Capital Market Expectations

Chapter 4

Key Learning Outcomes Discuss the role of capital market

expectations in the portfolio management process

Review a framework for setting capital market expectations

Learning Outcomes Identify and discuss the following as they

affect the setting of capital market expectations:◦ The limitations of economic data◦ Data measurement errors and biases◦ The limitations of historical estimates◦ Ex post risk as a biased measure of ex ante risk◦ Biases in analysts’ methods◦ The failure to account for conditioning information◦ The misinterpretation of correlations◦ Psychological traps◦ Model uncertainty

Learning Outcomes Explain the use of survey and panel

methods and judgment in setting capital market expectations

Distinguish between the inventory cycle and the business cycle

Identify and interpret business cycle phases and their relationship to short- and long-term capital market returns

Review the relationship of inflation to the business cycle and characterize the relationship between inflation/deflation and cash, bonds, equity, and real estate

Learning Outcomes Distinguish between business cycles and

economic growth trends and demonstrate the application of business cycle and economic growth trend analysis to the formulation of capital market expectations

Identify and interpret the components of economic growth trends and explain how governmental policies and exogenous shocks can affect economic growth trends

Identify and interpret macroeconomic and interest and exchange rate linkages between economies

Evaluate how economic and competitive factors affect investment markets, sectors, and specific securities

Recommend and justify changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors

Learning Outcomes

The Role of Capital Market Expectations Capital market expectations are the

investor’s expectations concerning the risk and return prospects of various asset classes (macro) as opposed to specific assets (micro)

Essential input to formulating a strategic asset allocation

Framework for Setting Capital Market Expectations Specify the final set of expectations needed, including

the time horizon to which they apply Research the historical record Specify the method(s) and/or model(s) that will be

used and their information requirements Determine the best sourced for information needs Interpret the current investment environment using

the selected data and methods, applying experience and judgment

Provide the set of expectations that are needed, documenting conclusions

Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process

Limitations of Economic Data Analyst must understand definition,

construction, timeliness and accuracy of any data used, including biases

Time lag can be an impediment to use Data are frequently revised by collecting

officials Definitions and calculation methods change

over time Data collectors often re-index, introducing the

risk of mixing data indexed to different bases

Data Measurement Errors and Biases Transcription errors – errors in gathering

and recording data (most serious if they reflect a bias)

Survivorship bias – including only those entities that have survived for the entire measurement period tends to paint an overly optimistic picture

Appraisal (smoothed) data – understates volatility and correlation with other assets due to infrequent measurement

Limitations of Historical Estimates Things could be different, altering risk/return

characteristics◦ Technological◦ Political◦ Legal and regulatory environments◦ Disruptions (war, natural disaster)

Such regime changes result in nonstationarity – differing underlying properties during different parts of a time series

Amount of data needed for statistical analysis may require a long time series, increasing nonstationarity risk (if the data is even available)

Ex Post Risk as a Biased Measure of Ex Ante Risk Prices at any one time reflect risk factors

that may not materialize When the risk fails to materialize, asset

prices rise Since the risk did not materialize, it is not

incorporated in the ex-ante estimate (i.e. risk is underestimated

The return did materialize, so it is incorporated in ex-ante estimates (return is overestimated)

Biases in Analysts’ Methods Data mining – with enough data there will

be random correlations that are not economically meaningful

Time period bias – research findings often sensitive to start and end dates for measurement period

Psychological Traps Anchoring – gives disproportionate weight to the

first information received on a topic Status quo – tendency to perpetuate recent

observations in forecasts Confirming evidence – giving greater weight to

information that supports existing or preferred point of view than to evidence that contradicts it

Overconfidence – overestimating accuracy of forecasts

Prudence – tempering forecasts to not appear extreme

Recallability – forecasts overly influenced by events that left a strong impression on the forecaster’s memory

Model Uncertainty Model uncertainty is the risk that the model

is not correct or appropriate Input uncertainty relates to whether the

inputs to the model are correct Model and input uncertainty make it difficult

to evaluate inefficiencies or market anomalies

Formal Tools for Setting Capital Market Expectations Discounted cash flow models – expressing

current value as discounted value of future cash flows

Risk Premium Approach – expresses expected return as risk free rate plus an appropriate risk premium

Financial Market Equilibrium Models – describe relationships between expected return and risk in which supply and demand are in balance

Survey/Panel Methods and Judgment Survey and panel methods consolidate the

opinions of a group of experts Judgment can improve forecasts relative to

objective methods

Business Cycles Business cycle (9-11 years) – These are generalizations – realize that each of the

listed effects do not always happen or do not occur at the same rate or frequency during different cycles across time – also realize that in order to take advantage of the listed occurrences, you must be in the correct stocks or bonds ahead of the phases occurring which means that you must predict the phases ahead of time◦ Recovery

still large output gap bond yields bottoming, stocks often surge risk pays.

◦ Early upswing robust growth without inflation Rising capacity utilization and profits Short rates start rising, long rates stable

◦ Late upswing Output gap closed, danger of overheating Inflation starts to pick up Rising interest rates, stock markets rising but volatile

◦ Slowdown Slowing economy, sensitive to shocks Peaking interest rates Interest sensitive stocks perform best

◦ Recession Declining GDP Falling short-term interest rates and bond yields Stock market bottoms early and begins to rise ahead of business cycle recovery

Factors Affecting Business Cycle Consumers

◦ 60-70% of GDP so typically the most important factor

◦ Monitor retail sales and personal income Business

◦ Smaller but more volatile◦ Monitor surveys such as ISM, PMI

Monetary policy◦ Mechanism for intervening in cycle◦ Watch inflation, pace of growth, unemployment

and capacity utilization

Differences Between Emerging and Developed Economies Emerging countries are catching up

economically Need higher investment rates in physical

and human capital If domestic savings are inadequate foreign

capital is needed More volatile political and social

environments Many need major structural reform to

unlock potential Tend to be commodity-driven or have

expertise in a narrow industrial range

Country Risk Analysis How sound are fiscal and monetary policy What are the economic growth prospects Is the currency competitive, and are

external accounts under control Is external debt under control Is liquidity plentiful Is political situation supportive of required

policies

econometric models approach◦ advantages◦ disadvantages

leading indicator based approach◦ advantages◦ disadvantages

checklist approach◦ advantages◦ disadvantages

Approaches to Economic Forecasting