Level III Review, Capital Market Expectations

Study session 6 in the Level III CFA Program curriculum consists of one reading (18) but 18 LOS covering capital market expectations.

Capital Market Expectations
The reading is largely a conceptual one so ideas, limitations and advantages/weaknesses are key. Capital market expectations go beyond basic stock market ideas to other economic tools and forecasting. The section on forecasting tools is the most quantitative but the formulas are pretty basic.
Understand the limitations of economic data: time lag, revisions, method changes to calculations as well as measurement errors like transcription, survivorship and smoothed data. Survivorship bias, also seen in hedge funds is when the data only reflects those entities that have been successful and survived through the period. Appraisal, or smoothed data, can occur with assets that do not have liquid markets so appraisal data (estimates) are used when actual transactions are not available and tend to smooth volatility.
Understand the trade-off between a long or shorter data series with regime changes versus sensitivity of parameter estimates to starting and ending dates.
Biases to analyst methods and psychological traps are important an you have a good chance of seeing these in the morning essay section. Data mining is when the analyst searches through the data to find a pattern and then uses that period. Out-of-sample periods can be used to check the validity and analysis should have an economic rationale.
Make flash cards for anchoring, status quo, recallability, prudence, overconfidence and the confirming evidence traps. Be able to identify the trap, given a behavior, and say how it could be prevented.
Understand the three components of the Grinold Kroner Model and how they equal the expected rate of return on equity:
Expected income return = dividend yield (D/P) minus expected % change in shares outstanding
Expected nominal earnings growth return = inflation rate + expected real total earnings growth rate
Expected repricing return is the expected percent change in the P/E multiple
The Gordon Growth Model is used extensively through the curriculum. It is used to find the long-term expected return to equity and includes the dividend yield (D1/P0) and the appreciation yield (g). This will be covered more in Equity.
Understand the Fed Model interpretation of valuation (i.e. stocks are overvalued if the market’s current earnings yield is less than the 10-year treasury yield)
The Taylor Rule is a way to assess the central bank’s stance on interest rates and to predict changes. The optimal rate = neutral rate plus half of the GDP gap plus half of the inflation gap. Thinking about it rationally can help remember the equation. If forecast inflation is below trend, then rates can be increased without fear of price increases. If forecasted economic growth is above trend, then rates should be lowered to avoid overheating.
Understand the concepts behind the types of economic forecasting and limitations of each (econometric models, economic indicators, and the checklist approach).
Study session 7 consists of two readings covering economic concepts for valuation and portfolio management. It is a little more quantitative but still not too bad.
‘til next time, happy studying
Joseph Hogue, CFA

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