The RDM Forecasting matrix Javier Estrada Rather trivial to - PDF document

Application 2: Forecasting & Downside Risk Javier Estrada ADFIN – Winter/2014 1. Forecasting • Back to the RDM • D/P, P/E, and CAPE • The Fed model 2. Downside Risk • Calculation of semideviations • Further thoughts on VaR The RDM  Forecasting matrix Javier Estrada  Rather trivial to calculate IESE Business • Just remember to annualize the changes in P/E School • Take DY 0 and P/E 0 out of the table Barcelona GoXls Spain  An interesting thought that follow from the RDM ADFIN Winter/2014 1

Multiples  Simple idea Javier Estrada  The higher the price paid per dollar of fundamental IESE Business value (E, B, D, …), the lower the subsequent return School • The more you pay, the less you get Barcelona Spain  Focus on three widely‐used multiples • P/E, (the inverse of) P/D, and CAPE  Theory v . evidence  The evidence is uncontroversial • High relative prices tend to be followed by low returns  Why this happens is controversial • Goes back to whether value riskier than growth ADFIN Winter/2014 D/P Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 2

D/P Javier Estrada IESE Avg (1900 ‐ 2009): 4.2% Business School Jan/1/2014: 1.9% Barcelona Spain 16.8% 13.9% 11.1% 9.9% 8.0% 1.2% (*) 10‐year subsequent returns, annualized ADFIN Winter/2014 P/E Javier Estrada IESE Avg (1900 ‐ 2009): 15.8 Business School Jan/1/2013: 18.9 Barcelona Spain 14.7% 10.1% 8.1% 7.2% 4.2% (*) 10‐year subsequent returns, annualized ADFIN Winter/2014 3

Cyclically ‐ Adjusted P/E (CAPE)  What is CAPE? Javier Estrada IESE Business Avg (1871 ‐ 2013): 16.5 School Jan/1/2013: 25.0 Barcelona Spain 6.0% 2.3% 1.6% ‐ 0.7% ‐ 1.5% ADFIN (*) 10‐year subsequent returns, annualized Winter/2014 CAPE  Three important points on CAPE Javier Estrada  CAPE data for the US market is available from Bob IESE Business Shiller’s Web page School Go  CAPE is becoming increasingly popular/discussed Barcelona Spain as a market valuation tool  ETFs with CAPE‐based active strategies are now available in the market ADFIN Winter/2014 4

CAPE Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 CAPE Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 5

CAPE Javier Estrada IESE Business School Barcelona Spain (*) Faber & Dalmia (JoI, 2013), “Global Value.” ADFIN Winter/2014 Fed Model E/P = Y 10 Javier Estrada IESE Business School  The model Barcelona Spain  Not really proposed or used by the Fed • Just a relationship mentioned in a Fed report  Long history as an informal ‘P/E check’ • Negative relationship between P/E and interest rates • Negative relationship between P/E and inflation  Underlying idea • Stocks and bonds are competitive assets in portfolios  Investors base their asset allocation on the relative expected returns of stocks and bonds ADFIN Winter/2014 6

Fed Model Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Fed Model – USA P * = E/Y 10 E/P = Y 10 Javier Estrada IESE Business School P: 1848.4 Barcelona Spain P * : 2992.2 ADFIN Winter/2014 7

Fed Model – USA Javier Estrada IESE P/P * : 0.62 ⇒ +61.9% Business School Barcelona Spain ADFIN Winter/2014 ‘Fed Model’ – USA Javier Estrada IESE Business School Barcelona Spain Y 10 : 3.0% D/P: 1.9% ADFIN Winter/2014 8

Fed Model – World ($) Javier Estrada IESE P: 1629.1 Business School P * : 3267.6 Barcelona Spain ADFIN Winter/2014 Fed Model – World ($) Javier Estrada IESE P/P * : 0.50 ⇒ +100.6% Business School Barcelona Spain ADFIN Winter/2014 9

‘Fed Model’ – World ($) Javier Estrada IESE Business School Barcelona Spain Y 10 : 3.0% D/P: 2.4% ADFIN Winter/2014 Downside Risk – SSD (& DB)  How risk is assessed will critically determine Javier Estrada financial decisions to be made IESE Business School Barcelona Spain  There are easy (one‐cell) ways to calculate …  semideviations ADFIN  downside betas Winter/2014 GoXls 10

Downside Risk – VaR (E. Derman) Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Downside Risk – VaR (M. Stanley) Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 11

Downside Risk – VaR (M. Stanley) Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Downside Risk – VaR Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 12