Macro expectations
* Expectations regarding classes of assets
* Top-down expectations
Micro expectations
* Expectations regarding individual assets
* Bottom-up expectations
Beta research
Forming capital market expectations
Alpha research
Earning excess returns through the use of specific strategies within specific asset groups
Steps to formulate capital market expectations
* Determine time period of needed expectations according to investor's situation
* Look at assets' historical performance to drivers of return in past and if they apply to future
* Identify valuation model used and its requirements
* Collect best data pos
Capital will flow into a country when...
...capital restrictions are reduced
...strong economy attracts capital
...interest rates are higher, increasing domestic currency value
Forecasting methods
*Relative purchasing power parity
*Relative economic strength
*Capital flows
*Savings and investment inbalances
Purchasing power parity
*Differences in inflation between two countries will be reflected in their exchange rate
*Higher inflation country will see its currency value decline
*Holds in long-term but not short or medium-term
Relative economics strength approach
*Favorable investment climate will attract capital, increasing demand for the country's currency and its currency value will rise
*If currency is overvalued based on fundamentals, high rates may still attract attention and keep currency overvalued
*Best u
Capital flows approach
Focuses on long-term capital flows
Savings-investment imbalances approach
*Not used for forecasting but helps explain why currencies diverge from equilibrium value
*If investment is greater than domestic savings, capital must be flowing in from abroad to finance investments, and domestic currency will rise in value
Government intervention
*Most observers don't think government can influence exchange rates since government trading of currencies is so small
*Currencies are most influenced by economic fundamentals than by government trading
Cash
*Managers adjust maturity and creditworthiness of their cash investments depending on forecast of interest rates
*To earn excess returns, manager must be able to forecast future rates better than other managers, requiring anticipation of central bank move
Risk-free bonds
*Most common are issued by governments of developed countries
*Include a real yield and expected inflation rate
*Investor with short time horizon will focus on cyclical changes to economy and short-term changes to rates
Risky bonds
*Most common are corporate bonds
*To estimate credit risk premium assigned to a bond, analyst can subtract the Treasury yield from the corporate bond of same maturity
*Spread will increase during a recession
Emerging market government bonds
*Most denominated in a non-domestic currency
*Government must get hard currency to pay off debt
*Default risk is higher
*Analysts use country risk analysis
TIPS
*Price and yield vary as economy changes
*Yield rise (falls) as real economy expands (contracts)
*Yields fall as inflation ramps up as more investors buy funds
*Yields change with changes in supply and demand
Common stock
*Short-term growth affected by business cycle
*Sales and earnings decrease in recessions
*Defensive stocks less affected by recession
*PE ratio are higher when interest rates are low and earnings prospects are high
*PEs can be high in a recession when rec
Emerging market stocks
Positively correlated to business cycles of developed markets due to trade and capital flows
Real estate
Affected by interest rates, inflation, shape of yield curve and consumption
Cash
*Managers adjust maturity and creditworthiness of their cash investments depending on forecast of interest rates
*To earn excess returns, manager must be able to forecast future rates better than other managers, requiring anticipation of central bank move
Risk-free bonds
*Most common are issued by governments of developed countries
*Include a real yield and expected inflation rate
*Investor with short time horizon will focus on cyclical changes to economy and short-term changes to rates
Risky bonds
*Most common are corporate bonds
*To estimate credit risk premium assigned to a bond, analyst can subtract the Treasury yield from the corporate bond of same maturity
*Spread will increase during a recession
Emerging market government bonds
*Most denominated in a non-domestic currency
*Government must get hard currency to pay off debt
*Default risk is higher
*Analysts use country risk analysis
TIPS
*Price and yield vary as economy changes
*Yield rise (falls) as real economy expands (contracts)
*Yields fall as inflation ramps up as more investors buy funds
*Yields change with changes in supply and demand
Common stock
*Short-term growth affected by business cycle
*Sales and earnings decrease in recessions
*Defensive stocks less affected by recession
*PE ratio are higher when interest rates are low and earnings prospects are high
*PEs can be high in a recession when rec
Emerging markets stocks
Positively correlated with business cycles in developed world due to trade and capital flows
Real estate
Affected by interest rates, inflation, shape of yield curve and consumption
Common forecasting methods
*Econometrics
*Economic indicators
*Checklist approach
Econometrics analysis
