Last Date: 8 June 2012

Discussion Question:
For the last many years, the automobile industry is not performing well due to high inflation and recession in the overall economy. The purchasing power of consumer is also decreasing over the years. To consume luxurious products has become a dream of middle income class while for lower data copied from vu solutions dot com income class it is difficult to meet both ends. Under such circumstances, the management of ABC Automobile wants to determine the affects of recession and inflation on its stock price. For this purpose they have constructed a bar chart of the stock prices of ABC Automobile for the month of January to April, 2012. The chart (hypothetical) is as follows:

Keeping in mind the above information, as a financial analyst you are required to answer the following questions with logical reasoning:

Identify the category of the stock of ABC Automobile.
Discuss how the recession and high inflation rates have affected the performance of ABC Automobile’s stock?

Solution:

category of the stock

Penny Stocks
A penny stock is a stock priced under one dollar per share (or in some cases, under five dollars per share). Most penny stocks have only a few million dollars in net tangible assets and have a short operating history. Penny stocks are almost always small cap stocks, but the reverse isn’t necessarily true. The term “penny stock” is sometimes used in a derogatory fashion, since many penny stocks are virtually worthless and should be considered extremely high-risk investments. There are also many cases of fraud involving penny stocks each year . We recommend that beginners steer clear of penny stocks.

Sector Stocks

Stocks are often grouped into different sectors depending upon the company’s business. Standard & Poor’s breaks the market into 11 different sectors. Two of these sectors, utilities and consumer staples, are said to be defensive sectors, while the rest tend to be more cyclical in nature . The other nine sectors are: transportation, technology, health care, financial, energy, consumer cyclicals, basic materials, capital goods, and communications services. Of course, other groups break up the market into different sector categorizations, and sometimes break them down further into subsectors.

Cyclical Stocks

Stocks can be classified according to how they react to business cycles. Cyclical stocks are stocks of companies whose profits move up and down according to the business cycle. Cyclical companies tend to make products or provide services that are in lower demand during downturns in the economy and higher demand during upswings. The automobile, steel, and housing industries are all examples of cyclical businesses.

Defensive Stocks

Defensive stocks are the opposite of cyclical stocks: they tend to do well during poor economic conditions. They are issued by companies whose products and services enjoy a steady demand. Food and utilities stocks are defensive stocks since people typically do not cut back on their food or electricity consumption during a downturn in the economy. But although defensive stocks tend to hold up well during economic downturns, their performance during upswings in the economy tends to be lackluster compared to that of cyclical stocks.

Tracking Stock

A tracking stock is a type of common stock that is tied to the performance of a specific subsidiary of the company. This means that the dividends and the capital gains for the stock depend upon the subsidiary rather than the company as a whole. Owning a tracking stock does not give the owner voting rights in the corporation, nor do owners of tracking stocks have a legal claim upon the general assets of the corporation. A company will sometimes issue a tracking stock when it has a very successful division that it feels is under appreciated by the market and not fully reflected in the company’s stock price.

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Recession:
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. Macroeconomic indicators such as GDP, employment, investment spending, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise.

Why Don’t Prices Decline During A Recession?
When there is an economic expansion, demand seems to outpace supply, particularly for goods and services that take time and major capital to increase supply. As a result, prices generally rise (or there is at least price pressure) and particularly for goods and services that cannot rapidly meet the increased demand such as housing in urban centers (relatively fixed supply), advanced education (takes time to expand/build new schools), but not cars because automotive plants can gear up pretty quickly.

First, do you agree with this and if not, how do you see it?
Second, when there is an economic contraction, supply initially outpaces demand. However prices for most goods and services don’t go down, and neither do wages.

My main question is why don’t prices go down for goods and services? I expect for wages, it’s just stickiness from the corporate/human culture… people don’t like to give pay cuts… managers tend to lay off before they give pay cuts (though I’ve seen exceptions). Why don’t prices go down for most goods and services?
Inflation and recession was due to a combination of the following four factors:

The supply of money goes up.
The supply of goods goes down.
Demand for money goes down.
Demand for goods goes up

Impact of Recession of Automobile :

As sales revenues and profits decline, the manufacturer will cut back on hiring new employees, or freeze hiring entirely. In an effort to cut costs and improve the bottom line, the manufacturer may stop buying new equipment, curtail research and development and stop new product rollouts (a factor in the growth of revenue and market share).

Stocks and Slumping DividendsAs declining revenues show up on its quarterly earnings report, the manufacturer’s stock price may decline. Dividends may also slump, or disappear entirely. Shareholders may become upset. They and the board of directors (B of D) may call for a new CEO and/or an entirely new senior management team. The manufacturer’s advertising agency may be dumped and a new agency hired. The internal advertising and marketing departments may also face

a personnel shakeup.
Credit Impairment and BankruptcyAlso impacted by the recession is the accounts receivable (AR). The customers of the company that owe it money may pay slowly, late, partially or not at all. Then, with reduced revenues, the affected company will pay its own bills more slowly, late, or in smaller increments than the original credit agreement required. Late or delinquent payments will reduce the valuation of the corporation’s debt, bonds and ability to obtain financing. The company’s ability to service its debt (pay interest on the money it has borrowed) may also be impaired, eventuating in defaults on bonds and other debt, further damaging the firm’s credit rating and preventing further borrowing. (Debt Reckoning can teach you how a company’s debt is an indicator of financial health.)

Employee Lay-offs and Benefit ReductionsThe business may cut employees, and more work will have to be done by fewer people. Productivity per employee may increase, but morale may suffer as hours become longer, work becomes harder, wage increases are stopped and fear of further layoffs persists.

Cuts to Quality of Goods and ServicesSecondary aspects of the goods and services produced by the recession-impacted manufacturer may also suffer. In an attempt to further cut costs to improve its bottom line, the company may compromise the quality, and thus the desirability, of its products. This may manifest itself in a variety of ways and is a common reaction of many big businesses in a steep recession.