chapter 4. discuss the role of capital market expectations in the portfolio management process ...
TRANSCRIPT
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