1 2013, Study Session # 6, Reading # 18 “CAPITAL MARKET EXPECTATIONS” CMEs = Capital Market Expectations ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES 2.1 A Framework for Developing Capital Market Expectations CMEs ⇒ β research (related to systematic risk) CMEs: Macro expectations ⇒ regarding asset classes Micro expectations ⇒regarding individual assets Process to formulate CMEs: Specify CMEs needed according to investor’s tax status, allowable asset classes & time horizon Research the historical record Identify the valuation model & its requirements Collect the best data possible Use experience & judgment to interpret current investment conditions Formulate CMEs & document conclusions Monitor actual outcomes & compare them to expectations & refined the process if needed Good forecasts are unbiased, objective, well researched & efficient 2.2 Challenges in Forecasting Poor forecasts can result in inappropriate asset allocation Some problems in the use of data & analysts mistakes & biases are as follows 2.2.1 Limitations of Economic Data Time log b/w collection & distribution of data Revisions are not made at the time of publication Data definitions & methodology ∆ over time Data indices are often rebased over time 2.2.2 Data Measurement Errors and Biases Transcription Errors Survivorship Bias Errors in gathering & recording data More problematic if biased in a certain direction Data of surviving entities only Return series convey an overly optimistic picture Appraisal (Smoothed/Data) Appraisal data are used in lieu of market price data for illiquid assets Correlation & SD of the asset Potential solution ⇒ rescale the data without effecting mean return Copyright © FinQuiz.com All rights reserved 2 2013, Study Session # 6, Reading # 18 2.2.3 The Limitations of Historical Estimates Past simply can’t be simply extrapolated to produce future results Regime changes ⇒ ∆ in the technological, political legal & regulatory environment (on stationary data) Statistical tools should be used to indentify regime ∆ or turning points Long Data Series Statistical Necessity (Advantages) Precisions with population parameters are estimated Parameters (e.g return, SD etc) are less sensitive to time span Problems Data may no longer be relevant Time series of required length may not be available Asynchronous data if frequency is Test shorter time series of data should be used If data is non-stationary Regime ∆ deleted statistically 2.2.4 Ex Post Risk Can Be a Biased Measure of Ex Ante Risk Export data ⇒ after the fact, ex ante data ⇒ before the fact Looking backward, analysts are likely to underestimate ex ante risk & overestimate ex ant anticipated returns 2.2.5 Biases in Analysts' Methods Data-Mining Bias Repeatedly searching a dataset until the analyst finds some statistically significant pattern To avoid the bias: Find economic basis for the variable Test the discovered relationship with out-of-sample data Time-Period Bias Results from the time span of the data chosen 2.2.6 The Failure to Account for Conditioning Information Relationship b/w security returns & economic variables is not constant overtime Analyst should account for expected market condition in their forecasts Copyright © FinQuiz.com All rights reserved 3 2013, Study Session # 6, Reading # 18 2.2.7 Misinterpretation of Correlations The analyst should take care in interpreting correlations because: Correlation may be spurious Endogenous variable may be unable to explain exogenous variable Correlation statistic missed the nonlinear relationship b/w two variables Multiple regressions (alternative to correlation) are used to uncover predictive relationship Partial correlation is used for desired analysis 2.2.8 Psychological Traps Anchoring Trap Status Quo Trap Disproportionate weight to the 1st information Solution ⇒ avoid premature conclusion Predict no change from the recent past To avoid cognitive cost or regret Solution ⇒ rational analysis within a decisionmaking process Confirming Evidence Trap Overconfidence Trap Greater weight to information that supports an existing or preferred view To ensure objectivity: Give all evidence equal scrutiny Seek out opposing opinions Be honest about your motives Overestimate the accuracy of forecasts Too narrow a range of scenarios in forecasting Solution ⇒ wider the range of possibilities Prudence Trap Recallability Trap Overly conservative forecasts Stay close to the crowed (herding behavior) Solution ⇒ wider the range of forecasted values Too many weights to the events that left a storing impression on a person’s memory Solution ⇒ conclusions on objective data 2.2.9 Model Uncertainty Model uncertainty ⇒ uncertainty concerning whether a selected model is correct Input uncertainty ⇒ uncertainty concerning whether the inputs are correct Some analysts believe that market anomalies are results of different valuation models Copyright © FinQuiz.com All rights reserved 4 2013, Study Session # 6, Reading # 18 TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS 3.1 Formal Tools Tools that are accepted within the investment community 3.1.1 Statistical Methods 3.1.1.1 Historical Statistical Approach: Sample Estimators20 Analyst use historical data for forecasting Project the historical mean, SD & correlations for a data set into the future Decision point relates to the choice b/w AM & GM AM best represents the mean return in a single period GM repents the multi period growth For a risky variable GM 4% is appropriate) Is the currency competitive, & are