*Utilizes economic theory to formulate forecasting models
*Least squares regression is most often used
Advantages of econometrics
*Models can be reused
*Might accurately model real world conditions
*Can provide precise quantitative forecasts of economic conditions
Disadvantages of econometrics
*Difficult and resource intensive to create
*May lose applicability in future time periods
*Better at predicting expansions than recessions
*Requires scrutiny of output to verify validity
Economic indicators
*Made available from governments, institutions, and private organizations
*Can be leading, lagging or coincidental indicators
Advantages of economic indicators
*Available from outside parties
*Easy to understand and interpret
*Can be adapted for specific purposes
*Verified effectiveness
Disadvantages of economic indicators
*Not consistently accurate as relationships can change with time
*Can be misleading and give false signals
Checklist approach
*Analyst checks off a list of questions that should indicate the future growth of the economy
*Given the answers, the analyst can use his judgement to formulate a forecast or derive a more formal model using statistics
*Subjective assessments must be made
Advantages of checklist approach
*Simple
*Allows for changes in the models over time
Disadvantages of checklist approach
*Requires subjective judgement
*Time intensive to create
*May not be able to model complex relationships
Emerging markets require...
...heavy investment in human and physical capital
Emerging market risks
*Unstable political and social systems
*Rely heavily on foreign borrowing
Questions to ask before committing capital to emerging markets
*Does the country have responsible fiscal and monetary policy?
*What is the expected growth?
*Does the country have reasonable currency values and current account deficits?
*Is the country too highly levered?
*What is the level of foreign exchange reserve
Macroeconomic links
Similarities in business cycles across countries
Interest rate differentials reflect...
...differences in economic growth, monetary policy and fiscal policy
Countries with high real interest rates should...
...see the value of their currency increase
Exogenous shocks
*Unanticipated events that occur outside the normal course of an economy
*Not reflected in market prices
Contagion
When exogenous shocks have an effect on an economy and spreads to others
Components of trend growth rate
*Changes in employment level
*Changes in economic productivity
Components of employment level
*Population growth
*Rate of labor force participation
Components of economic productivity
*Spending on new capital inputs
*Total factor productivity growth
Higher long-term growth rate trends benefit...
...the equity investor through a higher growth rate without excessive inflation
Trend growth rates for developed countries...
...are fairly stable over time
Trend growth rates for emerging markets...
...tend to be higher than developed countries
Largest component of GDP is...
...consumer spending, which stays pretty stable over a business cycle
Friedman's permanent income hypothesis
*Economic slowdowns won't affect consumers much
*In recessions, individuals will save less and decrease their spending by only a small amount
*In expansion, indivuals will spend more, but less than their income increases
Government structural policy guidelines
*Government should interfere with the economy as little as possible
*Government should have a responsible fiscal policy
*Government should have tax policies that are transparent, consistently applied, pulled from a wide base and not overly burdensome
*Gov
When both monetary and fiscal policies are expansive...
...yield curve is upward sloping and economy is likely to expand
When both monetary and fiscal policies are restrictive...
...yield curve is downward sloping and the economy is likely to contract
When monetary policy is restrictive and fiscal policy is expansive...
...yield curve is flat and the economy is unclear
When monetary policy is expansive and fiscal policy is restrictive...
...yield curve is moderately steep and the economy is unclear
Taylor Rule determines...
...target interest rate using the neutral rate, expected GDP relative to long-term trend and expected inflation to targeted amount
Aspects of fiscal policy
*Change in the deficit more important than level of deficit
*Changes in deficit that occur naturally are not stimulative or restricted
Inflation increases...
...as the economy expands and output gap narrows
Bonds in inflation
*Negative for bonds
*Tend to decrease in price as inflationary expectations rise
*Tend to increase in price as inflationary expectations fall
Stocks in inflation
*Usually do well in low inflation periods
*Provide inflation hedge when inflation is moderate and price increases can get passed to the consumer
*inflation over 3% are usually bad
*Decreasing inflation or deflation are usually bad
Real assets in inflation
Deflation reduces their value
Real estate in inflation
*If levered, declines in property value lead to steeper declines in equity position
*Cash flows rise slowly and returns near long-run average when inflation is at or below expectations
Cash and inflation
*Low inflation has no affect
*High inflation is positive for cash
*Deflation is negativd
Assets with higher returns during. business cycle lows...
