
real GDP growth.

11
John Y. Campbell and John H. Cochrane, “By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock
Market Behavior,” Journal of Political Economy, 107 (1999): 205–251.

c13.indd 349 1/23/2016 4:32:08 PM

 350 CHAPTER 13 ECONOMY/MARKET ANALYSIS

It is reasonable to expect corporate earnings to grow, on average, at about the rate of the
economy as a whole; however, there have been periods where the two have diverged substan-
tially. For example, during the last years of the 20th century, operating earnings per share
(EPS) for the S&P 500 grew an average of 10.2 percent a year versus a rate of 5.6 percent for
economic growth. This simply illustrates how difficult it is to accurately forecast earnings.
Extenuating factors can cause some divergences. For example, share repurchases by firms may
increase the rate of earnings growth relative to historical rates. Since earnings have to be allo-
cated over fewer shares as firms repurchase shares, EPS increase. In addition, GDP growth
includes the government portion of the economy, which is generally less productive than the
private sector.

Which Earnings Should We Use? Note that an annual EPS for the S&P 500 can be
constructed in various ways. For example, assume we are 10 days away from the end of 2014.
The fourth‐quarter earnings for 2014 are still an estimate, and even the third quarter has a
small element of uncertainty in it. All four quarters for 2015 are estimates. This is further
complicated by the fact that for the S&P 500, Standard & Poor’s provides a variety of earnings
estimates including top‐down, bottom‐up, “as‐reported,” and operating earnings. Furthermore,
S&P also provides an estimate of “core earnings” for the S&P 500, which removes the impact
of unusual items from the earnings estimate. The primary reasons that core earnings and as‐
reported earnings differ are pension income and stock option grant expenses, with the treat-
ment of pension gains having a very significant impact. The differences between these two
earnings numbers can be substantial.

The Multiplier or P/E Ratio The multiplier to be applied to the earnings estimate
is the other half of the valuation framework. Investors sometimes mistakenly ignore the
multiplier and concentrate only on the earnings estimate. But earnings growth is not
always the leading factor in significant price changes in the market. Instead, low interest
rates may lead to high P/E ratios, which in turn may account for much of the market’s price
change.
Figure 13‐3 shows the P/E ratio for the S&P 500 since 1980. Since 1980, there has been
a general upward movement of P/E ratios across time; however, the ratio has been highly
erratic over the years.
The volatility in the market P/E indicates that investors cannot simply extrapolate P/E
ratios into the future. While average P/E ratios over long periods are reasonably steady, the
variation over shorter periods is large. For the S&P 500, the average P/E for the last 100 years
is about 16.0. However, individual years can be very different. The P/E ratio was 7.9 in 1979,
32.9 in 1999, 46.2 in 2002, 14.9 in 2012, and over 18.0 by the end of 2014.
P/E ratios are generally depressed when economic growth is weak and interest rates and
the rate of inflation are high, such as around 1979–1981. P/E ratios tend to be high when
economic growth is relatively strong and inflation and interest rates are low, such as the period
of the mid‐to‐late 1990s. When earnings are growing fairly rapidly and the prospects for con-
tinued growth is strong, investors are willing to pay more for earnings.

✓ P/E ratios can be calculated based on historical earnings or estimated future earnings.

The earnings multiplier (P/E ratio) can be derived using several alternative earnings
measures including most recent year‐end, trailing 12 months (TTM), next year’s estimated

c13.indd 350 1/23/2016 4:32:08 PM

 Understanding the Stock Market 351

Figure 13-3 70
S&P P/E ratios
S&P P/E Ratios
60

50

40

30

20

10

0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
year‐end earnings, or earnings estimated over the next 12 months. If historical earnings are
used, the P/E is sometimes referenced as a trailing P/E; this is the standard P/E. When esti-
mated earnings are used in deriving the P/E, the ratio is commonly referenced as the forward
or leading P/E. Obviously, a significant difference can exist between P/E ratios calculated using
these different definitions.

The S&P 500 increased about 150 percent between the end of 1994 and December 1998.
Example 13-3 Stock prices are a function of both corporate earnings and the P/E ratio. At the end of 1994,
the P/E based on current earnings was 15. At the end of 1998, it was 32.6. Over the period
1994–1998, corporate earnings rose about 25 percent, and the P/E ratio more than doubled,
thereby accounting for much of the sharp rise in the S&P 500 during that period.

Putting the Two Together Valuing the aggregate market is not easy because the
market is always looking ahead. No one knows for sure how far the market is looking ahead,
and no one knows for sure what the market will be willing to pay for a dollar of earnings.
Furthermore, industry analysts are notoriously optimistic when forecasting market earnings
more than one quarter out, such as the earnings for next year for the S&P 500.
Regardless of the difficulties, the bottom line is this—to derive an estimate of the market
value, an investor must analyze both factors that determine stock prices: corporate earnings
and the multiplier.

c13.indd 351 1/23/2016 4:32:08 PM

 352 CHAPTER 13 ECONOMY/MARKET ANALYSIS

Concepts in Action

How Analysts Go About Valuing the Market

With the subprime crisis, record oil prices, and the Many analysts were already doubting the median
mass failure of financial institutions, 2008 was a year earnings forecast of about 8 percent for the year and
of great turmoil in the U.S. economy. In mid‐June were particularly dubious about forecasts of strong
2008, analysts were trying to figure out where the earnings growth for 2009. As for the P/E ratio, which was
S&P 500, then at 1,360, would go. As a Wall Street slightly less than 17 based on the previous 12 months of
Journal article noted, “Where the market ends up earnings, there were fears that higher inflation would
depends on how much companies earn during the lead to lower multiples. Holding earnings constant, this
rest of the year and what price, or multiple, investors would lead to a lower value for the S&P 500.
put on those earnings.” This illustrates the discussion Quote from Tom Lauricella, “Skeptics See
above—two variables determine stock prices, earn- Stocks Mired in the Muck,” The Wall Street Journal,
ings, and multiples. June 16, 2008, p. C1.

Checking Your Understanding

3. Assume you are convinced that you accurately know what corporate earnings will be for
next year. Can you then reliably predict the direction of the market?

Making Market Forecasts

✓ Accurate forecasts of the stock market, particularly short‐term forecasts, are impossible
for anyone to do consistently.

As discussed in Chapter 12, there is strong evidence that the market is generally efficient,
which implies that investors cannot easily predict market changes. Another implication is that
even professional money managers cannot consistently forecast the market using available
information, and the available evidence on the performance success of professional investors
supports this proposition.
Nevertheless, many investors seek to estimate likely changes in the stock market. Not
only do they want to try to understand what the market is doing currently and why, but they
also want some reasonable estimates of the future. Part of this process, as discussed earlier,
involves analyzing the health of the overall economy. Ultimately, to predict market value,
investors need earnings estimates and the P/E ratio for next year. As we have seen, however,
accurate estimates are difficult to obtain. What, then, can investors do in trying to assess
future movements in the market?

FOCUS ON THE IMPORTANT VARIABLES

It has long been known that stock prices are closely related to corporate earnings and that
interest rates play a major role in affecting both bond and stock prices. Consider an interview
with Warren Buffett.12 Buffett was asked to comment on the likely scenario for the market.

12
See “Warren Buffett on the Stock Market,” Fortune, December 10, 2001, p. 82.

c13.indd 352 1/23/2016 4:32:08 PM

 Making Market Forecasts 353

Buffett argued that long‐term movements in stock prices are caused by significant changes in
“two critical economic variables”:

1. Interest rates
2. Expected corporate profits

If investors wish to understand the stock market and make reasonable judgments about
future movements in stock prices, they must carefully analyze interest rates and expected
corporate profits.

Corporate Earnings, Interest Rates, and Stock Prices Interest rates and
P/E ratios are generally inversely related. When fixed‐income securities pay relatively low
rates, investors are willing to pay more for stocks; therefore, P/E ratios are higher. Stock prices
rise strongly as earnings climb and interest rates stay low.
Figure 13‐4 shows the three series together—interest rates, the percent change in cor-
porate profits, and the percent change in the S&P 500 return for the period 1987–2011. In
general, around recessionary periods, interest rates trended upward before the recession, cor-
porate profits fell, and stock returns were below average. Also notice the similarities in profit
changes and stock return changes in terms of highs and lows, and how rising (falling) interest
rates are generally associated with falling (rising) stock returns.

