Capital Expectation 10-11 Flashcards
fundamental law of investing is the uncertainty of the future.
Asset allocation is the primary determinant of long run portfolio performance
cross-sectional consistency
consistency across asset classes regarding portfolio risk and return characteristics.
Intertemporal consistency
consistency over various investment horizon regarding portfolio decision over time.
good forecast are unbiased, objective, well researched, efficient, and internally consistent.
at least 30 observations are needed to test a hypothesis.
transcription errors
errors in gathering and recording data
survivorship bias
biases arises when a data series reflects only entitles that survived to be end of the period.
appraisal (smoothed) data
appraisal values trend to be less volatile than market determined values. As a result, measure volatilities are biased downward and correlations with other assets tend to be understated.
limitation of historical estimates
- Regime changes cause non-stationary data
data may not be representative of futures period - analyst underestimating ex-ant risk and over-estimate ex-ante returns.
3.Time Period Bias – results that are period specific. The time period selected can alter results.
ex post risk vs. ex-ante risk (Peso prob)
analyst underestimating ex-ant risk and over-estimate ex-ante returns.
The high ex-post returns include risk premiums for adverse events (not materialized) provide a poor estimate of ex-ante expected return.
Biases in analysts’ method
- data mining arises from repeatedly searching a data set until a statistic significant pattern emerges
the statistical relationship cannot be expected to have predictive value. As a result, the modeling results are unreliable
use out-of-sample data to test and improve the reliability of model.
- time period bias relates to results that are period specific , research finding often turn out to be sensitive to the selection of specific starting/ending dates
to avoid:
test the discovered relationship with out-of-sample data to determine if the relationship is persistent.
failure to account for conditional information
a negligible measured correlation may reflect a strong but nonlinear relationship should explore the possibility if they have a solid reason for believing a relationship exist.
Psychological bias
modeling uncertainty
how exogeneous shocks may affect economic growth trend:
Economic growth trend is the LT average growth path of GDP around which the economic experiences semi-regular business cycles.
Trend changes that arises from significant exogeneous shocks to underlying economic and/or market relationships are not only impossible to foresee but also difficult to identify, assess, and quantify until the changes is well -established and retrospectively revealed in the data.
shocks arises from:
changes in gov’t policies that encourage LT growth fiscal policy, minimal gov’t interference with free market, facilitating competition in the private sector, development of infrastructure and human capital and sound tax policies.
new tech/products
geopolitics has potential to reduce growth by diverting resources to less economically productive uses
Natural disaster destroy productive capacity
natural resources/ critical inputs
financial crisis the financial system allow the economy to channel reserves to their most efficient use.
discuss the application of economic growth trend analysis to the formulation of capital market expectation:
trend rate of growth is an important input when setting capital asset expectation.
- forecasting returns with DCF models incorporate the trend rate of growth, the need to keep these forecast consistent with long-term economic growth imposes discipline on the models. the trend rate acts as an anchor for lt bond and equity returns.
- High trend growth rates may lead to higher stock returns assuming the growth is not already reflected in stock prices.
- a higher trend rate of growth in the economy allows actual growth to be faster before accelerating inflation becomes a significant concern.
- theory implies, and empirical evidence confirms, that the average level of real government bond yields is linked to the trend growth rate. Faster trend growth implies higher average real yields.
Solow growth model:
The theory states that economic growth is the result of three factors—labor, capital, and technology.
3 approaches to economic forecasting are
economic modeling
use of economic indicators
checklist approach
economic modeling use statistical model
Structural models - based on economic theory. The functional form and parameters of these models are derived from the underlying theory.
Reduced form models (losses to theory) can be models that are simply more-compact representations of underlying structural models or can be models that are essentially data driven, with only a heuristic rationale for selection of variables and/or functional forms.
structural models specifies functional relationship among variables based on economy theory
strength:
- model can be robust, with many factors included to approx. reality
- models can be revised by new info/input
- imposes consistency on analysis
weakness:
- complex and time-consuming
- requires adequate measure for real-world activities and relationships which maybe unavailable
- Model may be mis-specified, and relationships among variables may change over time.
economic leading indicator
Usually intuitive and simple in construction.
Focuses primarily on identifying turning points.
May be available from third parties. Easy to track.