...should have lower risk premiums
Assets with lower returns during business cycle lows...
...should have higher risk premiums
Initial recovery
*Lasts a few months
*Rising business confidence
*Government stimulus with low interest rates or budget deficits
*Falling inflation
*Large output gap
*Low or falling short-term rates
*Bond yields are bottoming out
*Stock prices rising
*Riskier stocks do we
Early upswing
*Lasts a year to several years
*Increasing growth with low inflation
*Increasing confidence
*Increasing inventories
*Rising short-term interest rates
*Output gap is narrowing
*Flat or rising bond yields
*Rising stock prices
Late upswing
*Confidence and employment are high
*Output gap eliminated and economy at risk of overheating
*Inflation increases
*Central banks limit growth of money supply
*Rising short-term interest rates
*Rising bond yields
*Rising stock prices but increased risk
Slowdown
*Lasts a few months to a year
*Declining confidence
*Rising inflation
*Falling inventories
*Short-term rates peaked
*Bond yields peaked
*Yield curve may invert
*Falling stock prices
Recession
*Last six months to a year
*Large declines in inventory
*Declining confidence and profits
*Increase in unemployment and bankruptcies
*Inflation peaks
*Falling short-term rates
*Falling bond yields
*Stocks start rising once anticipation of end of recession
Inflection point
When the economy changes directions, creating higher risk and return opportunities
Components of economic growth
*Cyclical
*Trend-growth components
Cyclical growth component...
...is short-term in nature
Trend-growth component...
...is long-term in nature
Components of cyclical analysis
*Inventory cycle
*Business cycle
An inventory cycle...
*Lasts 2 to 4 years
*Measured using the inventory to sales ratio
*Increases when businesses gain confidence, leading to more employment and economic growth
A business cycle...
...Lasts 9 to 11 years
Measures of economic activity
*GDP
*Output gap
*Recession
GDP
Measured in real terms because true economic growth should be adjusted for inflationary components
Output gap
*Difference between GDP based on a long-term trend line and the current level of GDP
*When the trend line is higher (lower) than the current GDP the economy has slowed (quickened) and inflationary pressures have weakened (strengthened)
*Used by policy mak
Recession
Decreases in GDP over two consecutive quarters
Phases of business cycle
*Initial recovery
*Early upswing
*Late upswing
*Slowdown
*Recession
Surveys
Poll of market participants as to what their expectations are regarding the economy or capital market
Panel method
If a survey is conducted consistently over a period of time
Judgement
Adjusting expectations using experience and insights
Statistical tools
* Projecting historical data
* Shrinking estimators
* Time series analysis
* Multifactor models
Projecting historical data
* Analyst projects the historical mean return, standard deviation and correlations for a data set into the future
* Arithmetic mean used for single periods
* Geometric mean used for multiple periods
Shrinkage estimators
* Weighted average of historical data and some other estimate, where the weights and other estimates are defined by the analyst
* Shrink the influence of historical outliers through the weighting process
* Mean return and covariance are most often adjuste
Time series analysis
* Forecasts a variable using previous values of itself and sometimes previous values of other variables
* Forecasts means as well as variance
Volatility clustering
* High (low) volatility tends to persist after high (low) volatility
* JPMorgan developed a model that states that the volatility of the current period is the weighted average of the previous period and a random error
Multifactor model
* Used to forecast returns and covariances
* Simplifies the forecasting procedure by reducing the forecast to a common set of factors
* Eliminates noise present in a sample of data and ensures consistent forecasts given a consistent covariance matrix
Discounted cash flow model
* Intrinsic value of an asset is the present value of its future cash flows
* Advantage is its focus on cash flows and being able to back out a required return from it
* Doesnt account for current conditions
* Best for long-term valuations
* Gordon growth
Gordon growth model
* Can be applied to the entire market
* Uses nominal GDP growth rate as the discount rate
* Price = (Dividend Next Period) / (Expected Return on Stock - Growth Rate of Dividends and Long Term Earnings)
Excess corporate growth rate
Adjustment for any differences between the economy's growth rate and that of the equity index
Grinold-Kroner model
* Builds on Gordon Growth Model by including variables for stock repurchases and market valuation represented by PE Ratio
