When it comes to predicting equity returns, analytical approaches can be divided into two major categories: top-down and bottom-up.
- In top-down forecasting, analysts use macroeconomic projections to produce return expectations for large stock market composites, such as SENSEX, NIFTY, S&P 500. These can then be further refined into return expectations for various market sectors and industry groups within the composites. At the final stage, such information can, if desired, be distilled into projected returns for individual securities.
- By contrast, the bottom-up forecasting begins with the microeconomic outlook for the fundamentals of individual companies. If desired, the forecasts for individual security returns can be aggregated into expected returns for industry groupings, market sectors, and for equity markets as a whole.
When engaged in fundamental security analysis, it can be wise to use both of the approaches. However, when we use both approaches, we often find ourselves in the situation of the person with two clocks, each displaying a different time. They may both be wrong, but they cannot be both right!
It is frequently the case that top-down and bottom-up forecasts provide significantly different results. In such instances, the analyst should investigate the underlying data, assumptions, and forecast methods before employing them as a basis for investment decisions.
However, in rare and significant instances, we will find that carefully retracing the steps reveals a gap between two forecast types that gives rise to significant market opportunities. In such instances, the process of reconciling the results from the two approaches creates instances where we differ significantly and correctly from the consensus.
Recent years have provided major examples of this. In early 2000s, top-down forecasts provided much more subdued outlooks compared to bottom-up projections for corporate profits, both in aggregate and for particular industries. Individual companies were optimistic about their own prospects. However, in aggregate many of their technologies and products compared with each other. Thus, the success of some companies meant failure of others, and this natural, competitive offsetting tendency was correctly reflected in aggregate, top-down sales growth for the industry. Aggregating the bottom-up forecasts of individual companies, however, produced wildly inflated forecasts of both sales quantities and average prices and profit margins. Those who recognized the inconsistency of the top-down and bottom-up forecasts, and the accuracy of the top-down forecast, much of the carnage of the bubble collapse was avoided.
More recently, the collapse of equity markets was a case where bottom-up forecasts proved their superiority over top-down approaches. In both the UK and the USA, some banking and real estate analysts perceived the excesses in residential real estate in a microeconomic sense. Those who pushed their analysis to a macro conclusion realized that certain large financial institutions were imperiled. Those who understood the pressure on these and other large financial institutions correctly foresaw that then-prevailing worldwide forecasts of economic activity and equity market returns were dramatically overstated.
-Team HBJ Capital