external accounts under control? (deficit > 4% of GDP is uncompetitive) It external debt under control? (ratio of foreign debt GDP A/C receipts > 200% is dangerous) Is liquidity plentiful? < 100 % ! Is the political situation supportive of the required policies? Copyright © FinQuiz.com All rights reserved 11 2013, Study Session # 6, Reading # 18 4.5 Economic Forecasting Approach of Economic Forecasting Econometric Models Leading Indicators Formals & mathematical approach to forecasting Variable found to lead turns in the economy Checklists Subjective integration of the answers to a set of questions 4.5.1 Econometric Modeling Definition Benefit Application of quantitative molding & analysis Can be reused Prices quantitative forecasts Limitations Complex & time taking Variables may also be measured with error 4.5.2 Economic Indicators Definition Advantages Contain information on an economy’s recent past activity or its current or future positions in business cycle Available from outside parties Easy to understand & interpret Adapted for specific purposes Verified by academic research Disadvantages Not consistently accurate Forecasts can be misleading 4.5.3 Checklist Approach Definition Advantages Check off a list of questions that should indicate the future growth of the economy Flexible Simple Disadvantages Require subjective judgment Time intensive to create 4.6 Using Economic Information in Forecasting Asset Class Returns 4.6.1 Cash and Equivalents Short term debt with maturity of a year or less Longer maturity & less credit worthy instruments have expected return & risk In order to outperform, manager must be able to forecast future rates better than other managers Copyright © FinQuiz.com All rights reserved 12 2013, Study Session # 6, Reading # 18 4.6.2 Nominal Default-Free Bonds Default free bonds issued by govt in developed countries Yield on these bonds: Real yield Expected inflation Stronger eco growth ⇒ bond yields (demand for capital & inflation) Changes in short term IR have less predictable effects on bond yield in short term rates ⇒ longer term bond’s yield (but if economy slows as result of in IR then yield ) 4.6.3 Defaultable Debt Debt with credit risk (particularly corporal debt) During recession (expansion) spread tend to widen (narrow) 4.6.4 Emerging Market Bonds Debt of non-developed countries Emerging countries usually borrow in foreign currency, so the risk of default is higher 4.6.5 Inflation-Indexed Bunds Yield on inflation indexed bonds changes over time with three economic factors: Strong economy ( real yields), real yields on TIPS will be higher Supply & demand may also effect yields on TIPS Yields fall if inflation accelerates 4.6.6 Common Shares 4.6.6.1 Economic Factors Affecting Earnings 4.6.6.2 The PIE Ratio and the Business Cycle 4.6.6.3 Emerging Market Equities The trend growth rate, the avg earnings growth Defensive stocks receive market valuation while cyclical stocks receive valuation during recession A P/E rate tends to be during early stages of a recovery Molodovsky effect ⇒ P/Es of cyclical companies may be than their own historical means during downturns (investors anticipates a sharp future earnings) Inflation rates tend to depress P/E ratios Equity risk premiums for emerging markets are on average higher & more volatile than developed markets 4.6.7 Real Estate Determinates of real estate returns ⇒ consumption growth, real IR, term structure of IR & unexpected inflation Low IR are positive for real estate valuation Copyright © FinQuiz.com All rights reserved 2013, Study Session # 6, Reading # 18 4.6.8 Currencies Imports, economic growth & IR, currency will depreciates 4.6.9 Approaches to Forecasting Exchange Rates 4.6.9.1 Purchasing Power Parity 4.6.9.2 Relative Economic Strength Exchange rate differential = inflation differential Does not hold in short or medium term Focus on investment flows rather than trade flows Strong economic growth, currency demand, currency appreciation Short-term deposit rates, capital moves in to the country, currency appreciation This approach tells nothing about level of exchange rates 4.6.9.3 Capital Flows 4.6.9.4 Savings-Investment Imbalances Particularly equity investment & foreign direct investment (FDI) FDI inflows, currency tends to appreciates Capital flows may reverse the usual relationship b/w IR & currency During expansion, if domestic savings are < investments then foreign borrowings (appreciate domestic currency to attract foreign capital) If investments < savings then currency will deprecates 4.6.10 Government Intervention Govt face three challenges when try to influence exchange rates: Foreign exchange trading value > foreign exchange reserves Exchange rates are determined by fundamentals (govt is just another player) Foreign exchange trends control is not encouraging in the absence of capital control Copyright © FinQuiz.com All rights reserved 13 ... for expected market condition in their forecasts Copyright © FinQuiz. com All rights reserved 3 2013, Study Session # 6, Reading # 18 2.2.7 Misinterpretation of Correlations The analyst should... anomalies are results of different valuation models Copyright © FinQuiz. com All rights reserved 4 2013, Study Session # 6, Reading # 18 TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS 3.1 Formal... condition so not suitable for short-term expectations Copyright © FinQuiz. com All rights reserved 5 2013, Study Session # 6, Reading # 18 Discounted CF Models 3.1.2.1 Equity Markets Fixed-Income Markets