Capital Market Expectations Flashcards
CME Who Comes Up With Them?
- The portfolio manager (investor) in conjunction with the IPS comes up with the asset allocation
- Items to include is the expected return, standard deviation, variance, and correlation between asset classes
- It can be done on a macro level or micro level
- It can be done on a long-term and/or short-term basis
- It can be done on an asset allocation level
Steps for Capital Market Expectations
7 Steps for Formulating:
1. Determine the specific CME that is needed
2. Research or investigate and asset classes historical performance
3. Identify the valuation model and the requirements of that model
4. Collect the best data possible; issue that can arise
5. Use experience and judgement to interpret the most realistic economic conditions and outcomes.
6. Formulate the CME using any number of methods (Discounted cash flow, Black-Letterman…etc)
7. Monitor the Performance
Problems in Forecasting
Poor forecast will lead you to allocate to asset classes that are inappropriate:
1. Limitations with using economic data
2. Data measurement and biases
3. Limitations of historical estimates
4. The use of ex-post risk and return measures
5. Non-repeating Data Patterns
6. Failing to account for conditional information
7. Misinterpretation of correlations
8. Psychological Bias
9. Model Uncertainty (parameter or input)
Limitations of using Economical Data
- Economic data with a lag, can be significant
- Data is revised, not made at the same time of distribution
- Redefining the item set or revising the methodology of calculations
- Data index are rebased over time
Advantages of Historical Estimates
- Statical Requirements: Number of data points must be larger than the covariances that are calculated
- Provides with us more piratical statical estimates with a smaller variance to those estimates
- If using a short time period, we may use more frequent data which, might miss out on certain value or outdate data called asynchronous data which, can result in distorted correlation calculations
Limitations of Historical Estimates
- Regime change where the underlying a shift in the data so much it no longer aligns (technological, political, legal, economic, or regulatory environments).
- The use of ex-post data for estimating ex-ante risk and return. “Monday morning quarterbacking” looking at the results without the prior risks taken into account.
Misinterpretations of Correlations
- Look at the relationship and misinterpreting the correlations
- Correlations assumes a liner relationship.
- There might be non-linear relationships that are not taken into account
- High Correlation DOES NOT Imply Causation.
Exogenous Shocks
Base on unanticipated “event” outside the normal course of the economy that is not already priced in the market price.
Caused by several factors:
1. Change in the Governance Policy
2. Political Events
3. Technology Progress (R&D and tax incentives)
4. Natural Disasters
5. Discovery of Natural Resources or New Methods
6. Financial Crisis
Financial Crisis Types
- Type 1: A permanent, one-time decline with resumption of the trend rate after the initial shock.
- Type 2: No persistent one-time decline but continuing at a lower trend rate.
- Type 3: Both a permanent, one-time decline and continuation at a lower trend rate.
Long-term Economic Trend Analysis
Labor input growth:
* Increase in hours worked
* Increase in labor force size (population growth)
* Increase in labor force participation rate
Labor productivity growth:
* Increase in capital inputs
* Total factor productivity (TFP) increase (technology improvement)
Economic Indicators
From multiple sources (government, organizations, public & private companies)
* Leading: Most useful that move ahead with a reasonable lead time
* Coincident: Move with the business cycle
* Lagging: Move after the business cycle
Advantages:
* Simple, intuitive, easy to track
* Reliable data from 3rd parties
* Can be tailored to meet any type
* Focusing on turning points
Disadvantages:
* Forecasting results have been inconsistent
* Indicators has given false signals
* Revising frequent indicators
* Binary (yes/no) directional guidance
* Overfitting
Econometric
Use statistical methods to try explain economic relationship to create/formulate forecasting models
* Ordinary least squares method used to develop models
Advantages:
* Many factors “robust”
* Quickly updated using new data
* Provides quantitative estimates
* Imposes analytical discipline/consistency
Disadvantages:
* Complex, time-consuming
* Forecasting inputs
* Model may be misspecified due to changing relationships
* False precision impression
* Turning points hard to forecast
Structural Model
Econometric Model
Assume a firm asset are directly observed in the market place where you could come up with a value for them and uses optionality to look at it from the bond holders and equity shareholders (everything remains the same)
May give a false sense of precision
Reduced Form Model
Econometric Model
Takes sophistical variables and assumes that balance sheet is not made up of one form of debt, does take into account flexibility
Checklist
Subjective Approach:
* Analysis will ask a series of questions (especially regarding GDP).
* Analyst will use their judgement of the reasons and models to formulate their expectations
Advantage:
* Less complex more flexible
* Can include a wide variety of check points (breadth)
Disadvantages:
* Arbitrary, judgmental, and subjective
* Time consuming
* More complex manual process
5-Phases of the Business Cycle
- Initial recovery
- Early Expansion
- Late Expansion
- Slowdown
- Contraction
Disinflation
The inflation is increasing, but at a decreasing rate
Deflation
- Environment with falling prices negative inflation rate can be a treat to an economy
- When inflation is negative interest rates will decline to almost zero which, will inhibit the central bank to simulate the economy
Initial Recovery
Economic Features: After the low point
* The output gap is large
* Inflation is decelerating, stimulative policies remain in place
* Economy starts to grow.
Capital Market Features:
* Short and Long-term government bond yields are likely to be bottoming
* Stock markets may begin to rise quickly
* Riskier small-cap stocks, high-yield bonds, and emerging market securities start to do well.
Early Expansion
Economic Features:
* Output gap remains negative, but unemployment starts to fall.
* Consumers start to borrow to spend
* Housing and consumer durable demand increases.
* Businesses step up production
* Profits begin to expand rapidly.
* Central bank begins to remove stimulus.
Capital Market Features:
* Short rates begin to increase; long rates remain stable or increase slightly.
* Flattening yield curve.
* Stock prices trend upward.
Late Expansion
Economic Features:
* Positive output gap and danger of inflation
* Low unemployment, strong profits, rising wages and prices (inflation).
* Debt coverage ratios may deteriorate as business borrows to fund growth.
* Monetary policy becomes more restrictive.
* credit spreads are contracting “steepen”
* corporate leverage is stable
* corporate defaults are falling
Capital Market Features:
* Private sector borrowing causes rates to rise.
* Yield curve continues to flatten as short rates rise faster than long rates.
* Stocks are volatile
* Inflation hedges (commodities) may begin to outperform other cyclical assets.
Slowdown
Economic Features:
* Fewer viable investment projects and overleveraging cause slowing growth
* Inflation continues to rise as business pricing attempts to outpace rising input costs.
* The economy is vulnerable to shocks.
Capital Market Features:
* Long-term bonds may top, but Short-term rates rise or may peak; yield curve may invert.
* Credit spread widens, depressing bond prices for lower credit issues.
* Stocks may fall; utilities and quality stocks are likely to outperform.
Contraction
Economic Features: (12 to 18 months):
* Firms cut investment spending, then decrease production; unemployment can rise quickly
* Profits drop sharply; credit markets tighten
* Accounting transgressions are uncovered,
* Bankruptcies can result.
Capital Market Features:
* Short and Long-term rates begin to fall; yield curve steepens
* Credits spread widens; remains wide until trough.
* Stock market:
Early phase—Declining
Late phase—Begins to rise
Monetary Policy
Determine by the federal reserve to either increase or decrease the money supply their goals is always promote stable prices
Fiscal Policy
By the direct government decision to stimulate or decrease the economy by increasing or decreasing taxes or spending
Taylor Rule
Determines a target interest rate using a neutral rate using a comparison between the expected GDP and the trend rate of growth in GDP and expected inflation vs the target interest rate of a country.