Figure 13-4 Interest rates

Interest Rates, 18
Corporate Profits, 15
and S&P 500 Returns, 12
1986–2011
9
SOURCE: National Economic 10-year treasury
Trends, Federal Reserve Bank of 6
St. Louis, March 2012, pp. 7, 21. 3 3-month treasury

0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Corporate profits
14
12 Profits (before tax)
10
8
6
4 Profits (after tax)

2
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

Standard and Poor’s 500 index with reinvested dividends

75

50

25

–25

–50
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

c13.indd 353 1/23/2016 4:32:08 PM

 354 CHAPTER 13 ECONOMY/MARKET ANALYSIS

It is logical to expect a relationship between corporate profits and stock prices. If the
economy is prospering, investors expect corporate earnings and dividends to rise and, other
things being equal, stock prices to rise. To a large extent, corporate earnings growth is thought
of by most market observers as the basis for share price growth. In fact, holding the P/E ratio
constant, growth in price should match growth in earnings.
Interest rates are a basic component of discount rates, with the two usually moving
together. As Figure 13‐4 shows, there is an inverse relationship between interest rate move-
ments and stock prices.

✓ As interest rates rise (fall), stock prices fall (rise), other things equal.

If the level of interest rates increases, the riskless rate of return, risk-free rate (RF),
increases. Therefore, other things being equal, the required rate of return (discount rate)
increases because the riskless rate is one of its two components; the other being the risk
premium.
Investors pay close attention to the release of information that could influence interest
rates such as material announcements by the FED.
Like most market relationships, the relationship between interest rates and stock prices
is not perfect. Nor do interest rates have a linear effect on stock prices. The analysts’ purpose
is to obtain general clues regarding the direction of the economy and the market. For example,
to say that we are confident the market will go to 20,000 or 14,000 (as measured by the Dow
Jones Industrial Average) one year from now is foolish. Similarly, a firm prediction that corpo-
rate earnings will rise next year by 10 percent, or that interest rates are sure to rise (or fall)
2 percent, is a virtually certain prescription for embarrassment.

✓ In truth, most individual investors—indeed, most professional investors—cannot time

the market consistently.

What, then, should investors do? The best approach is not only to recognize the futility
of attempting to accurately forecast the direction of the market but also to recognize that
periodically situations will develop that suggest strong action. An example is 1982, when
interest rates reached record levels. Either rates were going to decline or the U.S. economy
would face a crisis situation. Interest rates did decline, launching one of the greatest bull
markets in U.S. history.
Investors may simply choose to hold their positions when the market appears ready to
decline. Why? According to available evidence, investors lose more by missing a bull market
than by dodging a bear market. This is consistent with the evidence presented in Chapter 11
showing that investors who miss a relatively few months in the market may lose much of the
gains over the long‐run period.

Consider the following headlines from financial media:

Example 13-4
“Markets Fall on Absence of Rate Cut”
“Recent Rise in Long‐Term Interest Rates May Mean Trouble for the Stock Market”
“As Interest Rates Rise, Will Stocks Fall?”
“How Rising Interest Rates Could Affect Your Portfolio”

c13.indd 354 1/23/2016 4:32:08 PM

 Checking Your Understanding 355

Checking Your Understanding

4. Given that earnings and the P/E ratio determine stock prices, what is the logic for argu-
ing that interest rates are one of the two critical variables in forecasting the direction of
the market?

USING THE BUSINESS CYCLE TO MAKE MARKET FORECASTS

Earlier we established that certain composite indexes can be helpful in forecasting or ascer-
taining the position of the business cycle. However, stock prices are one of the leading indica-
tors, tending to lead the economy’s turning points, both peaks and troughs. This leading
relationship between stock prices and the economy must be taken into account in forecasting
likely changes in stock prices.
Stock prices generally decline in recessions, and the steeper the recession, the steeper
the decline. However, investors need to think about the business cycle’s turning points months
before they occur in order to have a handle on the turning points in the stock market. If a
business cycle downturn appears likely in the future, the market will also be likely to turn
down some months ahead of the economic downturn.
We can be somewhat more precise about the leading role of stock prices. Stock prices
have almost always risen as the business cycle is approaching a trough. These increases have
been large, so that investors do well during these periods. Furthermore, stock prices often
remain steady or even decline suddenly as the business cycle enters into the initial phase of
recovery.
The above analysis suggests:

1. If an investor can recognize the bottoming out of the economy before it occurs, a market
rise can be predicted before the bottom is hit. In the recessions since WWII, the market
started to rise about halfway between GDP starting to decline and starting to grow
again.
2. The market’s average gain over the 12 months following its bottom point is about
36 percent.
3. As the economy recovers, stock prices may level off or even decline. Therefore, a second
significant movement in the market may be predictable.
4. The market P/E usually rises just before the end of an economic slump. It then remains
roughly unchanged over the next year.

Some Practical Advice

Forecasting market movements is a humbling expe- rise in the market based on an apparent ending to the
rience and will cause the forecaster to look foolish economic slump. Although a profit recovery had not
sooner or later—in all likelihood, sooner. The points occurred, it appeared to many that it was time to get
mentioned above are based on past experience, but back in the market in anticipation of the market rising
the past does not always repeat itself. In the spring and before the absolute bottom. The anticipated market
summer of 2002, many market observers expected a rise, however, did not occur as early as expected.

c13.indd 355 1/23/2016 4:32:08 PM

 356 CHAPTER 13 ECONOMY/MARKET ANALYSIS

THE E/P RATIO AND THE TREASURY BOND YIELD

Practitioners on Wall Street sometimes use a valuation model that compares the earnings yield
with the nominal yield on a long‐term Treasury bond. This model, often referred to as the
“Fed model,” is based on the simple premise that investors switch between stocks and bonds,
based on the asset offering the higher yield. For example, when bond yields are relatively low,
investors switch out of bonds and into stocks driving stock prices up and bond prices down.13
To measure bond yields, one can use the yield on 10‐year Treasuries. The earnings yield
(E/P ratio) is calculated as earnings divided by stock price. Using the S&P 500, the earnings
figure used is a forward 12‐month earnings estimate.14 A simple approach to obtain the mar-
ket E/P ratio is to simply take the reciprocal of the S&P 500 forward P/E ratio.
The virtues of this model are its simplicity and the fact that variables can be obtained
with relative ease. Of course, the forward 12‐month earnings for the S&P 500 is an estimate,
and is subject to error.
This model is used to formulate the following decision rules:

◨ When the earnings yield on the S&P 500 is greater than the 10‐year Treasury yield,
stocks are relatively attractive.
◨ When the earnings yield is less than the 10‐year Treasury yield, stocks are relatively
unattractive.

An alternative way to use this model is to estimate the “fair value” level of the S&P 500
and compare it to the actual current index value.15 To do this, divide the estimated earnings
for the S&P 500 by the current 10‐year Treasury bond yield (expressed as a decimal) to obtain
the estimated fair value:

◨ If the estimated fair value of the market is greater than the current level of the market,
stocks are undervalued.
◨ If the estimated fair value of the market is less than the current level of the market,
stocks are overvalued.

This model has worked quite well, on average, over time, but it has not always performed
well. Furthermore, when interest rates are very low, it does not work as well as when rates are
in a more normal range. In fact, it can break down completely as far as sensible answers.
Using this formulation, we can use P/E ratios in a relative valuation format as explained
in Chapter 10:

◨ If the S&P 500’s actual P/E ratio is less than the estimated equilibrium P/E ratio, equities
are relatively attractive.
◨ If the S&P 500’s actual P/E ratio is greater than the estimated equilibrium P/E ratio,
equities are relatively unattractive.

13
This model has been widely referred to as the “Fed model” because it was discovered that the Fed had referred to
such a model in its deliberations; however, the Fed neither endorses this model nor necessarily uses it on any ongoing
basis.
14
Thus, on January 1, 2013, we would use an estimate of operating earnings for the S&P 500 for the next 12 months
through the end of the year. In a similar manner, on April 1, 2013, we would use an estimate of the next 12‐month
earnings through April 1, 2014.
15
Also note that the model implies that the reciprocal of the yield on 10‐year Treasuries is an estimate of the S&P 500’s
equilibrium P/E ratio. That is,

An equilibrium estimate of the S&P500 P/E ratio = 1/10‐year Treasury yield

c13.indd 356 1/23/2016 4:32:09 PM

 Checking Your Understanding 357

The Market’s P/E Ratio Perhaps the best known market indicator, and one watched
by many investors, is the market’s P/E ratio. Historically, the P/E ratio for the S&P 500 has
typically ranged from roughly 7 to 47.16 The market P/E was 7.25 at the beginning of 1980,
and the 1980s and 1990s were two of the greatest decades in our history for common stock
returns. Many market observers are extremely nervous when the P/E reaches levels in the high
20s and low 30s, as it did in the late 1990s. They were ultimately proven right, as the market
declined sharply in 2000–2002.
Consider the following analysis of returns over rolling 10‐year periods covering 1900–
2010, a total of 102 periods.17 Thirty‐five percent of the time, the annual return exceeded
12 percent. In every case, the P/E ratio started the 10‐year period at less than 15. Now consider
the 43 percent of the periods when the annual return was less than 8 percent. The starting P/E
ratio was usually above 15. While this is not conclusive proof of the P/E ratio’s importance in
affecting future market returns, it is certainly suggestive that investors should pay close atten-
tion to the ratio.