* States that the expected return of a stock is its dividend yield plus the inflation rate plus real earnings growth rate minus the c
Types of variables in Grinold-Kroner model
* Expected income return
* Expected nominal growth in earnings
* Expected repricing return
Expected income return of GK model
* Current yield in percent that stockholders can expect to receive from the stock
= (Expected dividend yield) - (Percent change in shares outstanding)
Expected nominal earnings growth
Real growth rate of stock price plus expected inflation
Repricing return
Expected change in PE ratio
DCF for fixed income
* Yield to maturity on the reference bond in a segment is used as expected return for that segment
* Drawback is that the yield to maturity assumes intermediate cash flows are reinvested at the yield to maturity (can instead adjust yield to maturity to ac
Risk premium (build up) approach
* Analyst begins with a bond yield and adds an equity risk premium
* Bond Return = Real risk free rate + Inflation risk premium + Default risk premium + Liquidity risk premium + Maturity risk premium + Tax premium
Financial equilibrium approach
* Assumes supply and demand in global asset markets are in balance
* An example is the International Capital Asset Pricing Model
* Risk premium for an asset is equal to its correlation with the global market portfolio multiplied by the standard deviation
Singer and Terhaar anaysis
*Adjusts ICAPM for market imperfections
*Liquidity or market segmentation
S&T risk premium
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Problems in developing forecasts
* Limitations to economic data
* Data measurement error and bias
* Limitations of historical estimates
* Use of ex post risk and return measures
* Non-repeating data patterns
* Failing to account for conditioning information
* Misinterpretation of correla
Limitations to using economic data
* Time lag between collect and distribution is long
* Data often revised and not made at the same time as publication
* Data definitions and methodology change over time
Data measurement errors and biases
* Transcription errors are recording information incorrectly and can be serious is biased in a certain direction
* Survivorship bias
* Use of appraisal, instead of actual, data results in correlations and standard deviations biased downward
Limitations of historical estimates
* Historical data must be revised as it ages
* A longer time period is preferred
Reasons for selecting a longer time period
* Statistically required
* More precise estimate with smaller variance
* Less sensitive to the starting and ending points selected
Potential problems from using long time periods
* More likely to include regime changes which have different characteristics
* Relevant time period might be too short to be relevant
* Creates temptation to use more frequent data, which may be outdated or missing data points
Questions to help select the time period
* Is there a reason to believe the entire time period is not appropriate?
* If yes, does a statistical test confirm there is a regime change and at what point did it occur
Non-repeating data
* Patterns unlikely to recur in the future and can produce bias
* Some variables may happen to have relationships that are coincidence and won't persist in future
When faced with patterns in data, an analyst should...
* Ask if there is an economic basis for the pattern
* Scrutinize the modeling process for susceptibility to bias
* Test the discovered relationship with out-of-sample data to determine if relationship is persistent
Failing to account for conditioning information
* When the relationship between security returns and economic variables is not consistent over time
* Analysts should account for current conditions in their forecasts
Psychological traps
* Anchoring trap
* Status quo trap
* Confirming evidence trap
* Overconfidence trap
*Prudence trap
Anchoring trap
Too much weight put in first data set received
Status quo trap
Analyst predictions are highly influenced by recent results
Confirming evidence trap
* Analysts give too much credence to evidence that supports their existing or familiar beliefs
* Can cause analysts to look for information that supports their perspective and ignore information that does not support their view
Overconfidence trap
Analysts ignore their past mistakes and overestimate the accuracy of their forecasts
Prudence trap
Overly conservative in their forecasts because they want to avoid the regret from making extreme forecasts that could end up being incorrect
Recallability trap
Let past disasters or dramatic events weigh too heavily in their forecasts
Model and inout uncertainty
*Model uncertainty is the inability to be sure that a predictive model is correct to use
* Input uncertainty refers to knowing with certainty the correct input values for the model