COURSE CONTENT

Approaches to capital market

expectations, economic and market
forecasting

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MARKET ANALYSIS

Sources:
• CFA Institute curriculum
• Several extracts from broker research
• Extracts from various internet sites
• Author’s documentation

2
COURSE CONTENT

1. Approaches to economic forecasting

2. Top-down and bottom-up forecasting techniques

3. Main approaches to forecasting returns

4. Framework for developing Capital Market Expectations (CME)

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APPROACHES TO ECONOMIC FORECASTING

• There are three main approaches to economic forecasting:

- Checklist assessments.
- Econometric models.
- Economic indicators.

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CHECKLIST APPROACH

• Checklist assessments are

straightforward but time-consuming
because they require continually
monitoring the widest possible
range of data.
• Data may be extrapolated into
forecasts via objective statistical
methods, such as time-series
analysis, or via more subjective or
judgmental means.
• An analyst may then assess whether
the measures are in an equilibrium
state or nearer to an extreme
reading.

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CHECKLIST APPROACH

Main strength of check-list approach: Main drawback:

• Flexibility: it allows the forecaster to • Subjectivity is perhaps its main
quickly take into account changes in weakness.
economic structure by changing the
variables or the weights assigned to
variables within the analysis.

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ECONOMETRIC MODELING

• Econometrics: the application of statistical methods to model

relationships among economic variables.
- Structural models specify functional relationships among variables
based on economic theory.
- Econometric models vary from small models with a handful of equations to
large, complex models with hundreds of equations.
• They are all used in essentially the same way: the estimated system of
equations is used to forecast the future values of economic variables, with
the forecaster supplying values for the exogenous variables.
• Econometric models are widely regarded as very useful for simulating the
effects of changes in key variables.
• Skillful econometric modelers monitor the model’s recent forecasts for signs of
systematic errors. If the model can not be overhauled, past forecast errors
could be incorporated into the model as an additional explanatory variable.

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ECONOMETRIC MODELING
Merit of the econometric approach:
• It constrains the forecaster to a
certain degree of consistency.
• It challenges the modeler to reassess
prior views based on model results.
Limitations of the econometric
approach:
• Econometric models require
adequate measures for the real-
world activities and relationships to
be modeled (problem: these
measures may be unavailable).
• Variables may be measured with
error.
• Relationships among variables may
change over time because of
changes in economic structure and/or
because the model may have been
based on faulty assumptions.
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ECONOMIC INDICATORS

• Economic indicators:
- Economic statistics published by official agencies and/or private
organizations.
- Information on an economy’s recent past activity or its current or future
position in the business cycle.
- Lagging economic indicators and coincident indicators reflect recent past and
current economic activity, respectively.
- A leading economic indicator (or LEI) moves ahead of the business cycle
by a fairly consistent time interval.

Most analysts focus primarily on leading indicators because they purport to

provide information about upcoming changes in economic activity, inflation,
interest rates, and security prices.

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ECONOMIC INDICATORS

• Analysts use both individual LEIs and composite LEIs, reflecting a collection
of economic data releases combined to give an overall reading.
• Individual LEIs can also be combined into a so-called diffusion index, which
measures how many indicators are pointing up and how many down.
• For example, if 7 out of 10 are pointing upward, then the odds are that the
economy is accelerating.

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ECONOMIC INDICATORS

Source: Goldman Sachs, February, 2020, respectively February 2023

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ECONOMIC INDICATORS

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ECONOMIC INDICATORS
Advantages of leading indicator-
based analysis:
• LEIs require following only a limited
number of statistics.
• No assumptions about the path of
exogenous variables.
Drawbacks of the (composite) leading
indicator methodology:
• The entire history may be revised
each month.
• The most recently published
historical indicator series will almost
certainly appear to have fit past
business cycles (i.e., GDP) better
than it actually did in real time (i.e.,
“look ahead” bias).
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COURSE CONTENT

1. Approaches to economic forecasting

2. Top-down and bottom-up forecasting techniques

3. Main approaches to forecasting returns

4. Framework for developing Capital Market Expectations (CME)

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TOP-DOWN AND BOTTOM-UP FORECASTING

Forecast Forecast Forecast

Macroeconomic Market Industry Security
Projections
Returns Returns Returns

Forecast Forecast Forecast

Microeconomic Security Industry Market
Projections
Returns Returns Returns

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TYPICAL APPROACH TO TOP-DOWN ANALYSIS

Market Analysis

Examine valuations in different equity markets to identify those with superior

expected returns.

