Alpha

earning excess returns with specific strategies within an asset class

Capital Market Expectation Process

- determine needs
- look at historical performance
- identify valuation model
- collect data
- interpret current conditions and assign values to inputs
- formulate expectations
- monitor/ repeat

Capital Market Forecasts

- consistent
- unbiased
- objective
- well supported
- accurate

Return Estimate Methods

- arithmetic average: single period
- geometric average (multiply): multiple periods; dec dramatic shifts
- weighted average (shrinkage estimate): historical estimates

Gordon Growth Model

E(r) = D_{1}/ P_{0} + g

Grinold-Kroner Model

R_{i }= D_{1}/ P_{0} + i + g - ΔS + Δ(P/ E)

return = div yeild + inflation + growth in earnings - % change in shares outstanding + change in P/ E ratio

Discounted Cash Flow Assumptions

reinvest cash flows at the realized rate of return

Time Series Model

forecasts generated using previous values of a variable and previous values of other variables

- volatility clustering: variance will persist for periods of time

Risk Premium Approach

YTM = r_{f} + risk premiums(s)

r_{bond} = r_{f} + inflation + default risk + liquidity + taxes + maturity premiums

r_{eqty} = LT gov bond yield + eqty risk premium

Sharpe Ratio

excess return per unit of risk

( R_{m }- R_{f} )/ σ_{m }

ERP_{m} / σ_{m}

β

systematic risk, used to value equity and fixed income sec

ρ_{i,m} σ_{i }/ σ_{m}

Covariance

cov_{i,j} = β_{i,1}β_{j,1}σ_{F}_{1}^{2} + β_{j,1}β_{j,2}σ_{F2}^{2} + ( β_{i,1}β_{j,1} + β_{j,1}β_{j,2} )cov(F_{1}, F_{2})

cov_{i,j} = β_{1 }β_{2 }σ_{m}^{2}

CAPM

r = r_{f} + β( r_{m }- r_{f })

Financial Equilibrium Approach

ERP = ρ_{i,m }σ_{i} ( ERP_{m}/ σ_{m })

segmented ERP = weighted avg of fully segmented and integrated ERP + additional risk premiums

E(r) = ERP + r_{f}

Inventory Cycle

- 2-4 years
- inv/ sales
- inc I/S b/c inc I = positive
- inc I/S b/c dec S = negative
- LR lower inv b/c better inventory management

Business Cycle

- 9-11 years
- phases

- initial recovery
- early upswing
- late upswing
- slowdown
- recession

Initial Recovery

- ST and LT rates = low or declining
- inflation = dec
- confidence = inc
- gov = exp FP
- bond prices = peak
- stock prices = inc

Early Upswing

- ST and LT rates = inc
- inflation = low
- confidence = high
- gov = less exp FP
- bond prices = dec, flat yield curve
- stock prices = inc

Late Upswing

- ST and LT rates = inc
- inflation = inc
- confidence = peak
- gov = rest MP
- bond prices = dec
- stock prices = peak

Slowdown

- ST and LT rates = peak
- inflation = peak
- confidence = dec
- gov = less rest MP
- bond prices = inc
- stock prices = dec

Recession

- ST and LT rates = dec
- inflation = inc
- confidence = low
- gov = exp MP and FP
- bond prices = inc
- stock prices = inc

Monetary Policy

- stimulate econ = dec int rates
- upward sloping yield curve

- slow econ = inc int rates
- downward sloping yield curve

Deflation

BAD

defer spending now b/c cheaper in future, bad for econ

hard to use MP - can’t really dec rates more

Fiscal Policy

changes to budget deficit

stimulate econ = inc deficit

slow econ = dec deficit

Taylor Rule

r = policy neutral rate + 0.5(exp - trend GDP growth) + 0.5(exp - acceptable inflation)

used to anticipate changes in central bank policy/ int rates

Inflation on Asset Returns

- avg inf: cash, bonds, eqty, real estate = good
- high inf: cash, real estate = good; bonds, eqty = bad
- deflation: bonds = good; cash, eqty, real estate = bad

MP and FP

Impact on Yield Curve and Economy

- both stim: upward sloping yield curve, econ growth
- both rest: downward sloping yield curve, econ cont
- MP rest, FP stim: flatter yield curve, econ = ?
- MP stim, FP rest: slightly steep yield curve, econ = ?

Trend Rate of Economic Growth

- changes in employment
- changes in productivity and capital (TFP growth)
- consumer spending
- exogenous shocks
- gov interference/ support

Twin Deficit Problem

large gov deficit (G > T) and large capital acct deficit (M > X)

potential problems when dec deficits:

- gov spending inc int rates
- gov inc taxes
- inc foreign inv = dec currency value (inflation)

Pegged Currency

developing country pegs their currency FX rate to that of a developed country’s currency

- must follow econ policy of dev country
- pegged int rates > dev country’s int rates (riskier)
- interest rate differential changes based on confidence of peg

Emerging Markets Warning Signs

- gov debt/ GDP > 4%
- growth < 4% (insufficient to keep up w/ pop growth)
- current account deficit > 4% GDP
- foreign debt/ GDP > 50%
- foreign currency reserves < ST foreign currency debt
- gov policies not supportive of growth

Forecasting by Asset Class

- cash/ cash eq: MP and ST int rates
- default-free bonds: LT int rates, inflation, S/D
- credit risky bonds: credit spread
- inflation indexed bond: real yield, S/D
- common stock: earnings, P/E ratio
- emerging market stock: forecast of developed markets
- real estate: int rates, S/D

Forecasting Exchange Rates

- purchasing power pairity: higher relative inflation = curr dep
- relative econ strength: attracts capital = curr app
- capital flows: attracts capital = curr app
- savings-inv imbalances: savings/ inv = deficit, need curr app to attract inv

Expected Growth in GDP

%ΔY ≅ %ΔA + α(%ΔK) + (1 − α)(%ΔL)

ΔA = managerial and technological innovation

Gordon Growth Model

V_{0} = D_{1} / ( r - g )

H-Model

for emerging economies

Security Selection

top-down: macro analysis; identify sectors > markets > securities; manager focus on markets and industries

bottom-up: micro analysis; research firm, determine if it’s a good inv; manager focused on long-short, market neutral strategy

Fed Model

EY > treasury yield, ratio > 1 - undervalued

EY < treasury yield, ratio < 1 - overvalued

CONS: ignores ERP, ignores earnings growth, compares real variable (EY) to nominal value (treasury yield)

Yardeni Model

compares theoretical EY to acutal EY; variation of the constant growth DDM where earnings = div, yield on A-rated corp bonds = r and a 5 year growth forecast = g

actual EY < fair value yield - overvalued

actual EY > fair value yield - undervalued

CONS: assumed r, d varies over time, earnings estimates can be wrong

CAPE

cyclically adjusted P/E ratio

CAPE > historical avg - overvalued

CAPE < historical avg - undervalued

10 yr avg earnings captures effects of business cycle and inflation

Q Models

MV/ replacement cost

q > 1 - equity overvalued

q < 1 - equity undervalued