Economic Concepts Flashcards

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1
Q

What are the disadvantages of the Fed model?

A

The Fed model:

  • Does not consider the equity risk premium.
  • Ignores growth in earnings.
  • Compares a real variable (index level) to a nominal variable (Treasury yield).
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2
Q

What is the assumption made by the Fed model?

A

The Fed model assumes that the yield on the long-term U.S. Treasuries should be the same as the expected operating earnings yield on the S&P 500.

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3
Q

What is the assumption made by the Yardeni model?

A

The Yardeni model assumes investors value total earnings rather than dividends.

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4
Q

What does the Yardeni model use as a proxy for the equity risk premium and describe it’s validity.

A
  • It uses the yield on A-rated corporate debt as the equity risk premium.
  • The risk premium is actually a measure of the default risk, not a true measure of equity risk.
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5
Q

What is the variable “d” in the Yardeni model?

A

It is an estimate of the value investors place on earnings growth (d), which is assumed to be constant over time.

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6
Q

What is the growth rate used in the Yardeni model and list a possible disadvantage?

A

The Yardeni model uses LTEG (Long-term Earnings Growth) which is the 5-year consensus long-term earnings growth forecast.
LTEG might not be a fair estimate of long-term sustainable growth.

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7
Q

Describe the numerator and denominator of the P/10-year MA(E).

A

P/10-year MA(E): The numerator is the value of the price index, and the denominator is the average of the previous 10-years’ reported earnings. Both are adjusted for inflation using the consumer price index.

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8
Q

What are some advantages and disadvantages of the P/10-year MA(E)?

A

Advantages:
*It considers the effects of inflation.
*It captures the effects of the business cycles.
Disadvantages.
*Current or expected earnings could provide more useful information.
*It does not consider the effects of changes in accounting rules or methods.
*Very high or low P/10-year MA(E) ratios can persist, limiting its usefulness in forming short-run expectations.

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9
Q

Explain each of the terms in the Cobb-Douglas (CD) production function.

A

The CD production function assumes constant returns go scale, relates the economy’s labor and capital inputs to real economic output:

Y = total real economic output
A = total factor productivity (TFP)
K = capital stock
L = labor input
alpha = output elasticity of K
1- alpha = output elasticity of L
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10
Q

What is the constant returns to scale in the Cobb-Douglas production function?

A

constant returns to scale:
A given percentage increase in capital stock and labor input results in an equal percentage increase in output. As a result if both capital and labor change by a percentage x, then the total change in output is alpha(x) + (1 - alpha)(x) = x.

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11
Q

Define and discuss the Solow residual.

A

The Solow residual is the percentage change in total factor productivity. An economy’s TFP cam change over time due to:

i. Changing technology.
ii. Changing restrictions on capital flows and labor mobility.
iii. Changing trade restrictions.
iv. Changing laws.
v. Changing division of labor.
vi. Depleting/discovering natural resources.

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12
Q

Describe top-down economic analysis.

A

in a top-down forecast, the analyst utilizes macroeconomic factors to estimate the performance of market-wide indicators. Successive steps include identifying sectors in the market and then individual securities that will perform best, given market expectations.

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13
Q

Describe bottom-up economic analysis.

A

In a bottom-up forecast, the analyst first takes a microeconomic perspective by focusing on the fundamentals of individual firms. For a macro forecast, the analyst can then aggregate the expected performance of individual securities.

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14
Q

Describe Tobin’s q.

A

Tobin’s q compares the current market value of a company to the replacement cost of its assets. The theoretical value of Tobin’s q is 1.0. If the current Tobin’s q is above (below) 1.0, the firm’s stock is presumed to be overpriced (underpriced). Tobin’s q is mean-reverting.

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15
Q

Describe equity q.

A

Equity q compares the current market value of the firm’s equity to the replacement value of the firm’s net worth.The theoretical value of equity q is 1.0. If the current equityq is above (below) 1.0, the firm’s stock is presumed to be overpriced (underpriced).Equity q is mean-reverting.

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16
Q

List the strengths and weaknesses for Tobin’s q and equity q.

A

Strengths of both models:

  • Both are mean-reverting, so they are easy to use.
  • Both have usefulness as demonstrated by a negative relationship with equity returns. Higher (lower) ratios have forecasted lower (higher) equity returns.

Weaknesses include:
*Replacement costs can be difficult to estimate.
Empirical studies have found thay very high or low ratios have persisted for both, limiting their usefulness in forming short-run expectations.

17
Q

What are the components of a long-term growth forecast (i.e., trend growth in GDP)?

A

Growth from labor inputs + growth from labor productivity.
Growth in potential labor force size + growth in actual labor force participation + growth in capital inputs + TFP growth.