Interest Rate Spreads Variables derived from interest rates are obvious variables to
monitor when attempting to forecast stock market returns. One of two very prominent rate
spreads is the term premium, which is calculated as the yield on long‐term bonds minus the
yield on short‐term bonds. The term premium reflects the shape of the yield curve as it is posi-
tive when the yield curve is upward sloping and negative when the curve is inverted. The
other prominent rate spread is the credit spread or default premium, which is calculated as the
yield on lower grade, long‐term corporate bonds minus the yield on long‐term, T‐bonds.
The term premium and credit spread are commonly identified as business conditions
indicators and are believed to reflect investor perceptions regarding economic uncertainty.
For example, a wider (narrower) spread indicates greater (less) uncertainty or economic risk.
In support of this belief, Fama and French (1995) report evidence showing that the term
premium and credit spread are both positively correlated with subsequent stock market
returns.18

Monetary Policy How much impact does the Fed have on stock prices? Studies have
consistently shown a systematic link between Fed policy actions and both long‐term and
short‐term stock returns. Specifically, the empirical evidence indicates that increases in Fed
policy rates (e.g., the Fed discount rate and federal funds rate) are associated with negative
market performance, whereas Fed policy rate decreases correspond with positive market
responses. Furthermore, the studies show that small stocks and value stocks are more sensitive
to policy changes, which is consistent with the view that such firms are more prone to becom-
ing strapped for funding.19
Based on the above evidence, the authors of one study examined the period 1966–2013
and showed that a portfolio consisting of small‐value stocks excelled when Fed monetary

16
The market P/E in 2008 was 60 because the financial crisis caused earnings to be abnormally low.
17
These numbers are from Ed Easterling, “Historical Performance and Future Stock Market Return Uncertainties, AAII
Journal, September 2011, p. 24.
18
See Eugene Fama and Kenneth French, Business Conditions and Expected Returns on Stocks and Bonds, Journal of
Financial Economics, 22 (November 1988): 23–49.
19
See Robert Johnson, Scott Beyer, and Gerald Jensen, “Don’t Worry About the Election, Just Watch the Fed,” Journal
of Portfolio Management, 30 (Summer 2004): 101–109, Ben Bernanke and Kenneth Kuttner, “What Explains the Stock
Market’s Reaction to Federal Reserve Policy?” Journal of Finance 60 (June 2005): 1221–1257, and C. Mitchell Conover,
Gerald Jensen, Robert Johnson, and Jeffrey Mercer, “Is Fed Policy Still Relevant for Investors,” Financial Analysts
Journal, 61 (Spring 2005): 70–79.

c13.indd 357 1/23/2016 4:32:09 PM

 358 CHAPTER 13 ECONOMY/MARKET ANALYSIS

conditions were expansive (when the Fed was decreasing policy rates) earning an annual
return of 44 percent. In contrast, during restrictive monetary conditions (when the Fed was
increasing policy rates), this same portfolio earned a meager return of only 4.8 percent.20
Thus, it is not surprising that one of the authors stated that “The Federal Reserve’s manage-
ment of U.S. monetary policy has a strong bearing on the stock market.”

Volatility A popular measure of market uncertainty is the Chicago Board Options

Exchange (CBOE) Volatility Index (VIX). The VIX is constructed based on implied volatilities
on S&P 500 options. It is often referred to as a “fear” index, but it is actually an index of
expected market volatility. There is historical evidence that volatile days tend to cluster
together rather than occur randomly. Investors who wish to avoid these volatile days can pos-
sibly use the VIX. Mark Hulbert has shown that historically average market returns have been
higher if the VIX is below its median value than if it is above this value.21

January Market Performance According to the adage, “as goes January, so goes
the year,” market returns in January serve as a bellwether for the subsequent 11 months. From
1928 through 2013, 31 of the 86 Januaries have had a negative return. In those 31 years, the
average return for the full year was −2.3 percent; however, the average return for the subse-
quent 11 months was 1.7 percent. Thus, there appears to be some general support for the
adage. Let’s look, however, at performance for the period 2004 through 2013. Of those
10 years, January returns were negative four times, and full‐year returns were below average
for only two of those four cases. Therefore, overall, it would appear that investors should not
rely on January to be an accurate barometer for the market’s full‐year performance.22
Finally, as you consider the state of the market, you might ask if any particular month is
riskier than others. Some believe that October is, and the historical evidence seems to support
this idea: Six of the 10 biggest down days since 1926 have occurred in October. As Mark
Twain said, “October is one of the peculiarly dangerous months to speculate in stocks.”
However, the rest of his quote goes as follows: “The others are: July, January, September, April,
November, May, March, June, December, August, and February.”

Summary
▶ The recurring pattern of expansion and contraction in economy are related, stock prices usually turn before
the economy is referred to as the business cycle. Stock the economy.
prices are related to the phases of the business cycle. ▶ Macroeconomic forecasts have become more accurate,
▶ Leading, lagging, and coincident indicators are used but there is much room for improvement.
to monitor the economy in terms of business cycle ▶ Although aggregate measures of money and credit
turning dates. are not very effective in forecasting the market, inves-
▶ Stock prices are a well‐known leading indicator for tors should monitor the actions of the Federal
the economy. Therefore, although the market and the Reserve.

20
See Robert Johnson, Gerald Jensen, and Luis Garcia‐Feijoo, Invest with the Fed: Maximizing Portfolio Performance by
Following Federal Reserve Policy (McGraw Hill Inc, 2015).
21
Mark Hulbert, “Cash is Still King, at Least for Now,” MarketWatch.com, January 10, 2012.
22
See Jeroen Blokland, http://seekingalpha.com/article/1999191‐as‐goes‐january‐so‐goes‐the‐year

c13.indd 358 1/23/2016 4:32:09 PM

 Questions 359

▶ The “market” is the aggregate of all security prices and ▶ Some intelligent estimates of possible changes in the
is conveniently measured by an index of stock prices. market can be made by considering what is likely to
▶ To understand what determines stock prices, it is happen to corporate profits and P/E ratios (or interest
desirable to think in terms of a valuation model such rates) over some future period, such as a year.
as the P/E model or the discounted cash flow model. ▶ An alternative approach to forecasting likely changes
▶ To value the market, investors can think in terms of in the market is to apply a model such as the E/P
expected corporate earnings and the P/E ratio. model (often called the Fed model), which involves a
comparison of bond yields to earnings yields.
▶ Corporate earnings are related to the growth rate of
the economy as measured by GDP. ▶ Other approaches to assessing the market’s likely
direction include assessing the market’s current P/E
▶ Forecasting market changes is difficult. Precise fore- ratio relative to its historical average, an analysis of
casts are generally out of the question. Instead, we are interest rates as seen in the yield curve, the status of
seeking the direction of stock prices and the duration monetary policy, the impact of volatility using the VIX
of any trend that may be occurring. index, and using January as an indicator.

Questions
13‐1 Why is market analysis so important? 13‐13 Suppose that you know with certainty that corpo-
13‐2 How did the performance of the Euro during 2002– rate earnings next year will rise 15 percent above
2004 affect U.S. investors in foreign securities? this year’s level of corporate earnings. Based on
this information, should you buy stocks?
13‐3 Why should investors be concerned with GDP
growth? 13‐14 What does a steepening yield curve suggest about
the economy? What about an inverted yield
13‐4 On average, how long are business cycle expan-
curve?
sions and contractions since WWII?
13‐15 In general, what should be the relationship
13‐5 What is the historical relationship between stock
between corporate earnings growth and the
prices, corporate profits, and interest rates?
growth rate for the economy as a whole?
13‐6 How can investors go about valuing the market?
13‐16 Using the so‐called Fed model relating the earn-
13‐7 What was the primary cause of the rise in stock ings yield on the S&P 500 to Treasury bond
prices starting in 1982? yields, when would stocks be considered an
13‐8 What is the “typical” business cycle–stock‐price attractive investment?
relationship? 13‐17 Why is so much day‐to‐day news coverage
13‐9 If an investor can determine when the bottoming devoted to consumer spending?
out of the economy will occur, when should 13‐18 Suppose you could correctly predict that the
stocks be purchased—before, during, or after business cycle was approaching a trough. What
such a bottom? Would stock prices be expected should your investment strategy for stocks be?
to continue to rise as the economy recovers
13‐19 What are the implications of a negatively sloped
(based on historical experience)?
yield curve for earnings growth and for the econ-
13‐10 Can money supply changes forecast stock‐price omy as a whole?
changes?
13‐20 The P/E ratio on the S&P 500 for 1998 and 1999
13‐11 What is the historical relationship between the was 30 or higher. Other things equal, would this
market’s P/E ratio and recessions? indicate a good time to buy stocks for a multiyear
13‐12 What is the likely explanation for the stock holding period or not?
market’s negative performance in 2000–2002?

c13.indd 359 1/23/2016 4:32:09 PM

 360 CHAPTER 13 ECONOMY/MARKET ANALYSIS

Problems
13‐1 During one week, the NASDAQ Composite went from 2,260.63 to 2,246.69, while the
NASDAQ 100 Index went from 1,701.70 to 1,683.35. Which index showed the
greater loss?
13‐2 The NASDAQ index lost more than 75 percent of its value in the early years of the 21st
century. Assuming a 75 percent loss, what return is needed on this index to make up
for the 75 percent loss?