Industry Analysis

Evaluate domestic and global economic cycles to determine those industries

expected to be top performers in the best-performing equity markets.

Company Analysis

Identify the best stocks in those industries that are expected to be top
performers in the best-performing equity markets.

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TYPICAL APPROACH TO TOP-DOWN ANALYSIS

• Market analysis: examine valuations in different equity markets to identify

those with superior expected returns.
- Compare relative value measures for each equity market with their
historical values to identify those markets where equities are relatively
cheap or expensive.
- Examine the trends in relative value measures for each equity market to
identify market momentum.
- Compare the expected returns for those equity markets expected to provide
superior performance with the expected returns for other asset classes
(e.g., bonds, equities).

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TYPICAL APPROACH TO TOP-DOWN ANALYSIS

• Industry analysis: evaluate domestic and global economic cycles to

determine those industries expected to be top performers in the best-
performing equity markets.
- Compare relative growth rates and expected profit margins across
industries.
- Identify those industries that will be favorably impacted by expected trends
in interest rates, exchange rates, and inflation.
• Company analysis: identify the best stocks in those industries that are
expected to be top performers in the best-performing equity markets.

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TYPICAL APPROACH TO BOTTOM-UP ANALYSIS

Company Analysis

Identify a rationale for why certain stocks should be expected to outperform,

without regard to the prevailing macroeconomic conditions.

Industry Analysis

Aggregate expected returns for stocks within an industry to identify the

industries that are expected to be the best performers.

Market Analysis

Aggregate expected industry returns to identify the expected returns for

every equity market.

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TYPICAL APPROACH TO BOTTOM-UP ANALYSIS

• Company analysis: Identify a rationale (i.e., fundamental analysis) for why

certain stocks should be expected to outperform, without regard to the
prevailing macroeconomic conditions.
- Identify reasons why a company’s products, technology, or services
should be expected to be successful.
- Evaluate the company’s management, history, business model, and
growth prospects.
- Use discounted cash flow models to determine expected returns for
individual securities.
• Industry analysis: Aggregate expected returns for stocks within an industry to
identify the industries that are expected to be the best performers.
• Market analysis: Aggregate expected industry returns to identify the expected
returns for every equity market.

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COURSE CONTENT

1. Approaches to economic forecasting

2. Top-down and bottom-up forecasting techniques

3. Main approaches to forecasting returns

4. Framework for developing Capital Market Expectations (CME)

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MAIN APPROACHES TO FORECASTING

• Until the late 1990 it was standard practice for institutional investors to
extrapolate historical return data into forecasts.
• Since that time, most institutions have adopted explicitly forward-looking
methods; hence, return projections have declined sharply. Projecting a
realistic overall level of returns has to be a top priority. However, even the
most sophisticated methods are subject to frustratingly large forecast errors
over relevant horizons.
• As a result, it is far more important is to ensure internal consistency across
asset classes (cross-sectional consistency) and over various time horizons
(intertemporal consistency):
- Inconsistency across asset classes is likely to result in portfolios with poor
risk-return characteristics over any horizon.
- Intertemporal inconsistency is likely to distort the connection between
portfolio decisions and investment horizon.

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MAIN APPROACHES TO FORECASTING

• Investment opportunities change in systematic but imperfectly predictable

ways over time. Forecasting returns is not simply a matter of estimating
constant but unknown parameters (e.g., expected returns, variances, and
correlations). In other words, time horizons matter.
• Financial analysts need to ensure intertemporal consistency and the relative
usefulness of specific information (e.g., the business cycle) over short,
intermediate, and long horizons.
• All forecasting techniques rely on notions of central tendency, toward which
opportunities tend to revert over time.
- Asset prices, risk premiums, volatilities, valuation ratios, and other metrics
may exhibit momentum, persistence, and clustering in the short run.
- Over sufficiently long horizons, they tend to converge to levels consistent
with economic and financial fundamentals.

