Chapter 13

ECONOMY/MARKET ANALYSIS

Multiple Choice Questions

Taking a Global Perspective

1. The general trend worldwide is to:

a. close economies and deregulate industries.

b. limit economies and regulate industries.
c. open economies and deregulate industries.
d. There is no general trend worldwide.

(c, easy)

2. By 2002, the euro:

a. fell against the dollar.

b. replaced the dollar as the most important currency.
c. gained significantly against the dollar.
d. was replaced by the British pound.

(c, easy)

Assessing the Economy

3. The beginning and ending of a business cycle is also known as a:

a. cycle.
b. trough.
c. peak.
d. contraction.

(b, easy)

4. On average, contractions since World War II last:

a. slightly less than 6 months.

b. slightly less than one year.
c. slightly less than 18 months.
d. slightly less than two years.

(b, moderate)

Chapter Thirteen 163

Economy/Market Analysis
 5. The National Bureau of Economic Research is:

a. a division of the Department of Commerce.

b. the largest association of professional economic forecasters.
c. a private nonprofit organization.
d. a division of the Federal Reserve.

(c, moderate)

6. Which of the following is not one of the components of GDP?

a. investment spending
b. government spending
c. net exports
d. financial transactions

(d, moderate)

7. The largest component of GDP is:

a. consumption
b. government spending
c. net exports
d. investment spending

(a, easy)

8. Indexes of general economic activity are considered all except:

a. lagging
b. emerging
c. leading
d. coincident

(b, moderate)

9. Which of the following is considered a lagging indicator?

a. duration of unemployment
b. stock prices
c. money supply
d. interest rate spread

(c, moderate)

Chapter Thirteen 164

Economy/Market Analysis
 10. The federal agency most involved with the money supply and interest
rates is

a. the Treasury Department

b. the Federal Reserve
c. the Department of Commerce
d. the U. S. Mint

(b, easy)

11. Which of the following statements concerning the stock market and the
economy is true?

a. The stock market generally leads the economy.

b. The stock market generally follows the economy.
c. The stock market has an inverse relationship with the economy.
d. The stock market has little relationship with the economy.

(a, moderate)

12. One explanation for stock prices leading the economy involves:

a. a political change, such as a change in administration.

b. investors switching from domestic to international stocks.
c. an investor change in the required return.
d. insider trading based on nonpublic information.

(c, difficult)

13. When speculation pushes asset prices to unsustainable highs, this is known
as a:

a. crash.
b. contraction.
c. recession.
d. bubble.

(d, easy)

Chapter Thirteen 165

Economy/Market Analysis
 14. Stock investors pay attention to the bond market because:

a. it is more stable than the stock market.

b. it can provide daily signals whereas stock market data is weekly, monthly
or quarterly.
c. it is a more accurate measure of overall economic activity.
d. it is privy to more government information, especially from the Federal
Reserve.

(b, moderate)

15. Which of the following is included in MZM?

a. M3
b. retail money market mutual funds
c. wholesale money market mutual funds
d. All are included in MZM.

(b, moderate)

16. Generally, when interest rates fall, bond prices

a. rise.
b. fall.
c. remain unchanged.
d. rise or fall depending on the expected inflation premium.

(a, easy)

17. An alternative money measure than includes M2, savings deposits, small
time deposits and retail money market mutual funds is:

a. M3.
b. MBM.
c. MZM
d. L

(c, moderate)

18. A steepening yield curve indicates:

a. the economy is accelerating.

b. economic activity is slowing down.
c. a pending recession.
d. rising inflation.

(c, easy)

Chapter Thirteen 166

Economy/Market Analysis
 19. _______ is a publication that compiles consensus economic forecasts.

a. The Wall Street Journal's Economic Letter

b. The Conference Board's Economic Forecast
c. Blue Chip Economic Indicators
d. The Kiplinger Letter

(c, moderate)

Understanding The Stock Market

20. In order to value the market with the P/E model, it is necessary to analyze

a. earnings forecasts.
b. P/E ratios.
c. earnings forecasts and P/E ratios.
d. earnings forecasts, P/E ratios, and the required rate of returns.

(c, easy)

21. In the recent past, operating EPS for the S&P 500:

a. grew faster than GDP growth.

b. grew slower than GDP growth.
c. grew the same as GDP growth.
d. showed no relationship to GDP.

(a, moderate)

22. Which of the following market indexes is favored by most institutional

investors and money managers?

a. DJIA
b. S&P 500
c. Wilshire 5000
d. NYSE Index

(b, moderate)

Chapter Thirteen 167

Economy/Market Analysis
 23. Current stock prices reflect:

a. investors' confidence in the current economy.

b. investors' confidence in the current administration.
c. investors' expectations of the future.
d. investors' attitudes about the past market.