Computational Problems
13‐1 The following annual data are available for a stock market index.

End‐of‐Year (D/E) (D/P)

Year Price (P) Earnings (E) Dividends (D) P/E (%) (%)

2010 107.21 13.12 5.35 8.17 40.78 4.99

2011 121.02 16.08 6.04 7.53 37.56 4.99
2012 154.45 16.13 6.55 9.58 40.61 4.24
2013 137.12 16.70 7.00 8.21 41.92 5.11
2014 157.62 13.21 7.18 11.93 54.35 4.56
2015 186.24 15.24 6.97

The 2015 values in italics are estimates.

a. Calculate the 2015 values for those columns left blank.
b. On the assumption that g = 0.095, calculate k for 2015 using the formula k =
(D/P) + g and show that k = 0.132425.
c. Using the 2015 values, show that P/E = 12.22.
d. Assuming a projection that 2016 earnings will be 25 percent greater than the 2015
value, show that projected earnings are expected to be 19.05.
e. Assuming further that the dividend payout ratio will be 0.40, show that projected
dividends for 2016 will be 7.62.
f. Using the projected earnings and dividends for 2016, and the same k and g used
in part b, show that the expected P/E for 2016 is 10.69.
g. Using these expected values for 2016, show that the expected price is 203.61.
h. Recalculate the values for 2016 P/E and P, using the same g = 0.095, but with
(1) k = 0.14, (2) k = 0.13, and (3) k = 0.12.

Spreadsheet Exercises
13‐1 Using the spreadsheet below, calculate:
a. Total returns for the S&P 500 for each year from 1991 through 2010
b. Cumulative wealth for the first 10 years (1991–2000) and for the second 10 years
(2001–2010)

c13.indd 360 1/23/2016 4:32:09 PM

 Checking Your Understanding 361

c. The P/E ratio for all 20 years

d. The dividend yield for each year, using the dividend in the current year and the
price at the end of the previous year (e.g., 2011 would be calculated as the 2011
dividend divided by the ending price for 2010)

Price Dividends Earnings Total Ret P/E Div Yield

1990 330.22
1991 417.09 12.2 15.91
1992 435.71 12.38 19.09
1993 466.45 12.58 21.88
1994 459.27 13.18 30.6
1995 615.93 13.79 33.96
1996 740.74 14.9 38.73
1997 970.43 15.49 39.72
1998 1229.23 16.2 37.71
1999 1469.25 16.69 48.17
2000 1320.28 16.27 50
2001 1148.08 15.74 24.69
2002 879.82 16.08 27.59
2003 1111.92 17.39 48.74
2004 1211.92 19.44 58.55
2005 1248.29 22.22 69.93
2006 1418.3 24.88 81.51
2007 1468.36 27.73 66.18
2008 903.25 28.39 14.88
2009 1115.1 22.31 50.97
2010 1257.64 23.12 76.97

Checking Your Understanding

13‐1 Assuming that you are correct in your analysis that the economy has reached a peak
this month, it is likely that the stock market has already turned sometime before now.
Stock prices typically lead the economy. Therefore, the market likely would have antic-
ipated a forthcoming peak in economic activity.
13‐2 Since World War II a downward‐sloping yield curve has almost always preceded a
recession. While there are never guarantees about the future, this is one indicator that
has been remarkably reliable in its predictions, so investors should pay close attention
to it.
13‐3 It takes two variables to determine stock price, whether for one stock or the market.
While you may have a reliable estimate of future earnings, you do not know what the
P/E ratio will be. Thus, even if you knew corporate earnings would be higher next year,
the P/E ratio could decline enough to offset this increase and leave stock prices lower.
13‐4 Interest rates are an important part of the required return for stocks and therefore affect
stock prices. Generally, interest rates and stock prices move in opposite directions.

c13.indd 361 1/23/2016 4:32:09 PM

 chapter
14
Sector/
Industry
Analysis

A s you prepare to invest your inheritance, you should consider some basic information about sectors and industries.
You have already learned that you must think ahead when you invest. Yesterday’s top performers are unlikely to
be tomorrow’s top performers. For example, the utility sector was one of the worst‐performing sectors from 2010
through 2013 but turned in one of the best sector performances for 2014. In contrast, consumer cyclicals excelled
from 2010 through 2013 but performed poorly in 2014. Many analysts attribute this performance to the effect of the
Federal Reserve’s quantitative easing program.
You cannot become proficient in analyzing sectors and industries unless you devote substantial time and effort
to the task; however, learning the basics of such an analysis is certainly beneficial for the management of a portfolio.
Following the recession of 2008–2009, dramatic changes in regulation and industry structure were put in place for
both the financial services sector and the healthcare sector. Over the subsequent five‐year period, the healthcare sector
was the top performer of all sectors, whereas the financial services sector was one of the worst‐performing sectors.1 An
analysis of the changes in these sectors may have alerted you to these results. Likewise, the continuing integration of
technology into almost every facet of an individual’s daily life has made the technology sector one of the top perform-
ing sectors since the beginning of the 21st century.
It is clear that being familiar with current conditions and expected developments in the major sectors of the
economy is crucial to overall investing success. Both short‐term and long‐term portfolio performance are dependent
on selecting sectors with the best earnings and growth prospects.

AFTER READING THIS CHAPTER YOU WILL BE ABLE TO:

▶ Assess the significance of sector/industry analysis in ▶ Understand how to go about using sector/industry
the top‐down approach to security analysis. analysis as an investor.
▶ Recognize how industries are classified and the
stages that industries go through over time.

1
Sector performance is available at websites such as Morningstar.com.

c14.indd 362 1/23/2016 4:58:17 PM

 What Is an Industry? 363

Introduction
The second step in the fundamental analysis of common stocks is sector/industry analysis.
Several studies suggest the industry factor continues to gain prominence.2 For example, the
strongest trading patterns for institutions appear to be based on the sector dimension.
Investors sometimes speak about industries and sometimes about sectors. In general,
a sector is a broader definition and can include several different industries. An industry, in
turn, can include several different subindustries.

✓ For organizational purposes, think of going from sectors to industries to subindustries.

An investor who is convinced that the economy and the market offer favorable condi-
tions for investing should proceed to consider those sectors that promise the most opportunities
in the coming years. In the next few years of the 21st century, for example, investors will not
view some U.S. industries with the same enthusiasm they would have even five years earlier—
desktop and laptop computers being a good example. On the other hand, it is highly likely
that industries such as medical services, social media, and telecom services will continue to
have an impact on most Americans for years to come.

Consider the medical appliances and equipment industry. Intuitive Surgical, Inc. (ISRG) pio-
Example 14-1 neered a robotic surgery machine that revolutionized certain surgical procedures by making
possible only minor incisions in the patient and therefore very rapid recovery from surgery.
The price of the stock soared and, in December 2014, reached $530 per share. Furthermore,
investors believed the company offered plenty of opportunities for future growth as it traded
with a P/E of 46.

The actual security analysis of industries as performed by professional security analysts

is typically quite tedious. Numerous factors are involved, including multiple demand and
supply factors, a detailed analysis of price factors, labor issues, government regulation, and so
forth. To do such analysis successfully requires experience, access to information, and hard
work. Such analysis is not practical for us to consider here. Instead, we will concentrate on the
justification for sector/industry analysis and on the conceptual issues involved.
The basic concepts of industry analysis are closely related to our previous discussion of
valuation principles. Investors can apply these concepts in several ways, depending on the
degree of rigor sought, the amount of information available, and the end objective. What we
seek to accomplish here is to learn to think analytically about industries and sectors. Investors
can in fact benefit from a reasonable and thoughtful approach to sector/industry analysis with-
out getting involved in myriad details.

