Mining The Web For Strategic Insight

By: Capital Spectator Wednesday, November 04, 2009 11:07 AM

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The first rule in the money game is recognizing that there are no silver bullets. Asset pricing is a black box. It's become somewhat less of a black box after a half century of analysis by financial economists, but what we don't know about how markets work still dominates by far.

Much of what we do know has come from reverse-engineering the system's output. We can see prices and we can measure their fluctuations and linkages in countless ways. The trouble is that the financial gods forgot to give us the code that produces the output. That leaves us with the thankless ask of predicting returns indirectly. But even then we're working with imperfect information. Ours is a world of ex post data. We know the past, but that's a poor window into the future. We have the output but we're forever debating the input. As a result, the link between ex post and ex ante data is shaky. That doesn't mean we should ignore the historical record, but it should only be one of several layers of analysis for developing capital market assumptions.

Much of what we discuss on the pages of The Beta Investment Report is focused on developing equilibrium risk premiums and then integrating those long-range forecasts with our near-term outlook. To the extent there's a divergence of some magnitude, and we're reasonably confident in our assumptions, we have some basis for adjusting the asset allocation for the market portfolio, which we define broadly, as per finance theory. A global value-weighted mix of stocks, bonds, commodities and REITs is a reasonable definition, a.k.a. our proprietary Global Market Index.

You can't spend too much time studying history and applying what finance has taught in the quest to anticipate prospective risk premiums for the major asset classes. It's tempting to think that a few metrics will do the trick, but it's never quite so simple. Any given factor has limits as a window into the future. An intelligent blending of factors helps minimize those limits, if only slightly. But we need all the help we can get.

That's one reason why we routinely review how other strategists think and act. In a world where no one has absolute knowledge, sharing and comparing capital market assumptions is productive if only to test our own notions of how markets price assets. As a small sampling of what's out there, we offer three recent perspectives on how to look ahead, along with a tidbit from each paper.

The first comes from EnnisKnupp, the institutional investment consultant. In a July 2009 paper reviewing capital market modeling assumptions, the firm reasoned that expected return for equities can be divided into three main components: dividend income, nominal growth in corporate earnings and changes in valuation levels.

Next, WellsFargo advised last month that recent market history posted contradictory results in terms of what standard finance theory predicts, namely, that higher risk is rewarded with higher return. "Asset class returns over the past two years have not provided investors with better performance in exchange for higher risks," the paper notes. "In fact, the better performing asset classes have been bonds, which usually are associated with lower risk." But this divergence offers clues about the future, the author explains. "Over the full market cycle, the relationships we expect to see between asset classes should generally hold." Thus the paper's lead question: "Back to Normal?"

You can surely find more exciting market commentary on the web, but rarely will you uncover more strategically relevant fare. The crowd loves to talk about the trees, but sometimes you can locate intelligent discussion of the forest too.

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The above story is the opinion of the author only and it does not reflect iStockAnalyst opinion. Further, the author is not personally advising you regarding the suitability of the story for your investment needs. In no event iStockAnalyst will be liable for any loss or damage including without limitation, indirect or consequential loss or damage, or any loss or damage whatsoever arising from or arising out of, or in connection with the use of this information. Please consult your investment advisor before making any investment decision.

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