(c, moderate)

24. If someone was to tell you that "the market" was up by two percent, they
generally mean that __________ up by two percent.

a. the level of a stock price index was

b. retail prices of goods went
c. productivity was
d. costs were

(a, easy)

25. Which of the following statements regarding the uses of market indicators
is FALSE?

a. Historical records of market indicators are used to determine unsystematic

risk.
b. Historical records of market averages are used for gauging market trends.
c. The historical returns on market indices are used in computing betas.
d. Market averages and indices are useful to investors in evaluating portfolio
performance.

(a, difficult)

26. Assume that the dividend payout ratio on the S&P 100 will be 40 percent
when the rate on long-term government bonds falls to 9 percent. Investors
being more risk averse demand an equity risk premium of eight percent. If
the growth rate of dividends is expected to be 10 percent, what will be the
price of the market index if the earnings expectation is $30?

a. $384.00 Solution: D1 = 0.40($30) = $12

b. $213.44 k= 0.09 + 0.08 = 0.17
c. $266.56 P0= D1/(k – g)
d. $171.43 = 12/(0.17 - 0.10) = $171.43

(d, difficult)

Chapter Thirteen 168

Economy/Market Analysis
 27. P/E ratios are generally depressed when interest rates are _____ and
inflation is ________.

a. high; low
b. low; high
c. high; high
d. low: low

(c, moderate)

Making Market Forecasts

28. Many market participants believe that when the dividend yield on the
Standard and Poor's 500 is ____, the market is in for a downward
correction.

a. above 6 percent
b. below 6 percent
c. above 3 percent
d. below 3 percent

(d, difficult)

29. The Fed model, which uses the E/P ratio in its calculations, :

a. is relatively complex.
b. uses the yield on the 3-month Treasury bill as the risk-free rate.
c. assumes investors can easily switch between stocks and bonds.
d. all of the above

(c, difficult)

30. Which of the following types of yield curves is typically followed by a

declining stock market?

a. an upward-sloping yield curve

b. a flat yield curve
c. an inverted yield curve
d. a skewed yield curve

(c, moderate)

Chapter Thirteen 169

Economy/Market Analysis
 31. Warren Buffett thinks long-term movements in stock prices are caused by
which of the following two economic variables?

a. interest rates and corporate profits

b. interest rates and inflation
c. inflation and unemployment
d. corporate profits and growth in GDP

(a, difficult)

32. Which of the following statements regarding market P/E ratios is true?

a. P/E ratios are higher when interest rates are lower.

b. P/E ratios are higher when interest rates are higher.
c. P/E ratios are higher when inflation is higher.
d. P/E ratios are lower when unemployment is higher.

(a, moderate)

33. The earnings yield, which is used in the Fed model, is the:

a. same as the dividend yield.

b. inverse of the dividend yield.
c. same as the P/E ratio.
d. inverse of the P/E ratio.

(d, moderate)

True-False Questions

A Global Perspective

1. Despite political, cultural and economic differences, foreign markets are

driven by the same factors that drive U.S. markets.

(F, moderate)

Assessing The Economy

2. The longest peacetime expansion ran from 1991 to 2000.

(T, moderate)

3. To value the market, an investor must analyze both corporate earnings and
multipliers.

(T, moderate)

Chapter Thirteen 170

Economy/Market Analysis
 4. Most analysts today agree that using money as an indicator of future
economic activity is extremely inaccurate.

(F, moderate)

5. The stock market is a leading indicator of the economy because investors

discount future earnings.

(T, moderate)

6. The typical business cycle in the United States seems to lead the stock
market’s turning point by a few months.

(F, moderate)

7. Most investors should keep a watch on the Federal Reserve because of the
effect of the money supply on interest rates.

(T, easy)

Understanding the Stock Market

8. Most market indexes are designed to measure the entire stock market.

(F, moderate)

9. P/E ratios are generally inflated when interest rates and inflation are high.

(F, moderate)

10. If interest rates rise, the riskless rate of return declines.

(F, moderate)

11. If the economy is prospering, investors expect corporate earnings to rise.

(T, easy)

12. When using the P/E valuation model, it is important to remember that the
multiplier is more volatile than the earnings component.

(T, moderate)

Making Market Forecasts

13. Assuming a constant P/E ratio, the growth in stock prices should equal the
growth in earnings.

(T, moderate)

Chapter Thirteen 171

Economy/Market Analysis
 14. According to available evidence, investors lose more by staying in a bear
market than by missing a bull market.

