CFA LEVEL 3
CAPITAL MARKET EXPECTATIONS
CAPITAL MARKET EXPECTATIONS, PART 1: FRAMEWORK AND MACRO CONSIDERATIONS
LOS 1.a: Discuss the role of, and a framework for, capital market expectations in the portfolio
management process.
Capital Market Risk & return expectations w.r.t. classes of assets - long & short term
Expectations
CME + objectives + constraints = strategic asset allocation
Portfolio Consistency Cross-sectional: across asset classes w.r.t. risk & return characteristics
Intertemporal: over investment horizon w.r.t. portfolio decision
Formulating CME 1. Determine CME needed w.r.t. allowable asset class & investment horizon
2. Investigate past performance to determine factors & forecast future
3. Identify valuation model and its requirements
4. Collect best data
5. Decide and verify consistency of model inputs
6. Formulate CME, record any rationale & assumptions
7. Monitor performance, refine process and model
Supporting Information Geography, major/sub asset classes
Good Forecasts Unbiased, objective, well-researched, efficient, internally consistent
>30 observations needed to test hypothesis
LOS 1.b: Discuss challenges in developing capital market forecasts.
Limitations to Economic Time lag between collection & distribution
Data Data revision, change in definition & methodology
Rebasing of indices
Data Measurement Transcription error: misreporting, incorrect recording
Error & Bias Survivorship bias: deletion of poor performance data
Appraisal data: standard deviation, correlation biassed downward
Limitations of Historical Regime changes result in non-stationary data - pick relevant subperiods
Estimates
Benefits of longer period: precision of estimates, statistical requirement, can
use less frequent data
Caution w.r.t. normality assumption: fat tail, skewness
Ex Post Data to Ex E.g. market reaction to event investors feared but never happened
Ante Risk & Return E.g. sample includes rare negative events
Data Mining Patterns unlikely to occur, or strategy unlikely to work in the future
Look for economic basis, scrutinise modelling process, test with
out-of-sample data
Conditioning Data reflects performance over different cycles
Information
Use different estimates for expansion and contraction (e.g. for beta)
,Misinterpretation of Mistaking exogenous & endogenous variable
Correlation
Relationships may be spurious, nonlinear or related to third variable
Psychological Bias Anchoring: first information received overweight
Status quo: predictions influenced by recent past
Confirmation: only information supporting existing belief considered
Overconfidence: past mistakes ignored, accuracy of test overestimated
Prudence: overly conservative to avoid extreme forecasts and being wrong
Availability: what’s easiest to remember is overweight
Model Uncertainty Parameter: estimation error in parameter
Input: knowing correct input values
LOS 1.c: Explain how exogenous shocks may affect economic growth trends.
Economic Growth Important in setting capital market expectations
Cyclical variations (short-term) vs. growth trends (long-term)
Exogenous Shocks Unanticipated, non-normal events in economy, not priced into market
Likely to produce regime changes
Changes in Sound fiscal & tax policy, free economy, facilitating competition,
Government Policies development of infrastructure and human capital
Political Events Geopolitical tensions divert resources to less productive uses
Technological Process New markets, products, technologies
Natural Disasters Short-term growth ↓ but long-term growth ↑ if new capacity more efficient
Discovery of Natural New resource or new ways to recover existing resource =
Resource Resource production cost ↓
Financial Crises Shocks to financial systems reduce investor confidence
LOS 1.d: Discuss the application of economic growth trend analysis to the formulation of capital
market expectations.
Economic Growth Trend rate of growth used as long-term equity/bond returns in DCF
Trend Analysis
Higher trend growth rate = higher bond yields, stock returns (if not priced in)
Economy can grow at faster rate before inflation becomes a concern
Forecasting Economic Labour input: labour force (population, demographics), participation
Growth Rate
Capital per worker: increases labour productivity
Total factor productivity: technological progress, changes in policies
Growth in Capital Associated with high growth in economy, but may already be priced in
Investment
Equity returns related to return on capital
- If capital growth > economic growth, return on capital ↓
,LOS 1.e: Compare major approaches to economic forecasting.
Econometric Analysis Statistical method to explain economic relationship & form forecast models
OLS regression often used, but other models may also be used
Structural model: based on economic theory
Reduced form model: compact version of structural approaches
Econometric Analysis: Can incorporate many variables
Benefits
Model can be reused
Output is quantified and based on consistent set of relationships
Econometric Analysis: Complex and time-consuming to construct
Drawbacks
Data difficult to forecast and relationships change
Output may be unrealistic or require interpretation
Does not work well to forecast turning points
Economic Indicators Available from governments, international and private organisations
May be complemented by own, proprietary indicators
Leading indicators often used (individually or as a composite)
Coincident and lagging indicators to confirm economic trend
Diffusion index: # of indicators pointing towards expansion vs. contraction
Economic Indicators: Simple, intuitive, easy to interpret, data readily available
Benefits
Indicator lists can be tailored to meet specific forecasting needs
Economic Indicators: Forecasting results can be inconsistent, may produce false signals
Drawbacks
Indicators revised frequently to fit business cycles better
Checklist Approach Uses judgement and statistical modelling to answer series of questions,
which is used to formulate a forecast
Judgement used in deciding which factors to consider and how to interpret
Checklist Approach: Less complex
Benefits
Flexible in mixing statistical analysis with judgement
Checklist Approach: Subjective in nature
Drawbacks
Time consuming and manual, leading to limited complexity
LOS 1.f: Discuss how business cycles affect short- and long-term expectations.
Business Cycles Deviations from long-term expectations
Cancels out in long term, but useful in making short-term projections
, Business Cycles (cont.) Cyclicality of economic activities due to nature of business decisions
- Imperfect information
- Adjustments to unexpected events
- Reversing incorrect decisions
Cycles vary in duration and intensity
- Difficult to predict
- Difficult to distinguish between long-and-short-term factors
Capital market returns are related to real economy, but also related to
investor expectations and risk tolerances
Initial Recovery Few months of rising business confidence and government stimulus
Decelerating inflation, large output gap, low or falling short-term rates
Bond yield bottom out, stock price rise, riskier asset do well (small-cap, HY)
Early Expansion (Several) years of increasing growth, low inflation, rising confidence
Short-term rates rise, output gap narrow
Bond yields stable/rise, stock price rise
Late Expansion High confidence and employment, output gap eliminated, risk of overheating
Increasing inflation, central bank limits money supply growth
Short-term rates and bond yields rise, stock prices rise/peak
Increasing volatility and risk
Slowdown Few months ~ year of declining confidence, inflation still rising
Short-term interest rate at peak, bond yield peak then fall
Falling stock prices and possible YC inversion
Contraction 12-18 months of declining confidence and profits
Unemployment & bankruptcies rise, inflation tops out, short-term rates fall
Bond yields and stock prices rise during later stages
LOS 1.g: Explain the relationship of inflation to the business cycle and the implications of inflation for
cash, bonds, equity, and real estate returns
Inflation Generally rising prices
Investors and central banks target and expect some level of inflation
Disinflation Deceleration in the rate of inflation; recession indicator
Deflation Generally falling prices; severe threat to the economy
Encourages default on debt obligations (home prices fall → panic sell)
Limits ability of CB to lower rates → QE (larger, more varied than OMO)