What Is an Industry?
At first glance, the term industry may seem self‐explanatory. At its most basic, an industry con-
sists of a group of companies primarily engaged in producing or handling the same products or
in rendering the same services. Everyone is familiar with the auto industry, the pharmaceutical

2
See, for example, Stefano Cavaglia, Jeffrey Diermeier, Vadim Moroz, and Sonia de Zordo, “Investing in Global
Equities,” Journal of Portfolio Management, 30 (Spring 2004): 88–94.

c14.indd 363 1/23/2016 4:58:17 PM

 364 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

industry, and the electric utility industry. But are these classifications as clear‐cut as they seem?
Apparently not, because while we have had industry classification schemes for many years, the
classification system for industries continues to evolve, as shown below. Furthermore, invest-
ment advisory services and popular press sources use different classification systems.

Consider General Electric, a classic industrial company that has been in business for more
Example 14-2 than 100 years. Today it is well known for making CT scanners, jet engines, locomotives, gas
turbines, appliances, and light bulbs. However, it also has GE Capital, a 100 percent owned
financial subsidiary, which traditionally has provided a significant percentage of GE’s profits.

CLASSIFYING INDUSTRIES
Standard Industrial For more than 60 years, the Standard Industrial Classification (SIC) System was the
Classification (SIC) system used to classify firms into industries.3
System A classification
SIC codes brought order to the industry classification problem by providing a consistent
of firms on the basis of
what they produce using basis for describing industries and companies in as broad, or as specific, a manner as desired.
census data Nevertheless, the SIC system was criticized for not being able to handle rapid changes in the
U.S. economy. This led to the development of the North American Industry Classification
North American System (NAICS), which replaced SIC codes in 1997.
Industry Classification
System (NAICS) A
company classification THE NAICS CLASSIFICATION SYSTEM
system that uses a
production‐oriented The North American Industry Classification System (NAICS) is a significant change for analyzing
conceptual framework economic activities. It was developed using a production‐oriented conceptual framework; there-
fore, companies are classified into industries based on the activity in which they are primarily
engaged. Basically, companies that do similar things in similar ways are classified together.
NAICS uses a six‐digit hierarchical coding system to classify all economic activity into
20 sectors, which provides greater flexibility relative to SIC codes. Fifteen of these sectors are
devoted to services‐producing sectors compared to five sectors that are mainly goods‐
producing sectors. NAICS allows for the identification of 1,170 industries.
Nine new service sectors and 250 new service industries are recognized. NAICS is now
the standard used by federal statistical agencies to classify businesses.

Using NAICS codes, the plastics product manufacturing industry is coded 3261. Within this
Example 14‐3 code are several breakdowns, including, among others, plastic pipe and pipe fitting manufac-
turing (326122), and plastics bottle manufacturing (326160).

Global Industry
OTHER INDUSTRY CLASSIFICATIONS
Classification Standard The SIC system of industry classification has probably been the best‐known system available
(GICS) Provides a to users. As noted, NAICS is a new classification system providing more detail. However, in
complete, continuous
set of global sector and
the money management field, several well‐known investment advisory companies have devel-
industry definitions using oped their own industry groupings. For example, since March 2002, Standard & Poor’s
10 economic sectors Corporation has provided the Global Industry Classification Standard (GICS) in order to

3
Developed in the 1930s when manufacturing dominated the U.S. economy, this system was revised many times
because of rapid changes in our economy, particularly the expansion of services.

c14.indd 364 1/23/2016 4:58:18 PM

 The Importance of Sector/Industry Analysis 365

provide “one complete, continuous set of global sector and industry definitions.” This system
divides everything into 10 “economic sectors”: consumer discretionary, consumer staples,
energy, financials, health care, industrials, information technology, materials, telecommunica-
tions services, and utilities. Within this framework, there are 24 industry groupings, 68 indus-
tries, and 154 subindustries (as of late 2011). This system is intended to classify companies
around the world and already includes more than 25,000 companies.
S&P’s GICS system, developed jointly with Morgan Stanley Capital International
(MSCI), provides considerably more detail than S&P’s previous classification system. Thus,
the GICS system facilitates the creation and customization of portfolios and indexes.
The Value Line Investment Survey covers roughly 1,700 companies, divided into approxi-
mately 98 industries, with a discussion of industry prospects preceding the company analysis.
Value Line’s industry classifications can be quite useful to investors because Value Line ranks
their expected performance (relatively) for the year ahead.
Other providers of information use different numbers of industries in presenting
data. The important point to remember is that multiple industry classification systems are
used.

The Importance of Sector/Industry Analysis

WHY SECTOR/INDUSTRY ANALYSIS IS IMPORTANT OVER THE LONG RUN

Sector and industry analysis is important to investor success because, over the long run, very
significant differences occur in the performance of industries and major economic sectors of
the economy. To see this, we examine the performance of 16 sectors over a long time period
using sector price indexes.
Kenneth French makes available an extensive collection of financial data on his website,
including return data for several alternative industry/sector classifications. We use his value‐
weighted sector return data to derive cumulative value indexes for 16 sectors and the S&P 500
for a 50‐year plus time period. In constructing the cumulative value indexes, we set the base
index value at 100 for the starting period, 1960. In effect, the value indexes reflect the wealth
an investor would have accumulated by each specified year from making a $100 investment
in 1960 in the index.
Table 14‐1 shows the cumulative wealth indexes for the 16 sectors and the S&P 500 for
five selected year‐ends, 1980, 1990, 2000, 2010, and 2014. Based on the table values, you can
see that a $100 stock market (S&P 500) investment in 1960 would have grown to $18,024 by
the end of 2014. The table values make it clear that equity investors did extremely well during
the decade of the 1980s and 1990s as equities advanced by 3.6 times and 4.9 times, respec-
tively, during these decades. In contrast, during the first decade of the 21st century, equities
only advanced by 1.15 times. This decade is commonly referenced as the “lost decade” for
investment performance.
Overall, there was tremendous variation in the full‐period performance across the
sectors. The best performing sectors, food and drugs, accumulated values of $70,724 and
$66,847, respectively, from the initial $100 investment. In contrast, the worst‐performing
sectors, steel and consumer durables, accumulated values of only $1,533 and $7,472, respec-
tively. Clearly choosing the right sectors for investment made a tremendous difference in an
investor’s final result.
In addition, to the variation in performance across sectors, there was also substantial
variation in performance across time. For example, the mining sector performed relatively
poorly from 1960 through year 2000, then performed incredibly well between 2000 and
2010, but experienced dismal performance again over the final four years of the period.

c14.indd 365 1/23/2016 4:58:18 PM

 366 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

Table 14-1 Cumulative Value Indexes for Selected Sectors across Time (1960 = 100)

Sector 1980 1990 2000 2010 2014

S&P 500 Index 493 1,796 8,857 10,158 18,024

Food 520 5,609 22,373 39,831 70,724
Mining and minerals 1,978 2,750 5,136 31,157 14,898
Oil and petroleum products 1,603 3,738 14,277 35,451 43,283
Apparel and footwear 541 2,449 6,569 17,195 36,221
Consumer durables 383 1,084 2,773 4,179 7,472
Chemicals 340 1,180 3,873 9,306 14,370
Drugs, soap, perfumes, and tobacco 587 4,091 25,209 30,853 66,847
Construction and building materials 401 1,157 5,430 7,644 17,599
Steelworks 264 400 1,312 1,549 1,533
Fabricated products 773 1,809 4,425 12,579 21,934
Machinery and business equipment 613 1,113 8,772 9,432 15,654
Automobiles 347 1,178 4,557 7,354 11,495
Transportation 592 1,616 7,016 13,756 28,967
Utilities 434 1,900 6,660 10,953 19,705
Retail stores 413 2,653 11,463 19,987 37,688
Banks, insurers, and other financials 569 1,770 15,888 14,274 25,387

Source: Values were derived from data obtained from the Kenneth French website.

In contrast, the drug sector had phenomenal performance during the 1990s, performed rela-
tively poorly during the 2000s, but returned to tremendous performance again over the final
four years of the sample period. Note that the financial crisis produced a net reduction in
value for the finance sector during the 2000s, which was a unique result relative to any other
sector for any other decade.
The values reported in Table 14‐1 make it clear that the asset allocation decision across
sectors is crucial. An investor that is proficient at choosing the best performing sectors at the
appropriate times can greatly enhance portfolio performance. Virtually, all sectors showed
decades where performance shined and decades where performance languished. Investors
that are able to assess economic conditions and forecast such patterns are richly rewarded for
their skill.
The lesson to be learned from Table 14‐1 is simple.