- leading indicators that more ahead of the business cycle with a reasonable stable lead time
3 consecutive months of up/down for index are expect to signal the start of an economic expansion/contraction
strengths:
1. simple since it requires following a limited number of economic/financial variables.
2. focuses on identifying turning points
3. may be available from 3rd party easy to track
weakness:
1. Can provide false signals on the economic outlook.
2 Data subject to frequent revisions resulting in “look-ahead” bias.
3. “Current” data not reliable as input for historical analysis.
History subject to frequent revision.
Overfitted in-sample.
Likely overstates forecast accuracy.
Can provide false signals.
checklist approach
most subjective, straightforward but time consuming
strength:
1. limited complexity
2. flexible
weakness:
no consistency of analysis across items or at different points in time.
1. subjective, judgmental
2. time-consuming
3. manual process limits depth of analysis
how business cycle affect short/long term expectations
turning point for business cycle/capital market expectation is not straight:
turning point are difficult to predict
also depends on investor’s behavior
difficult to distinguish effects result from LT and those result from ST
BUSINES CYCLES ARISES IN RESPONSE TO THE
interaction of uncertainty
expectation errors
rigidity
reflect decisions that
- made based on imperfect info
- require significant current resources and/or time to implement
- costly/difficult to reverse
monitor business cycle
gdp growth
industrial production
unemployment rate
output gap=
Actual GDP - potential GDP
>0 expansion
<0 recession
business cycle
initial recovery
Duration of a few months.
Business confidence rising.
Government stimulus provided by low interest rates and/or budget deficits.
Falling inflation.
Large output gap.
Low or falling short-term interest rates.
Bond yields bottoming out.
Rising stock prices.
Cyclical, riskier assets such as small-cap stocks and high yield bonds doing well.
business cycle
early expansion
Duration of a year to several years. Increasing growth with low inflation. Increasing confidence. Rising short-term interest rates. Output gap is narrowing. Stable or rising bond yields. Rising stock prices. yld increase, front ylf steeping back half flattening
business cycle
late expansion
restrictive
output gap closed
inflation rise
stock market peak
volatile stock market
Bond yld/yld curve
st/lt rates increase, curve flattening
maturiesi inward
business cycle
slowdown
less restrictive
accelerate inflation
bond prices increases
stock fall
Bond yld/yld curve
curve flat and invert
business cycle
contraction
simulative
peaking inflation
stock rise
Bond yld/yld curve
curve steeping, steepest
Falling short-term interest rates.
Falling bond yields, rising prices.
deflation
encourage default on debt
interest rate decline to near zero and limit central banks to lower interest rate and stimulate the economy
Within the equity market, higher inflation benefits firms with the ability to pass along rising costs. In contrast, falling inflation or deflation is especially detrimental for asset-intensive and commodity-producing firms unable to pass along the price increases.
QE
use open market to increase money supply and decrease short term rates
buying high quality fixed income instrument
Effect of monetary and fiscal policy on business cycles
monetary policy to stimulate growth
mechanism for intervention in the business cycle
fiscal policy
gove’t spending and taxation
Taylor rule:
ntarget = rneutral + iexpected
+ [0.5(GDPexpected − GDPtrend)
+ 0.5(iexpected − itarget)]
negative interest rate complicate the process of forming capital market expectation:
- policy neutral rate in the Taylor rule can be used a discount rate in DCF models
- multiple path projection is essential to allow for uncertainty regarding convergence.
- Negative I/R are consistent with the business cycle expectations
loose monetary policy
ST rate decrease
spending increase
value of equity fi, inflation increase
tight monetary policy
st rate increase , expected inflation decline
loose fiscal policy
decrease tax increase spending
budget deficit = tax - spending
in an expanding economy, deficits will decrease
tax receipt increase
large government budget deficits forecasted by are unlikely to have much of a lasting impact on the yield curve, especially given that private sector borrowing will be falling during the contraction, somewhat offsetting the increase in the supply of government securities.
disbursement to unemployed decrease
tight fiscal policy
int rate interest
increasing the rate of tax
both policies are simulative (loose)
yld curve steep, encourage spending/growth
both policies are restrictive
yld curve inverted, contract conomy
money policy is restrictive (mp domintes)
fiscal policy is simulative
yield curve is flat, less clear
money policy is stimulative (MP dominate)
fiscal policy is restrictive
yld curve moderately steep
the implications for the economy are less clear.