(F, moderate)

15. Stock prices have almost always risen as the business cycle is approaching
a trough.

(T, moderate)

16. Over the past 30 years, the P/E ratio for the S&P 500 Index has ranged
from 5 to 50.

(F, moderate)

17. During periods of restrictive Federal Reserve monetary policy, the stock
market usually performs poorly.

(T, moderate)

Short-Answer Questions

Assessing the Economy

1. Why is the stock market a leading indicator of the economy? Use the
constant-growth dividend discount model in your explanation.

(moderate)

Answer: Stock prices are based on investors’ expectations about the future
and are, therefore, indicators of the future. The model P0 = D1/(k –
g) shows that the current price depends on future dividends, thus
making market prices a leading indicator of the economy.

2. Why do stock investors pay attention to the bond market?

(easy)

Answer: The bond market provides daily information about the economy
through interest rates. This information is useful to stock
investors.

Understanding the Stock Market

3. Is it useful to do a trend analysis of P/E ratios of the S&P 500 Composite

Index over time and extrapolate it to project future expected P/Es?

(easy)

Chapter Thirteen 172

Economy/Market Analysis
 Answer: No. P/Es vary too much from year to year.

4. The financial news reports that the market is overvalued at a near record
high based on the earnings multiplier. What does that mean to you?

(moderate)

Answer: This suggests that prices are increasing faster than earnings, thus
P/E ratios (also called earnings multipliers) are higher than usual.
Some analysts would prepare for the market to fall back to more
“normal” P/E levels, meaning that price declines are in store.
Others would expect the exuberance to continue.

5. Use the constant-growth dividend discount model to explain why stock

prices have an inverse relationship to interest rates.

(moderate)

Answer: The stock price (P0) based on the model P0 = D1/(k – g) increases
as the required rate of return (k) decreases.

6. Why is there an inverse relationship between P/Es and dividend yield?

(moderate)

Answer: Price is in the numerator on P/Es and in the denominator in

dividend yield. Dividends are paid from earnings, which links the
other variable in each ratio.

Making Market Forecasts

7. Explain how dividend yield on the S&P 500 Index can be used to make
market forecasts.

(moderate)

Answer: When dividend yield drops below three percent, the market is
expected to fall in the near future. Investors will sell stocks and
seek higher yielding bonds, causing prices to adjust.

Chapter Thirteen 173

Economy/Market Analysis
 Critical Thinking/Essay Questions

1. How does the increased globalization of business and finance affect

business cycles and the leading, lagging, and coincident economic
indicators?

(difficult)

Answer: It may be that economic cycles may be more attuned to global

economics instead of domestic economics. Likewise, traditional
domestic economic indicators may lose some of their effectiveness
as global business exercises more influence over the domestic
economy.

2. What are the implications of the article “Overcoming the Bear Market
Blues” for investors?

(moderate)

Answer: Two points emerge: The first is that the investor is better off in
the market than out of the market waiting for the right time to
invest, because one has more to lose by missing the bull markets
than by avoiding the bear markets. The second point is that
depressed markets are the best time to buy, so investors should
overcome their emotional inclination to sell when the market is
down.

Problems

1. Assume that the dividends to be paid on a particular market index next

period are $20. Investors require 15 percent to invest in stocks, and expect
dividends to grow at 10 percent per year. What is the value of this index?

(moderate)

Solution: P0 = D1/(k – g) = 20/(0.15 – 0.10) =

$400

2. Value Line's estimated dividends on its Industrial Composite for 199X are
$2.00 while estimated earnings are $4.30. The expected spread between k
and g is .04.

(a) What is the P/E ratio?

(b) What is the estimated price for this Index?

(moderate)

Chapter Thirteen 174

Economy/Market Analysis
 Solution: (a) P/E = (D1/E1)/(k – g) = (2.00/4.30)/(0.04)
= 11.63

(b) P = (P/E)(EPS) = (11.63)(4.30)

= $50

3. The earnings per share on a composite stock index this past year was
$3.25. The earnings are expected to grow at a constant rate of 7 percent
forever. The dividend payout ratio is expected to continue at its current
rate of 35 percent and the dividend yield is expected to be 4 percent.
Calculate the intrinsic value of the composite stock index.

(moderate)

Solution: D1 = D0(1 + g)
= (D0/E0)(E0)(1 + g)
= (0.35)(3.25)(1.07) = $1.22

D1/P0 = Dividend Yield

1.22/P0 = 0.04
P0 = $30.50

Expected price = 36.45(20) = 729

Chapter Thirteen 175

Economy/Market Analysis