✓ Sector/industry analysis pays because sectors perform very differently over time and
portfolio performance is significantly affected by the particular sectors represented in
investor portfolios.

Finally, let’s note that Warren Buffett, arguably the best‐known investor in the United
States, seeks to identify “excellent” businesses based in part on the prospects for the industry.

Checking Your Understanding

1. How important is sector/industry analysis to investors?
2. What has been the major change in the U.S. economy in the last 30 or 40 years as far as
sectors are concerned?

c14.indd 366 1/23/2016 4:58:18 PM

 Checking Your Understanding 367

SECTOR PERFORMANCE OVER SHORTER PERIODS

What about shorter periods of time and recent data? Does the same principle hold true—that
sectors perform very differently?
Let’s consider the performance for the S&P 500 and 16 sectors over a recent seven‐year
period that includes the recession of 2008 and the subsequent market rebound. In Table 14‐2,
we report average annual returns over this period for the same indexes included in Table 14‐1.
As you can see, the recent performance shows incredible variation across the sectors,
with the minimum average return of −1.54 percent for the steel sector and the maximum aver-
age return of 19.53 percent for the apparel sector. Investors with portfolios concentrated in
firms from the steel, mining, oil, and finance sectors would have been greatly disappointed by
the performance of their equity portfolios during this seven‐year period. In stark contrast,
investors with heavy allocations to the apparel, autos, construction, and transportation sector
would have been elated with their stock portfolio performance during these years.
In analyzing the values in Table 14‐1 and the returns reported in Table 14‐2, it is clear
that short‐term performance frequently deviates from long‐term performance. Some of the
best long‐term performers were poor performers during recent times, and similarly, some of
the worst long‐term performers showed strong recent performance. Interestingly, there are a
few sectors that stand out for their consistency of performance. For example, the steel and
consumer durables sectors performed poorly and did so on a pretty consistent basis. In con-
trast, the food and drugs sectors were “winners” pretty consistently across the long term and
short term; however, it took a while for them to get started as prior to the 1980s their perfor-
mance was about average.
To be successful at sector analysis, an investor has to be able to identify crucial economic
and sector‐specific factors and then answer a number of relevant questions. Relevant questions
include: What factors will allow firms within the sector to maintain or expand their profitability?

Table 14-2 Average Annual Sector Returns for 2008–2014

Sector Average Return (%)

S&P 500 Index 9.69

Food 11.23
Mining and minerals 0.92
Oil and petroleum products 3.27
Apparel and footwear 19.54
Consumer durables 14.70
Chemicals 14.69
Drugs, soap, perfumes, and tobacco 14.27
Construction and building materials 15.74
Steelworks −1.54
Fabricated products 12.93
Machinery and business equipment 13.07
Automobiles 18.78
Transportation 14.98
Utilities 8.33
Retail stores 13.63
Banks, insurers, and other financials 7.03

Source: Values were derived from data obtained from the Kenneth French website.

c14.indd 367 1/23/2016 4:58:18 PM

 368 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

Are there forthcoming changes in economic/sector conditions that are going to erode future
profitability of the firms within the sector? Are there economic/sector forces that will prevent
the sector from ever generating strong profits?

HOW ONE INDUSTRY CAN HAVE A MAJOR IMPACT ON INVESTORS:

THE TELECOM INDUSTRY
Let’s consider an example of an industry moving into and out of favor with investors in a very
dramatic manner. The telecommunications sector was one of the great growth stories of the late
1990s. Telecom was deregulated in 1996. Predictions of how quickly Internet traffic would grow
proliferated. One of the major contributing factors to what happened to the telecom industry is
the huge amount of money that poured into the industry. When stock prices were rising rapidly
in the late 1990s, it was easy for the industry to raise large amounts of capital by borrowing.
Figure 14‐1 shows the tremendous increase in the telecom index in 1998 and 1999.
Many of the companies in this industry were market favorites, such as Global Crossing,
WorldCom, and Qwest.
Amazingly, after only a couple of years of the telecom industry being regarded as a
superstar industry, investors realized that the need for communications and bandwidth ser-
vices could not grow at the rates that had been predicted. Meanwhile, the crushing debt loads
these companies had assumed were catching up with them, as was the recession that started
in 2001. Telecom collapsed and, in all likelihood, was the greatest bursting of a bubble in one
sector in history. One estimate is that investors in the telecommunications industry lost
$2 trillion by mid‐2002.
Figure 14‐1 tells the rest of the story, and it was ugly. The downward spiral of telecom
companies seemed to be nonstop, with numerous bankruptcies along the way.

CROSS‐SECTIONAL VOLATILITY HAS INCREASED

Finally, consider another indication that paying attention to the relative performance of indus-
tries and sectors is important. A study by the Frank Russell Company measures “cross‐sectional
volatility,” or the variation in returns across various sectors of the market. The Russell study

Figure 14-1
DJ Telecommunica- 360
tions Index, 1998 340
through Mid‐2002 320
SOURCE: BigCharts, Inc. 300
280
260
240
220
200
180
160
140
120
100

1998 1999 2000 2001 2002

c14.indd 368 1/23/2016 4:58:18 PM

 Analyzing Sectors/Industries 369

found that cross‐sectional volatility began to rise in the mid‐1990s, and even after some
decline in 2000 and 2001, it was twice what it was in 1995. Obviously, what happened in the
technology sector contributed to this volatility, but the study found that even ignoring the tech
sector, cross‐sectional volatility has increased significantly.

✓ An increase in cross‐sectional volatility across sectors enhances the importance of sector/

industry analysis. Any ability to distinguish between the top and bottom performers will
pay off.

Analyzing Sectors/Industries
Sectors and industries are analyzed through the study of a wide range of data, including sales,
earnings, dividends, capital structure, product lines, regulations, innovations, and so on. Such
analysis requires considerable expertise and is usually performed by industry analysts
employed by brokerage firms and other institutional investors.
A useful first step is to classify industries by their stage in the life cycle. The idea is to
assess the general health and current position of the industry. A second step involves a qualita-
tive analysis of industry characteristics designed to assist investors in assessing the future
prospects for an industry. Each of these steps is examined in turn.

THE INDUSTRY LIFE CYCLE

Many observers believe that industries evolve through at least four stages: the pioneering
stage, the expansion stage, the stabilization stage, and the deceleration in growth and/or
decline stage. There is an obvious parallel in this idea to human development. The concept of
Industry Life Cycle The an industry life cycle could apply to industries or product lines within industries. The
stages of an industry’s industry life cycle concept is depicted in Figure 14‐2, and each stage is discussed in the fol-
evolution from pioneering lowing section.
to stabilization and
decline
Pioneering Stage In the pioneering stage, rapid growth in demand occurs. Although a
number of companies within a growing industry will fail at this stage because they will not
survive the competitive pressures, most experience rapid growth in sales and earnings, pos-
sibly at an increasing rate. The opportunities available may attract a number of companies, as
well as venture capital. Considerable jockeying for position occurs as the companies battle
each other for survival, with the weaker firms failing and dropping out.

Figure 14-2
The Industry Life Cycle
Sales

Pioneering Expansion Stabilization Declining

Time

c14.indd 369 1/23/2016 4:58:18 PM

 370 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

Investor risk in an unproven company is high, but so are expected returns if the com-
pany succeeds. Profit margins and profits are often small or negative. In the pioneering stage,
it can be difficult for security analysts to identify the likely survivors, just when the ability to
identify the future strong performers is most valuable. By the time it becomes apparent who
the real winners are, their prices may have been bid up considerably beyond what they were
in the earlier stages of development.
In the early 1980s, the microcomputer business—both hardware and software—offered
a good example of companies in the pioneering stage. Given the explosion in expected demand
for these products, many new firms entered the business, hoping to capture some share of the
total market. By 1983, there were an estimated 150 manufacturers of home computers, a
clearly unsustainable number over the longer run.

Expansion Stage In the expansion stage, the survivors from the pioneering stage are
identifiable. They continue to grow and to prosper, but the rate of growth is more moderate
than before.
At the expansion stage, industries are improving their products and perhaps lowering
their prices. They are more stable and solid, and at this stage, they often attract considerable
investment funds. Investors are more willing to invest in these industries now that their poten-
tial has been demonstrated and the risk of failure has decreased.
Financial policies become firmly established at this stage. The capital base is widened
and strengthened. Profit margins are very high. Firms often begin paying dividends in this
stage, which further enhances the attractiveness of the companies to investors.

Stabilization Stage Industries eventually evolve into the stabilization stage (some-
times referred to as the maturity stage), at which point the growth begins to moderate. This is
probably the longest part of the industry life cycle. Products become more standardized and
less innovative, the marketplace is full of competitors, and costs are relatively stable.
Management’s ability to control costs and produce operating efficiencies becomes very impor-
tant in terms of affecting individual company profit margins.
Industries at this stage continue to move along, but typically the industry growth rate
matches the growth rate for the economy as a whole.

