CME - Framework & Macro considerations

Question 1

What are the Learning Outcomes of
Capital Market Expectations, Part 1: Framework and Macro Considerations

Answer 1

1. framework for capital market expectations in portfolio management process
2. challenges in developing capital market forecasts
3. exogenous shocks affect on economic growth trends
4. relevance of economic growth trend analysis to CME
5. approaches to economic forecasting
6. business cycles’ impact on short- and long-term expectations
7. inflation’s and business cycle
8. implications of inflation for cash, bonds, equity, and real estate returns
9. effects of monetary and fiscal policy on business cycles
10. shape of the yield curve as an economic predictor
11. relationship between the yield curve and fiscal & monetary policy
12. macroeconomic, interest rate, and exchange rate linkages between economies

Question 2

What are key elements for projecting an internally consistent portfolio returns?

Answer 2

emphasis should not be on accuracy but on limiting the forecast errors and ensuring
1. cross-sectional consistency (internal consistency across asset classes) and
2. intertemporal consistency (across various time horizons).

Question 3

1. framework for capital market expectations in portfolio management process

Answer 3

1. Specify the set of expectations needed (asset classes etc.)
2. Research the historical record for drivers of past performance
3. Specify the *method, model *(DCF etc.) to be used and their information requirements
4. Determine the best sources of info
5. Interpret the current Investment environment using the selected data, methods and judgement
6. Provide the set of expectations needed, documenting conclusions.
7. Monitor outcomes, compare with expectations, and provide feedback to improve the expectations’ setting process.

Question 4

Five Attributes of Good
Forecasts

Answer 4

1. unbiased
2. objective
3. well researched;
4. efficient (small forecast error)
5. internally consistent

A general guideline is that at least 30 observations are needed to test a
hypothesis

Question 5

Challenges in developing CME Forecasts

Answer 5

1. Limitations of Economic Data (time-lag, revisions, index rebasing)
2. Data Measurement Errors and Biases (transcription errors, survivorship bias, appraisal data / smoothing returns)
3. Limitations of Historical Data (regime changes result in nonstationary data)
4. Ex-post Risk can be biased measure of Ex-ante Risk (underestimate the risks that equity overestimate their potential returns.
5. Bias in Analysts’ methods (data mining, random change, time-period bias - smalls caps)
6. Failure to act for Conditioning information (relationships between variables not constant - eg; business cycle and difference in beta )
7. Interpretation of Correlations (Causality, can be spurious, or maybe affected by a third variable)
8. Psychological biases
9. Model uncertainty (eg; DCF, relative value mode) - Parameter uncertainity (estimation error in model parameters), Input uncertainty

Question 6

Limitations of Historical estimates

Answer 6

1. Regime changes - non stationary data - different statistical properties
2. Long time preferred for the following reasons a) maybe statistically required number of data points must exceed no of covariances b) larger data set more precise with smaller variations
3. Problem with longer data likelihood of regime changes increases
4. Shorter period data - more frequency does not improve precision and may distort correlations. Tendency towards outdated values)
   * Caution with assumption of normal distribution as Asset returns have historically exhibited “fat tails” and “skewness”

Question 7

How to avoid Biases in Analyst methods when Forecasting CME?

Answer 7

1. Ask if there is any economic basis for the variables found to be related to stock returns
2. Scrutinize the modeling
   process for susceptibility to bias
3. test the discovered relationship with out-of-sample data to determine if the relationship is persistent

Question 8

Exogenous shocks

Answer 8

unanticipated events that occur outside the normal course of an economy. Because the events are unanticipated, they are not already built into current market prices, whereas normal trends in an economy, which would be considered endogenous, are built into market prices. Note that the impact of these events will likely produce statistical regime changes.

Question 9

Trend growth rate

Answer 9

When we speak of higher trend growth rates, we mean the economy can grow at a faster pace before inflation becomes a major concern. This consideration influences monetary policy and the level of bond yields.

Higher trend growth rates tend to generate higher government bond yields.

Sum of growth in Labour force participation rate + growth in capital spending + growth in total factor productivity

Question 10

Market Value of Equity Returns

Answer 10

Market value of equity returns =
%Δ nominal GDP (Real + Inflation) + %Δ profits/GDP + %Δ PE

Question 11

Impact of high growth in Capital Investment on Equity Returns

Answer 11

associated with high rates of growth in the economy. However, not necessarily linked to favourable equity returns.

1. growth rates already factored into equity prices.
2. Additional explanation is that the source of equity returns is related to the rate of return on capital. If the rate of growth of capital is faster than the rate of economic growth, return on
   capital may decrease and equity returns may become less attractive (higher interest cost).