R16 - Applications Of Economic Analysis To Portfolio Management

Question 1

Write out the Cobb-Douglas Production Function equation and describe assumptions and what it’s used for.

Answer 1

Y = AKaLb

Y = total real economic output
A = total factor productivity
K = capital stock
L = labor
a = output elasticity of K (this is a weight)
b = output elasticity of L (also a weight)
a + b = 1

CB function is a neoclassical model for estimating real GDP growth.
Assumptions:
-constant returns to scale
—a given percentage change in labor and capital produces same percent change in output
—TFP is a constant (total factor productivity)

Question 2

What do you use the Solow Residual for?

Answer 2

To solve for percentage change in TFP in the Cobb-Douglas function.

Just algebra to get % change in TFP.

Question 3

What factors can cause TFP to change?

Answer 3

• technology
• labor mobility and capital flows
• trade restrictions
• laws
• depletion/discovery of natural resources

Question 4

What factors can improve or hurt an economy?

Answer 4

Improve:

• increase in savings rate
• increase in work force
• increase in production efficiency
• increase in retirement age

Hurt:

• increase in environmental controls
• increase in taxes

Question 5

Effects of types of costs on ST and LT economic growth?

Answer 5

One time costs hurt economy in short term.

Permanent, ongoing changes have LT impact.

Question 6

Show H-model equation.

Answer 6

P(0) = (D/r-g)[(1+g)+N/2(g(short term)-g)]

R = equity discount rate
g = long term growth rate
N = number of years of high growth

Question 7

List pitfalls of top down and bottom up equity market valuation methods.

Answer 7

Top-down:
-slow to reflect structural changes because use long term historical relationships

Bottom-up:
-analysts tend to be emotional so too optimistic in expansion and too pessimistic in recession

Question 8

Explain two reasons why bottom up earnings estimates might exceed top-down estimates for a few quarters in a row.

Answer 8

• bottom up estimates may be too optimistic

- economy may be in expansion phase and top down models not recognizing change in business cycle

Question 9

Relative equity market valuation models: show and interpret the Fed Model.

Answer 9

Compares forward S&P earnings yield to treasury bond yield

Fed ratio = S&P EY / 10-yr Treasury yield

EY = expected operating earnings / current price of S&P

If ratio > 1 then stock market may be under valued
If ratio < 1 then maybe overvalued

Question 10

Pros and cons of the Fed Model?

Answer 10

Pros:

• easy to understand
• consistent with DCF analysis: higher discount rate (treasury yield) result in lower stock values

Cons:

• no equity risk premium
• long run equity returns exceed treasury returns
• ignores earnings growth
• compares real to nominal value

Question 11

Increasing inflation effect on earnings and market multiple vs treasuries given that equities are “real” and treasuries “nominal”

Answer 11

Equity: “real”

• earnings can increase
• multiple doesn’t necessarily

Treasuries: “nominal”

• fixed coupons and purchase YTM don’t increase
• market YTM increases

Question 12

Yardeni model equation:

Answer 12

Calculates fair earnings yield. Same as Gordon growth but using forward earnings instead of dividend.

E/P = Yb - d*g

d = adjustment factor (typically 0.10)
Yb = A-rated corp bond yield (used as the discount rate)

If actual earnings yield (E/P) < EY using Yardeni then stocks overvalued

Question 13

Pros and cons of Yardeni model:

Answer 13

Pros:
-improves on fed model by partially incorporating equity risk using corp bond yield and including earnings growth

Cons:

• equity risk premiums are higher than corp bond premiums
• earnings estimates can be wrong
• assumes discount rate applied to future earnings is constant
• d is a “fudge factor” and can vary over time

Question 14

Pros and cons of using P/10-yr avg earnings + how is 10-yr avg earnings calculated?

Answer 14

Calculated:
Current price / 10-yr avg earnings adj. to today’s dollars

Pros:

• removes effect of inflation when comparing price to earnings of different date
• reduce effects of business cycle

Question 15

Asset based market valuation models: tobin’s q vs equity q formulas + pros and cons?

Answer 15

Tobin = asset market value / replacement cost
Equity = market value of equity / rc assets - liabilities

Pros:
-supported by Econ theory and empirical evidence

Cons:

• estimating replacement value tough
• value can diverge from 1 for long time