Declining Stage In the decline stage, sales growth can decline as new substitute prod-
ucts are developed and shifts in demand occur. Think of the industry for home radios, tobacco
products, and desktop computers. Some firms in an industry experiencing decline face signifi-
cantly lower profits or even losses. Rates of return on invested capital tend to be low.

Assessing the Industry Life Cycle The industry life cycle classification helps
investors to assess company growth potential. The approach helps in estimating potential
stock returns and risk for companies in the industry.
However, there are limitations to this type of analysis. First, it is only a generalization,
and investors must be careful not to attempt to categorize every industry, or all companies
within a particular industry, into neat categories. Second, even the general framework may not
apply to some industries with unique features. Finally, the bottom line in security analysis is
stock prices, a function of the expected stream of benefits and the risk involved.
The industry life cycle tends to focus on sales, market share, and investment in the indus-
try. Although all of these factors are important to investors, they are not the final items of interest.
Given these qualifications to industry life cycle analysis, what are the implications for investors?
The pioneering stage may offer the highest potential returns, but it also poses the great-
est risk. Many companies in the industry will fail or do poorly. Such risk may be appropriate
for some investors, but many will wish to avoid the risk inherent in this stage.

c14.indd 370 1/23/2016 4:58:18 PM

 Checking Your Understanding 371

Investors interested primarily in capital gains should avoid the maturity stage. Companies
at this stage may have relatively high dividend payouts because they have fewer growth pros-
pects. These companies often offer continuing stability in earnings and dividend growth.
Clearly, in most cases, companies in the decline stage of the industrial life cycle should
be avoided. Investors should seek to spot industries that are transitioning into this stage and
avoid them.

✓ It is the expansion stage that is probably of most interest to investors. Industries that
have survived the pioneering stage often offer good opportunities. Growth is rapid but
orderly, an appealing characteristic to investors.

Checking Your Understanding

3. What does an increase in the cross‐sectional volatility of various sectors mean to inves-
tors in general?

QUALITATIVE ASPECTS OF INDUSTRY ANALYSIS

The analyst or investor should consider several important qualitative factors that can charac-
terize an industry. Knowing about these factors will help investors to analyze a particular
industry and will aid in assessing its future prospects.

The Historical Performance As we have learned, some industries perform well and
others poorly over long periods of time. Although performance is not always consistent and
predictable on the basis of the past, an industry’s track record should not be ignored. In
Table 14‐1, we saw that the steel industry performed poorly in the 1980s through 2000 and
continued to do badly in the post‐2000 period. The food industry, on the other hand, showed
strength at each of the checkpoints since 1980.
Investors should consider the historical record of sales, earnings growth, and price per-
formance and identify the factors that contributed to the performance. The past cannot simply
be extrapolated into the future; however, it does provide useful information.

Competition The nature of competitive conditions existing in an industry provides use-

ful information in assessing the industry’s future. Is the industry protected from the entrance
of new competitors as a result of control of raw materials, prohibitive cost of building plants,
the level of production needed to operate profitably, and so forth?
Michael Porter has written extensively on the issue of competitive strategy, which
involves the search for a competitive position in an industry4 The intensity of competition in
an industry determines that industry’s ability to sustain above‐average returns. This intensity
is not a matter of luck but a reflection of underlying factors that determine the strength of five
basic competitive factors:

1. Threat of new entrants

2. Bargaining power of buyers
3. Rivalry between existing competitors
4. Threat of substitute products or services
5. Bargaining power of suppliers

4
See Michael Porter, “Industry Structure and Competitive Strategy: Keys to Profitability,” Financial Analysts Journal
(July August 1980): 30–41. See also Michael Porter, Competitive Advantage: Creating and Sustaining Superior Performance
(New York: Free Press, 1985).

c14.indd 371 1/23/2016 4:58:18 PM

 372 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

Because the strength of these five factors varies across industries (and can change over
time), industries vary from the standpoint of inherent profitability.
The five competitive forces determine industry profitability because they influence the
components of return on investment. The strength of each of these factors is a function of
industry structure. Investors must analyze industry structure to assess the strength of the five
competitive forces, which in turn determine industry profitability.

✓ The important point of the Porter analysis is that industry profitability is a function of
industry structure.

Government Effects Government regulations and actions can have significant effects
on industries. The investor must attempt to assess the results of these effects or, at the very
least, be well aware that they exist and may continue.
Consider passage of the Dodd–Frank Act following the financial crisis of 2008. The Act
was signed into law in 2010 and produced the most significant change to financial regulation
since the reform that followed the Great Depression. This Act greatly increases the regulatory
compliance costs incurred by financial institutions, increases their capital requirements, and
limits their activities. Clearly, the Act substantially impacts the future risk and return of U.S.
financial firms. As a second example, consider the actions of the Environmental Protection
Agency (EPA) with regard to the coal industry since 2010. At the end of 2010, the Market
Vectors coal ETF (KOL) was trading at $47 per share and by early 2015 had dropped to about
$13 per share.

Structural Changes A fourth factor to consider is structural changes that occur in the
economy. As the United States continues to move from an industrial‐manufacturing society to
an information‐communications‐services society, major industries will be affected. New
industries with tremendous potential are, and will be, emerging, whereas some traditional
industries, such as steel, may never recover to their former positions.
Structural shifts can occur even within relatively new industries. For example, in the
early 1980s, the microcomputer industry was a young, dynamic industry with numerous
competitors, some of whom enjoyed phenomenal success in a short time. The introduction of
microcomputers by IBM in 1982, however, forever changed that industry. Other hardware
manufacturers sought to be compatible with IBM’s personal computer, and suppliers rushed
to supply items such as software, printers, and additional memory boards. IBM’s decision to
enter this market significantly affected virtually every part of the industry.

Using Sector/Industry Analysis as an Investor

ASSESS THE BUSINESS CYCLE

A useful procedure for investors to assess sector/industry prospects is to analyze sectors by
their operating ability in relation to the economy as a whole. That is, some sectors perform
poorly during a recession, whereas others are able to weather it reasonably well. Some sectors
move closely with the business cycle, outperforming the average sectors in good times and
underperforming it in bad times. In analyzing sectors and industries, investors should be
aware of these relationships.
Growth Industries
Industries with above‐ A primary goal of fundamental security analysis is to identify growth industries.
average expected earnings Growth industries have characteristics that allow companies operating in the industry to
growth maintain above‐average earnings growth even when there are setbacks in the economy.

c14.indd 372 1/23/2016 4:58:18 PM

 Using Sector/Industry Analysis as an Investor 373

Cyclical Industries Cyclical sectors/industries have above‐average sensitivity to economic conditions—they

Industries most affected, do unusually well when the economy prospers and are harmed more when the economy falters.
both up and down, by the Sectors that manufacture durable goods are typically identified as cyclical sectors. For example,
business cycle
autos, appliances, computers, and heavy equipment tend to be avidly sought when times are
good, but such purchases are commonly postponed during recessions because consumers can
often make do with the old units.5 Companies in cyclical sectors sell products that are generally
purchased with discretionary income. The products are often considered luxury items.
Defensive Industries At the opposite end of the scale are the defensive sectors, which are least affected by
Industries least affected recessions and economic adversity. Food, healthcare, and utilities have long been considered
by recessions and
economic adversity
examples of defensive sectors. People must eat, heat and cool their homes, and take medica-
tion regardless of the economy. Companies in defensive sectors offer products that are consid-
ered necessities.
Cyclical sectors are often differentiated from defensive sectors by the sectors’ beta. Since
cyclical sectors have above‐average sensitivity to economic conditions, they generally have
above‐average betas (betas greater than 1.0). In contrast, defensive sectors have below‐average
sensitivity to economic conditions, and their betas are typically less than 1.0.
Table 14‐3 reports the betas for the 16 sectors discussed previously. Those sectors that
rely on consumers having significant disposable income to make purchases of “big ticket”
items have relatively high betas. For example, the highest betas are reported for the steel, min-
ing, chemicals, autos, and consumer durables sectors. On the other hand, the sectors that offer
products that are considered necessities have relatively low betas. For example, the lowest
betas are reported for the utility, food, and drugs sectors.
If an investor forecasts that the economy is heading into a recession, cyclical industries
are likely to be affected more than other industries, whereas defensive industries are likely to be
least affected. Therefore, the investor would want to increase his allocation to defensive sectors

Table 14-3 Sector Betas

Sector Beta

Food 0.58
Mining and minerals 1.46
Oil and petroleum products 1.23
Apparel and footwear 1.10
Consumer durables 1.30
Chemicals 1.39
Drugs, soap, perfumes, and tobacco 0.62
Construction and building materials 1.27
Steelworks 1.69
Fabricated products 1.23
Machinery and business equipment 1.28
Automobiles 1.38
Transportation 1.05
Utilities 0.49
Retail stores 0.84
Banks, insurers, and other financials 1.23

Source: Values were derived from data obtained from the Kenneth French website.

