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Capital market expectations define the conclusions investment analysts arrive at regarding the potential risks and returns of entire classes of investments, as opposed to specific investments. When investors or investment managers need to develop an investment strategy, part of this strategic development will include figuring the right ratio of investments that will balance the expected risks and returns sought. In doing so, taking into account capital market expectations is a crucial undertaking. Therefore, most analysts, investors and investment managers will use a consistent framework for analyzing and assigning such expectations to various investment classes. Despite the development of such framework, however, the data derived and conclusions drawn are sometimes highly subjective, and the process requires expertise to approach concise conclusions.
Developing or using an existing framework is the first step to figuring and assigning capital market expectations. This usually involves identifying what expectations need to be answered and during what time periods those expectations apply. Thereafter, the framework will account for historical analysis of investment classes, determine methods, tools and models to perform further analysis, and ascertain what information is required and from where to secure that information. Leveraging expertise and inference, the analyst will draw conclusions based on derived data, document those conclusions, and assign them expectations in relation to the investment class. Furthermore, the analyst will continually watch the performance of the investment class for both expectation improvements as well as to ensure the investment class performs as concluded.
At first glance, the framework to arrive at capital market expectations appears rather straightforward, but within the framework there are potential issues for which the analyst must account. Time-sensitivity is one crucial determinant that can shift capital market expectations due to the inherent propensity for data to change in response to a wide-range of factors. Analysts must account for the fact that economic data analyzed almost always involves limitations for usefulness. Furthermore, the analyst must recognize the limitations posed by each piece of information analyzed. Other limitations directly related to the framework include bias of data gathered, errors in data collected, frequency of data measured, that historical data is often construed by circumstances that must be accounted for, and bias in the information the analysts selects to interpret.
While the framework used for establishing capital market expectations is filled with potential pitfalls, there are tools available to expedite the process and arrive at reasonable conclusions. Tools utilized include models, such as cash flow models, risk premium and equilibrium models. Surveys can be used to consolidate the opinions of experts, in addition to enlisting the judgment of specific economic experts. Other tools utilized include business cycles and accounting for factors that impact them, analyzing national economies for risks, using economic forecasting, and accounting for the important differences between developing and developed economies in data analysis.
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