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Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

Related Websites
This is a very comprehensive site with links to other
sites containing extensive industry and economic
information. These sites provide information on industry sectors.
Many of them also contain other useful links.
These sites have numerous economic reports and
analyses available at no charge. The Federal Reserve
site links you to any Federal Reserve bank site. Each of
the reserve banks publishes research and economic

o determine a proper price for a firm™s stock, the security analyst must forecast

T the dividends and earnings that can be expected from the firm. This is the
heart of fundamental analysis, that is, the analysis of determinants of value
such as earnings prospects. Ultimately, the business success of the firm determines
the dividends it can pay to shareholders and the price it will command in the stock
market. Because the prospects of the firm are tied to those of the broader economy,
however, valuation analyses must consider the business environment in which the firm
operates. For some firms, macroeconomic and industry circumstances might have a
greater influence on profits than the firm™s relative performance within its industry. In
other words, investors need to keep the big economic picture in mind.
Therefore, in analyzing a firm™s prospects it often makes sense to start with the
broad economic environment, examining the state of the aggregate economy and
even the international economy. From there, one considers the implications of the
outside environment on the industry in which the firm operates. Finally, the firm™s po-
sition within the industry is examined.
This chapter examines the broad-based aspects of fundamental analysis”macro-
economic and industry analysis. The following two chapters cover firm-specific analysis.
We begin with a discussion of international factors relevant to firm performance and
move on to an overview of the significance of the key variables usually used to summa-
rize the state of the economy. We then discuss government macroeconomic policy and
the determination of interest rates. We conclude the analysis of the macroeconomic
environment with a discussion of business cycles. Next, we move to industry analysis,
treating issues concerning the sensitivity of the firm to the business cycle, the typical life
cycle of an industry, and strategic issues that affect industry performance.
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

382 Part FOUR Security Analysis

A top-down analysis of a firm™s prospects must start with the global economy. The interna-
The analysis of
determinants of firm tional economy might affect a firm™s export prospects, the price competition it faces from for-
value, such as
eign competitors, or the profits it makes on investments abroad. Certainly, despite the fact that
prospects for earnings
the economies of most countries are linked in a global macroeconomy, there is considerable
and dividends.
variation in the economic performance across countries at any time. Consider, for example,
Table 11.1, which presents data on several so-called emerging economies. The table docu-
ments striking variation in growth rates of economic output in 2001. For example, while the
Indian economy grew by 5.3% in 2001, Turkish output fell by 7.1%. Similarly, there has been
considerable variation in stock market returns in these countries in recent years.
These data illustrate that the national economic environment can be a crucial determinant
of industry performance. It is far harder for businesses to succeed in a contracting economy
than in an expanding one. This observation highlights the role of a big-picture macroeconomic
analysis as a fundamental part of the investment process.
In addition, the global environment presents political risks of far greater magnitude than are
typically encountered in U.S.-based investments. In the last decade, we have seen several in-
stances where political developments had major impacts on economic prospects. For example,
in 1992 and 1993, the Mexican stock market responded dramatically to changing assessments
regarding the prospect of the passage of the North American Free Trade Agreement by the
U.S. Congress. In 1997, the Hong Kong stock market was extremely sensitive to political de-
velopments leading up to the transfer of governance to China. The biggest international eco-
nomic story in late 1997 and 1998 was the turmoil in several Asian economies, notably
Thailand, Indonesia, and South Korea. These episodes also highlighted the close interplay be-
tween politics and economics, as both currency and stock values swung with enormous
volatility in response to developments concerning the prospects for aid for these countries
from the International Monetary Fund. In August 1998, the shock waves following Russia™s
devaluation of the ruble and default on some of its debt created havoc in world security mar-
kets, ultimately requiring a rescue of the giant hedge fund Long Term Capital Management to
avoid further major disruptions. In the immediate future, the degree to which the European

Stock Market Return, 2001
TA B L E 11.1 Growth in
Country Real GDP 2001
, Local Currency $ Terms
performance in
Brazil 0.3 16.1 31.5
selected emerging
China 7.0 29.8 29.8
Hong Kong 0.3 27.4 27.4
Hungary 3.7 1.9 0.4
India 5.3 15.7 18.4
Indonesia 3.5 1.7 5.2
Israel 2.7 10.5 20.2
Mexico 1.6 16.4 21.6
Poland 0.8 12.3 12.0
Russia 4.9 110.3 97.5
Singapore 7.0 13.1 17.8
South Africa 0.1 28.0 17.2
South Korea 1.8 40.9 36.0
Taiwan 4.2 15.7 9.5
Turkey 7.1 35.2 34.1

Source: The Economist, January 19, 2002.
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

