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Reading 16

Capital Market Expectations

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Introduction
• Capital Market Expectations: investor’s expectations concerning
the risk and return prospects of asset classes
• Investor can decide how he defines assets classes
• Macro Expectations vs. Micro Expectations

Major Sections in this Reading:


– Framework and Challenges
– Tools for Formulating Capital Market Expectations
– Economic Analysis

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2. Organizing the Task: Framework and Challenges
1. Specify final set of expectations that are needed

2. Research the historical record

3. Specify required models and information requirement

4. Determine best sources for information needs

5. Interpret current investment environment

6. Provide set of expectations that are needed, documenting conclusions

7. Monitor, feedback

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Step 1: Specify the final set of expectations that are needed,
including the time horizon to which they apply

• Understand specific objectives of analysis

• Set boundaries  focus on what is relevant

• Write the questions which need to be answered

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Step 2: Research Historical Trend
• Most forecasts have connection to the past
• Understand factors which drive returns
• Can collect data based on geographic region, assets classes, sub-asset
classes…

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Step 3: Specify methods and/or models that will be used and their
information requirement
• Consider time-horizon when selecting appropriate model
• Long time horizon  DCF Model

Step 4: Determine the best sources for information needs

• Data quality, Cost, Frequency

Step 5: Interpret the current investment environment using the selected


data and methods, applying experience and judgment

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Step 6: Provide the set of expectations that are needed,
documenting conclusions
• Answer the questions which were formulated in Step 1
• Read Example 4
• Good forecasts are:
– Unbiased, objective and well researched
– Efficient  minimize forecast errors
– Internally consistent (Example 5)

Step 7: Monitor, feedback  improve forecasts

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2.2 Challenges in Forecasting
• Limitations in Economic Data
– Definitions (GDP vs GNP, Example 6), construction, timeliness, accuracy,
biases

• Data Measurement Errors and Biases


– Transcription Errors
– Survivorship Bias
– Appraisal (Smoothed) Data (Examples 7 and 8)

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2.2 Challenges in Forecasting (Cont…)
• The Limitations of Historical Estimates
– Changes in regime  non-stationarity
– You can use regression analysis to identify change in regime (Ex 9)

• Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

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2.2 Challenges in Forecasting (Cont…)
• Biases in Analysts’ Methods
– Data Mining Bias
– Time-Period Bias: biases which are time period specific. Ex: high small
cap returns from 1975 - 1983

• Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

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2.2 Challenges in Forecasting (Cont…)
• Failure to Account for Conditioning Information
– Classic error: not recognizing that equity returns are conditional on the
economy. Exhibit 2:

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2.2 Challenges in Forecasting (Cont…)
• Misinterpretation of correlations. Example 10. High correlation
between A and B could be because:
– A predicts B
– B predicts A
– C predicts A and B

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2.2 Challenges in Forecasting (Cont…)
• Psychological Traps Example 3 is Important.
Also applies to SS3
– Anchoring Trap
– Status Quo Trap
– Confirming Evidence Trap
– Overconfidence Trap
– Prudence Trap
– Recallability Trap
• Model Uncertainty
– Uncertainty about whether selected model is correct
– Uncertainty about input data

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3. Tools For Formulating Capital Market Expectations

3.1 Formal Tools


– Statistical Methods
– Discounted Cash Flow Models
– Risk Premium Approach

3.2 Survey and Panel Methods

3.3 Judgment

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Statistical Tools
• Historical Statistical Approach: Sample Estimators. Use past data to
forecast future outcomes
– Example: use historical returns to predict future returns

• Shrinkage Estimators involve taking weighted average of a historical


estimate of a parameter and some other parameter estimate
– Example: covariance is 48 using one model and 80 using another

– Example 12

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Statistical Tools
• Time-Series Estimators: Forecasting based on lagged values of the variable
being forecasted
• Multi-factor Models