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MAIN APPROACHES TO FORECASTING

1. Formal tools: established research methods compliant enough to precise

definition and independent replication of results. They usually fall into
three broad sub-categories:
- i. Statistical methods.
- ii. Discounted cash flow models (e.g., Gordon Growth, Grinold-Kroner
model).
- iii. Risk premium models (e.g., CAPM, Singer-Terhaar model).
2. Surveys: asking a group of experts for their opinions. One of the most
useful as a way to gauge consensus views, which can serve as inputs into
formal tools and the analyst’s own judgment.
3. Judgment: qualitative synthesis of information derived from various
sources and filtered through the lens of experience.

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MAIN APPROACHES TO FORECASTING

• DCF and related models are • Choosing among forecasting

sometimes said to reflect the
“supply” of equity returns since they
outline the sources of return.
• In contrast, risk premium models
usually reflect “demand” for returns.
techniques: opportunities change
over time, hence strategic
investment decisions and how
positions respond to changing
forecasts are both affected.

Focus on judgment for this course

(other approaches covered in your valuation / other asset management courses)

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COURSE CONTENT

1. Approaches to economic forecasting

2. Top-down and bottom-up forecasting techniques

3. Main approaches to forecasting returns

4. Framework for developing Capital Market

Expectations (CME)

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FRAMEWORK FOR DEVELOPING CME

1. Specify the set of expectations needed (explicitly list asset classes and
investment horizon(s)) for which projections are needed.
2. Research historical record. Analysts should seek to identify and understand
the factors that affect asset class returns.
3. Specify the methods / models to be used & their information requirements.
4. Determine the best sources for information needs (accurate and timely).
5. Interpret the current investment environment using selected data and
methods, applying experience, judgment, and consistent projections.
6. Document conclusions. Projections should be accompanied by the
reasoning and assumptions behind them.
7. Monitor actual outcomes and compare them with expectations, providing
feedback to improve the expectations-setting process.

Source: CFA curriculum

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FRAMEWORK FOR DEVELOPING CME

Example: framework for developing CME

• The more granular the classification of assets, the more granular the
breakdown of information will need to be to support the investment process.
• Financial analysts need to slice data in multiple dimensions, including:
- Geography: global, regional, domestic versus non-domestic, economic blocs
(e.g., the European Union), individual countries.
- Major asset classes: equity, fixed-income, real assets, etc.
- Sub-asset classes:
- Equities: styles, sizes, sectors, industries.
- Fixed income: maturities, credit quality, securitization, fixed versus floating,
nominal or inflation-protected.
- Real assets: real estate, commodities, timber.

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FRAMEWORK FOR DEVELOPING CME

• Consider two investment strategists charged with developing capital market

expectations for their firms, John Pearson and Michael Wu.
- John Pearson works for a bank trust department that runs US balanced
separately managed accounts (SMAs) for high-net-worth individuals.
- These accounts’ mandates restrict investments to US equities, US
investment-grade fixed-income instruments, and prime US money market
instruments.
- The investment objective is long-term capital growth and income.

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FRAMEWORK FOR DEVELOPING CME

• Consider two investment strategists charged with developing capital market

expectations for their firms, John Pearson and Michael Wu.
- Wu’s firm runs SMAs with generally long-term time horizons and global
tactical asset allocation (GTAA) programs.
- Michael Wu works for a large Hong Kong SAR-based, internationally
focused asset manager that uses the following types of assets within its
investment process:
Equities Fixed Income Alternative Investments
Asian equities Eurozone sovereign Eastern European venture capital
Eurozone equities US government New Zealand timber
US large-cap US commercial real estate
US small-cap
Canadian large-cap

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FRAMEWORK FOR DEVELOPING CME

Question:
• Compare and contrast the information and knowledge requirements of
Pearson and Wu.

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Guideline answer:
• Pearson’s in-depth information requirements relate to US equity and fixed-
income markets.
• Wu’s information requirements relate not only to US and non-US equity and
fixed-income markets but also to three alternative investment types with non-
public markets, located on three different continents. Wu has a more urgent
need to be current on political, social, economic, and trading-oriented
operational details worldwide than Pearson.
• Given their respective investment time horizons, Pearson’s focus is on the
long term whereas Wu needs to focus not only on the long term but also on
near-term disequilibria among markets (for GTAA decisions).
• One challenge that Pearson has in US fixed-income markets that Wu does not
face is the need to cover corporate and municipal as well as government debt
securities. However, Wu’s overall information and knowledge requirements are
clearly more demanding than Pearson’s.

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