11 Macroeconomic and Industry Analysis

Monetary Union is successful will again illustrate the important interaction between the polit-
ical and economic arenas.
Of course, political developments can be positive, as well. For example, the end of
apartheid in South Africa and the resultant end of the economic embargo seemed to portend
great growth for that economy. These political developments (and the bumps along the way)
offer significant opportunities to make or lose money.
Other political issues that are less sensational but still extremely important to economic
growth and investment returns include issues of protectionism and trade policy, the free flow
of capital, and the status of a nation™s workforce.
One obvious factor that affects the international competitiveness of a country™s industries
is the exchange rate between that country™s currency and other currencies. The exchange rate exchange rate
is the rate at which domestic currency can be converted into foreign currency. For example, in The rate at which
April 2002, it took about 130 Japanese yen to purchase one U.S. dollar. We would say that the domestic currency can
exchange rate is ¥130 per dollar, or equivalently, $0.0077 per yen. be converted into
foreign currency.
As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly
fluctuates. For example, in 1980, the dollar“yen exchange rate was about $0.0045 per yen.
Since the exchange rate in 2002 was $0.0077 per yen, a U.S. citizen would have needed about
1.7 times as many dollars in 2002 to buy a product selling for ¥10,000 as would have been re-
quired in 1980. If the Japanese producer were to maintain a fixed yen price for its product, the
price expressed in U.S. dollars would have to increase by 70%. This would make Japanese
products more expensive to U.S. consumers, however, and result in lost sales. Obviously, ap-
preciation of the yen creates a problem for Japanese producers like automakers that must com-
pete with U.S. producers.
Figure 11.1 shows the change in the purchasing power of the U.S. dollar relative to the pur-
chasing power of the currencies of several major industrial countries in the period between
1986 and 2001. (The Italian, German, and French currencies have since been subsumed into
the euro, the common currency of the 12 members of the European Union.) The ratio of
purchasing powers is called the “real” or inflation-adjusted exchange rate. The change in the
real exchange rate measures how much more or less expensive foreign goods have become to

“10.2% U.K.


“15.3% Germany


“12.3% Japan

Canada 15.3%
“25.0 “20.0 “15.0 “10.0 “5.0 0.0 5.0 10.0 15.0 20.0

F I G U R E 11.1
Change in real exchange rate: Dollar versus major currencies, 1986“2001
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

384 Part FOUR Security Analysis

U.S. citizens, accounting for both exchange rate fluctuations and inflation differentials across
countries. A positive value in Figure 11.1 means that the dollar has gained purchasing power
relative to another currency; a negative number indicates a depreciating dollar. Therefore, the
figure shows that goods priced in terms of the Japanese, U.K., and former German, Italian, or
French currencies became more expensive to U.S. consumers in the last 15 years but that
goods priced in Canadian dollars became cheaper. Conversely, goods priced in U.S. dollars
became more affordable to Japanese consumers, but more expensive to Canadian consumers.

The macroeconomy is the environment in which all firms operate. The importance of the macro-
economy in determining investment performance is illustrated in Figure 11.2, which compares
the level of the S&P 500 stock price index to estimates of earnings per share of the S&P 500
companies. The graph shows that stock prices tend to rise along with earnings. While the exact
ratio of stock price to earnings per share varies with factors such as interest rates, risk, inflation
rates, and other variables, the graph does illustrate that, as a general rule, the ratio has tended to
be in the range of 10 to 20. Given “normal” price-to-earnings ratios, we would expect the S&P
500 Index to fall within these boundaries. While the earnings-multiplier rule clearly is not per-
fect”note the dramatic increase in the P/E multiple in the 1990s”it also seems clear that the
level of the broad market and aggregate earnings do trend together. Thus, the first step in fore-
casting the performance of the broad market is to assess the status of the economy as a whole.
The ability to forecast the macroeconomy can translate into spectacular investment per-
formance. But it is not enough to forecast the macroeconomy well. One must forecast it bet-
ter than one™s competitors to earn abnormal profits.
In this section, we will review some of the key economic statistics used to describe the state
of the macroeconomy.

Gross Domestic Product
gross domestic
Gross domestic product, or GDP, is the measure of the economy™s total production of goods
and services. Rapidly growing GDP indicates an expanding economy with ample opportunity
The market value of
for a firm to increase sales. Another popular measure of the economy™s output is industrial
goods and services
production. This statistic provides a measure of economic activity more narrowly focused on
produced over a
the manufacturing side of the economy.
period of time.

F I G U R E 11.2 1,600 S&P 500 Price
S&P 500 Index versus
earnings per share
estimate 1,200
Source: Thomson Financial,
1,000 20 EPS
Global Comments,
December 3, 2001. 800
15 EPS
10 EPS


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