5
Countercyclical industries also exist, actually moving opposite to the prevailing economic trend. The gold mining
industry is said to follow this pattern.

c14.indd 373 1/23/2016 4:58:18 PM

 374 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

and reduce his allocation to cyclical sectors. Of course, to be successful, the investor would
need to be proficient in forecasting economic changes in advance of his fellow investors.
General economic conditions play a crucial role in the performance of companies in all
sectors; however, investors should be aware that other factors have a substantial impact on the
performance of particular sectors. For example, interest rate‐sensitive sectors are particularly
sensitive to expectations about changes in interest rates. The finance and construction sectors
are obvious examples of interest rate‐sensitive sectors.

Investments Intuition

Clearly, business cycle analysis for industries is a any given time, and the smart investor thinks care-
logical and worthwhile part of fundamental secu- fully about the impact that economic factors will
rity analysis. Industries have varying sensitivities to have on industry profitability.
business conditions and interest rate expectations at

REVIEW INVESTMENT ADVISORY SERVICES ABOUT INDUSTRIES

It is important for the investor to know what the current thinking is about sector and industry
prospects. The quickest and easiest way to do this is to consult independent, trusted advisory
services that have the resources to analyze industry prospects on an ongoing basis.
One of the most convenient and useful sources of information about industries is The Value
Line Investment Survey, which ranks approximately 100 industry groupings. Investors can quickly
see which industries are expected to perform well over the year ahead and which are not.

SECTOR ROTATION
Numerous investors use sector analysis in their investing strategy. The premise here is simple—
companies within the same industry group are generally affected by the same market and
economic conditions. Therefore, if an investor can spot important developments in the sector
or industry quickly enough, appropriate portfolio changes can be made to attempt to profit
from these insights.
Institutional investors such as mutual funds analyze industry groupings carefully in
order to determine which are losing momentum and which are gaining. When a sector trend
is spotted, these investors rotate into the favorable sector and out of a sector losing favor with
investors. The strategy at the beginning of these events is to invest in the likely best perform-
ing companies in the sector. When these companies rise in price and appear to be fully valued,
secondary companies are identified and purchased. Ultimately, the entire sector becomes fairly
valued or overvalued, or economic conditions for the sector become less favorable, and money
rotates out of this sector and into a new one.
Individual investors can utilize sector rotation for industries and avoid analyzing indi-
vidual companies. If, for example, the technology industry is ranked highly for one‐year ahead
performance, an investor can buy a sector fund offered by a mutual fund company. As noted
in Chapter 11, investment companies offer a multitude of sector funds and ETFs, which facili-
tate a sector rotation strategy.

EVALUATING FUTURE INDUSTRY PROSPECTS

Picking Industries for Next Year To determine industry performance for shorter
periods of time (e.g., one year), investors should ask themselves the following question: Given
the current and prospective economic situation, which industries are likely to show improving

c14.indd 374 1/23/2016 4:58:18 PM

 Using Sector/Industry Analysis as an Investor 375

earnings? In many respects, this is the key question for industry security analysis. Investors
can turn to I/B/E/S, which compiles institutional brokerage earnings estimates for various
industries.
Given the importance of earnings and the availability of earnings estimates for industries
and companies, are investors able to make relatively easy investment choices? The answer is no,
because earnings estimates are notoriously inaccurate. Of course, investors must also consider
the likely P/E ratios for industries. Which industries are likely to show improving P/E ratios?

Would it surprise you to learn that in early 2012 the home building industry was ranked next
Example 14-4 to last out of all industries ranked by The Value Line Investment Survey? Probably not, given
what everyone knows about the real estate market and the large inventory of empty houses.
However, you probably would have been surprised to learn that railroads ranked fifth and
automotive eleventh.

Other questions to consider are the likely direction of interest rates and which industries
would be most affected by a significant change in interest rates. A change in interest rates, other
things being equal, leads to a change in the discount rate (and a change in the multiplier).
Which industries are likely to be most affected by possible future political events, such as a new
administration, renewed inflation, new technology, an increase in defense spending, and so on?
As with all security analysis, we can use several procedures in analyzing industries.
Much of this process is common sense. For example, if you can reasonably forecast a declining
number of competitors in an industry, it stands to reason that, other things being equal, the
remaining firms will be more profitable.

Assessing Longer‐Term Prospects To forecast industry performance over the

longer run, investors should ask the following questions:

1. Which sectors and industries are likely candidates for growth and prosperity over, say,
the next decade?
2. Which sectors and industries appear likely to have difficulties as the United States con-
tinues to change to an information‐collecting and information‐processing economy
with a significant service component?

Concepts in Action

One Way Investors Can Use Published Information Involving Industries

Standard & Poor’s Outlook, a weekly publication, STARS rating (up to five stars) is selected to repre-
periodically reports on the performance of an sent that industry. An industry can be removed when
“Industry Momentum Portfolio.” A buy recommen- its relative 12‐month performance is below the top
dation results when an industry has been in the top 30 percent of all industries covered. This portfolio
10 percent of all industry changes over the preceding is updated on the last trading day of each month.
12 months. (Note that this procedure involves relative According to Standard & Poor’s, this portfolio has
strength, a technique discussed in Chapter 16.) substantially outperformed the S&P 500.
The company in the industry with the highest S&P

c14.indd 375 1/23/2016 4:58:18 PM

 376 CHAPTER 14 SECTOR/INDUSTRY ANALYSIS

Summary
▶ Sector/industry analysis is the second of three steps in primarily engaged. Basically, companies that do simi-
a top‐down framework of fundamental security analy- lar things in similar ways are classified together.
sis, following economy/market analysis but preceding ▶ A number of investment information services, such as
individual company analysis. The objective is to iden- Standard & Poor’s and Value Line, use their own indus-
tify those sectors/industries that will perform best in try classifications.
terms of returns to stockholders.
▶ To analyze industries, a useful first step is to examine
▶ Is sector/industry analysis valuable? Yes, because over their stage in the life cycle, which in its simplest form
the long run some sectors and industries perform consists of the pioneering, expansion, maturity, and
much better than others. decline stages.
▶ Industry performance is not consistent; past price per- ▶ One industry analysis approach is business cycle anal-
formance does not always predict future price perfor- ysis. Industries perform differently at various stages in
mance. Particularly over shorter periods such as one the business cycle.
or two years, industry performance rankings may
completely reverse themselves. ▶ Another approach involves a qualitative analysis of
important factors affecting industries.
▶ Although the term industry at first seems self‐
explanatory, industry definitions and classifications ▶ Sector rotation involves identifying sectors that are
are not straightforward, and the trend toward diversi- expected to perform well; individual company analy-
fication of activities over the years has blurred the sis can be avoided. ETFs and specialized mutual funds
lines even more. called sector funds can be used to implement this
approach.
▶ North American Industry Classification System
(NAICS) uses a production‐oriented conceptual ▶ Investors interested in evaluating future industry
framework; therefore, companies are classified into prospects have a wide range of data available. These
industries based on the activity in which they are data can be used for an in‐depth analysis of industries
using standard security analysis techniques.

Questions
14‐1 Why is it difficult to classify industries? 14‐9 Explain how aggregate market analysis can be
14‐2 Why is the NAICS coding system said to be supe- important in analyzing industries in relation to
rior to SIC codes? the business cycle.
14‐3 Is sector/industry analysis valuable? 14‐10 Name the five competitive forces identified by
Porter.
14‐4 Name some industries that you would expect to
perform well in the next 5 years and in the next 14‐11 The important point of the Porter analysis is that
10 to 15 years. industry structure is a function of industry profit-
ability. Agree or disagree with this statement.
14‐5 What are the stages in the life cycle for an indus-
try? Can you think of other stages to add? 14‐12 Explain the concept used in valuing industries.
14‐6 Name an industry that currently is in each of the 14‐13 What sources of information would be useful to
four life cycle stages. an investor doing a detailed industry analysis?
14‐7 In which stage of the life cycle do investors face 14‐14 Explain how Figure 14‐2 might be useful to an
the highest risk of losing a substantial part of investor doing industry analysis.
their investment?
14‐8 Which types of industries are the most sensitive
to the business cycle? The least sensitive?

c14.indd 376 1/23/2016 4:58:18 PM