Useful for modeling covariances among asset returns

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Global Equity Factor and Global Bonds Factor drive returns of all assets

Std dev 14% 4% Corr = 0.30

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To derive asset covariance matrix we need to know how a market responds to factor movements

If Market A moves 110 points in response to 100 point move of global equities…

Factor sensitivity = 1.1

We can say Market A is a pure equity market

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Factor Covariance

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Discounted Cash Flow Applications

Equity Markets  Gordon Growth Model

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Grinold-Kroner Model Do Examples 13 and 14

Fixed income markets  DCF is standard tool

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The Risk Premium Approach
• Sum of risk free rate and one or more risk premiums Examples 15, 16 and 17

• Equity Risk Premium

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Financial Market Equilibrium Models
• These models assume that markets are efficient… fully integrated and in
equilibrium
• Example: International CAPM

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Example 19. Setting CME using
Singer-Terhaar Approach

Based on ICAPM but


considers market
imperfections

1. Calculate risk of asset


class assuming full
integration
2. Calculate risk premium of
asset class assuming
complete segmentation
(consider illiquidity
premium)
3. Weighted average based
on level of integration

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Example 18 covers several concepts. A couple of refreshers:

Lock up period  higher expected return

Correlation between two assets:

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3.2 Survey and Panel Methods
• Survey: ask group of experts for their expectations… use their responses in
coming up with CME

• If we have a panel of experts  Panel Method

• Example 20

3.3 Judgment
• Example 21

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4. Economic Analysis
• Relationship between realized asset returns, expected returns
and economic activity
• This is a long session which covers:
– Business cycle and inventory cycle
– Economic growth trends
– Exogenous shocks
– International interactions
– Economic forecasting
– Forecasting asset class returns

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4.1 Business Cycle Analysis

• Inventory Cycle
• Business Cycle
• Inflation and Deflation in the Business Cycle
• Market Expectations and Business Cycle
• Factors Impacting Business Cycle

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Inventory Cycle
• Measures fluctuations in inventories; lasts 2 – 4
years
• Caused by companies trying to keep inventories at
desired levels as expected level of sales changes
• In up phase businesses are confident about future
sales and increasing production
– Higher employment  boosts economy
• When sales don’t increase as expected business
cut back (inflection point)
• Takes a year or two to correct inventory levels
• Major indicator: inventory/sales ratio
– When down businesses increase production 
Expect strong economy in near term

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Business Cycle
• (Real) GDP
• Output Gap
• Recession

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Exhibit 15. Five Phases of the Business Cycle

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Inflation and Deflation in the Business Cycle
• Inflation tends to rise in late phases of a business cycle
• Declines during recession and early stages of recovery
• Inflation and deflation have an impact on asset returns (Exhibit
18, next slide)
• Analysts should forecast inflation (Example 24)

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Market Expectations and the Business Cycle
Business cycle analysis…

• Consumers
– Store sales data, consumption data
– Consumer income after tax
– Employment data
• Business
– Business investment, inventories
– US Example: Purchasing Managers Index (PMI)
• Foreign Trade
• Monetary and Fiscal Policy

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Analyst should try to predict central bank’s policy rate

This can be done using the Taylor Rule

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If the inflation forecast is 4 percent and the forecast for GDP growth is 1
percent, what is the optimal short-term interest rate?

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Fiscal Policy:

Manipulating budget deficit to influence economy

1. Focus on changes in budget deficit, not the actual level

2. Focus on deliberate changes in government fiscal policy

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4.2 Economic Growth Trends
• Components of Economic Growth Trends
– Growth from changes in employment
– Growth from changes in labor productivity
• Capital
• Technology (Total Factor Productivity)
• Investment  Capital  Growth
– Singapore and China invested 30 – 40% of GDP
• Economic growth also influenced by government
policy
– Sound fiscal policy, minimal intervention, competition
encouraged, infrastructure and human capital
development encouraged, sound tax policy

