18 RELATE TO MONICA GARZA. MONICA GARZA IS A PORTFOLIO MA...

Questions 13-18 relate to Monica Garza.

Monica Garza is a portfolio manager for Southwood Group, a large investment management firm,

where she is in charge of economic and capital market forecasting. Brett Crosby, director of

research at Southwood, has asked Garza to assist him in identifying the forecasting approach

that would best suit an equity long-short hedge fund the company would like to open. The fund

will purchase securities from its investment universe that are considered to have the highest

forecasted alphas and sell short securities with negative forecasted alphas. The overall long-

short exposure will vary based on the number of securities with positive and negative forecasted

alphas.

After reviewing the forecasting method to be used by the new hedge fund, Crosby asks Garza to

forecast GDP growth. To do this, Garza obtains predictions for changes in several underlying

macroeconomic factors, including those listed Exhibit 1 with their predicted changes.

Exhibit 1: Predicted Changes in Economic Factors

Factor Predicted Change

Savings rate Decrease

Pollution controls Increase

Retirement age Increase

Garza then gathers the data in Exhibit 2 for the periods 1991-2000 and 2001-2010.

Exhibit 2: Historical Economic Data

Growth in

Output

Elasticity of

Capital

Total Factor

Labor Input

Capital (α)

Stock

Productivity

1991-2000 1.25% −0.50% 2.50% 0.6

2001-2010 2.35% 1.25% 0.42% 0.6

Using the data she gathered, Garza will calculate the implied price of the market index. She

notes that the major equity market index value is currently 1600 and the last dividend was $75.

She believes the required rate of return for the market is 8.0%.

Crosby then asks Garza to review the major relative valuation models and provide short

descriptions of each. Garza reviews the Fed model, the Yardeni model, and the 10-year moving

average price/earnings ratio model, P/10-year MA(E), and makes the following comments:

Comment

The Fed model compares the earnings yield for the S&P 500 index

1:

to the yield on U.S. Treasury securities. When the earnings yield

for the S&P 500 is greater than the yield on Treasury securities,

equities are said to be over-valued and should fall.

The Yardeni model is used to estimate earnings yield for a market

2:

index and is computed as the yield on A-rated corporate bonds less

the long-term growth rate forecast multiplied by a weighting

factor. Although the Yardeni model incorporates a risk premium

above that of Treasuries, the premium is not a true measure of

equity risk.

The 10-year moving average price/earnings ratio model is

3:

computed as the value of the S&P 500 index divided by the

average of the previous 10-years' reported earnings. One of the

major drawbacks of this model is that it does not consider the

effects of inflation.

After completing a review of the relative valuation models, Garza turns back to evaluating the

value of the market index. She now decides to employ the equity q ratio and gathers the

information in Exhibit 3:

Exhibit 3: Valuation Data ($Billions)

Market value (replacement cost) of assets 50

Book value of assets 35

Market value of liabilities 26

Market value of equity 20

...

In response to Crosby's question regarding the forecasting approach that would be best suited

for the hedge fund, Garza should suggest using a:

A) top-down approach.

B) bottom-up approach.

C) combination of top-down and bottom-up approaches.

Question #14 of 60

Which of the following is most likely correct regarding the predicted changes in the underlying

factors? All else equal, the predicted change in:

A) the savings rate will lead to an increase in GDP growth.

B) the retirement age will lead to an increase in GDP growth.

C) pollution controls will lead to an increase in GDP growth.

Question #15 of 60

The component of economic growth that contributed the most to real GDP growth during 1991-

2000 is:

A) labor input.

B) capital stock.

C) total factor productivity.

Question #16 of 60

If Garza assumes that the sustainable economic growth rate will be the same as the growth rate

realized over the period 2001-2010, the intrinsic value of the market index would be closest to:

A) 1578.

B) 1586.

C) 1637.

Question #17 of 60

Which of Garza's comments regarding relative equity market valuation models is correct?

A) Comment 1.

B) Comment 2.

C) Comment 3.

Question #18 of 60

Based on the equity q ratio, Garza would most likely conclude that the equity index is:

A) overvalued.

B) undervalued.

C) fairly valued

Question #19 of 60