Economic Concepts Flashcards
What are the disadvantages of the Fed model?
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).
What is the assumption made by the Fed model?
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.
What is the assumption made by the Yardeni model?
The Yardeni model assumes investors value total earnings rather than dividends.
What does the Yardeni model use as a proxy for the equity risk premium and describe it’s validity.
- 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.
What is the variable “d” in the Yardeni model?
It is an estimate of the value investors place on earnings growth (d), which is assumed to be constant over time.
What is the growth rate used in the Yardeni model and list a possible disadvantage?
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.
Describe the numerator and denominator of the P/10-year MA(E).
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.
What are some advantages and disadvantages of the P/10-year MA(E)?
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.
Explain each of the terms in the Cobb-Douglas (CD) production function.
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
What is the constant returns to scale in the Cobb-Douglas production function?
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.
Define and discuss the Solow residual.
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.
Describe top-down economic analysis.
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.
Describe bottom-up economic analysis.
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.
Describe Tobin’s q.
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.
Describe equity q.
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.