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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
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2. Organizing the Task: Framework and Challenges
1. Specify final set of expectations that are needed
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
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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
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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)
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2.2 Challenges in Forecasting
• Limitations in Economic Data
– Definitions (GDP vs GNP, Example 6), construction, timeliness, accuracy,
biases
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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)
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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
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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
3.3 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
– Example 12
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Statistical Tools
• Time-Series Estimators: Forecasting based on lagged values of the variable
being forecasted
• Multi-factor Models
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Global Equity Factor and Global Bonds Factor drive returns of all assets
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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…
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Factor Covariance
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Discounted Cash Flow Applications
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Grinold-Kroner Model Do Examples 13 and 14
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The Risk Premium Approach
• Sum of risk free rate and one or more risk premiums Examples 15, 16 and 17
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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
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Example 18 covers several concepts. A couple of refreshers:
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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
• 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
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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:
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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
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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)
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Economic Indicators
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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
Defaultable Debt
Spread over treasuries depends on: default risk of issuer and state of the economy
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Emerging Market Bonds
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Common Shares
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2. P/E Ratio and the Business Cycle
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
1. Purchasing Power Parity: movements in exchange rate should offset difference in inflation
rates
3. Capital Flows: Focus on expected capital flows (FDI and Equity Investments)
Example 36
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4.7 Information Sources for Economic Data and Forecasts
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Conclusion
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