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4.3 Exogenous Shocks
• Events from outside the economic system that affect its course
• Shifts in government policies
– For example: limits on spending
• Oil Shocks
– Impacts consumer income and reduces spending
• Financial Crises
– Growth rate down because of reduced bank lending
– Reduced investor confidence

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4.4 International Interactions
• Dependence of a particular economy on international
interaction depends on size and degree of specialization

• Macroeconomic Linkages
– Economies impacted by changes in foreign demand for their exports
– Weakness in the U.S. has a major impact on many countries
– Integration is increasing, especially between developed countries
– Correlation is not perfect

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Interest Rate/Exchange Rate Linkages
• Some economies linked through fixed/pegged
exchange rates
– Example: GCC country currencies pegged to the USD
– Interest rate differential depends on confidence in the peg

• With floating exchange rate, currency with higher real


exchange rate will appreciate

• If we assume real interest rate differential is 0 


predict exchange rate based on interest rate parity
relationships

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Emerging Markets
• High risk, high return
• High investment, high debt
• Important questions to ask when investing in emerging
markets
– Monetary and fiscal policy
– Economic growth prospects
– Currency competitive? External accounts?
– External debt?
– Liquidity
– Political situation supportive of necessary economic policies

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4.5 Economic Forecasting
Three major approaches:

1. Econometric Modeling

2. Economic Indicators

3. Checklist Approach

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Econometric Modeling
Quantitative methods + economic theory  economic forecasts
GDP Growth = f(Consumer Spending Growth, investment growth)

• Model complexity depends on number of variables


• Requires good data
• Useful for simulating effect of changes in specific variables
• Require judgment
• Poor at forecasting recessions

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Economic Indicators

Early signs of probable events to


come

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Checklist Approach

Consider range of
economic data to
assess future position of
the economy

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Exhibit 25
Advantages and
Disadvantages of
Three Approaches

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Example 30.
Analyst Forecasts

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4.6 Using Economic Information in Forecasting Asset
Class Returns
• Cash and equivalents
– Make money through selection of maturity and by taking credit risk
– If interest rates likely to fall go with higher maturity
Example 31

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Nominal Default-Free Bonds

Total yield = real yield + inflation

Investors determine whether bonds are cheap or expensive

Say 10-year bonds yield 5% and inflation = 2%


Investor expects inflation to be 0.5%
Should he invest?

Investing in long term bonds over a short period…


News of stronger economic growth  higher yields  low prices

Defaultable Debt

Spread over treasuries depends on: default risk of issuer and state of the economy

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Emerging Market Bonds

Sovereign debt of non-developed countries

Inflation Indexed (Real) Bonds

Economic growth rising  Yields rise

Inflation expectations rise  Yields fall

Investor demand rises  Yields fall

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Common Shares

1. Economic factors impacting earnings

Also take a close look at Example 33/Exhibit 28

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2. P/E Ratio and the Business Cycle

High in early stages of economic recovery

High inflation rates depress P/E ratios

3. Emerging Market Equities

Equity risk premiums are higher and more volatile than developed market equities

Real Estate

Value determined by: growth in consumption, real interest rates, term structure and
unexpected inflation

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Example 34: Modifying Historical Capital Market Expectations (Extremely Important!)

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Currencies

Four broad approaches to exchange rate forecasting:

1. Purchasing Power Parity: movements in exchange rate should offset difference in inflation
rates

2. Relative Economic Strength: focus on investment flows. If investment opportunity is good


capital flows in and currency strengthens

3. Capital Flows: Focus on expected capital flows (FDI and Equity Investments)

4. Savings-Investment Imbalances: Currency movement explained by domestic savings-


investment imbalances

Example 36

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4.7 Information Sources for Economic Data and Forecasts

• Take a look at Exhibit 33


• Good for the real world
• Not too useful for ‘exam-world’

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Conclusion

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