Case 039Market view and security pitchHard

Tell me where you think the market is headed. With an index at 22 times earnings, earnings growth of 12% and a 10-year government yield of 7%, build a one-year base, bull and bear range and say how a client portfolio should be positioned.

BNY MellonNew York · 2022

The situation

The interviewer asks, with no data: where do you think the market is headed? You ask for three numbers and are given them. An illustrative broad equity index trades at 22 times trailing earnings. Analysts expect earnings to grow 12% over the next year. The 10-year government bond yields 7%.

The client in mind is a moderate investor whose policy allows 50% to 70% in equity, with a 60% target, and who is at 60% today.

Your task

Give a one-year range with a base, bull and bear case built from earnings and the multiple. Compare it with the bond, and say how you would position the client, without pretending to know the level a year from now.

Quick check

If earnings grow 12% and the P/E stays at 22, what does the index return in a year, before dividends?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

A one-year range of about minus 14% to plus 25%, with a base case of plus 12% and a weighted middle of about 8.8%, against 7% on the bond. At 22 times, equity yields 4.5% on today's earnings, less than the bond, so the base case depends on growth arriving. The premium for owning equity is thin, not absent. That argues for holding the client at the 60% target, not above it, with no big bet either way.

Step 1How do you answer a question nobody can answer?

A weather forecaster does not say it will rain at 4 pm; she says a 60% chance of rain, and why. Nobody knows where the market will be in a year, so the useful answer is a range built from two levers, earnings growth and the multiple, and a view on how the client should sit inside it. Say that framing first. It shows the interviewer you know what can and cannot be forecast, before a single number.

Step 2What does the bond comparison say?

The earnings yieldEarnings divided by price, the inverse of the P/E. At 22 times, the index earns about 4.5% on its price. at 22 times is 1 over 22, 4.5%. On next year's earnings, if they grow 12%, the multiple is 19.6 and the yield 5.1%. Both sit below the 7% a government bond pays with no growth required, so equity at this price is a bet that growth arrives. The comparison is rough, since earnings grow and bond coupons do not, but it tells you the cushion is thin.

What each asset pays you today, per centIndex earnings yield, 1 / 224.5%On next year's earnings, 1 / 19.65.1%10-year government bond7.0%Equity has to earn its gap through growth: 12% a year is what the base case assumes.
At 22 times, the index earns 4.5% on its price, or 5.1% on next year's earnings, against 7.0% on the 10-year government bond, so equity starts behind the bond and relies on growth to catch up.
Step 3How do you build the three scenarios?

Next year's price is next year's earnings times next year's multiple, so each case sets both. Base: earnings up 12% and the multiple unchanged at 22, a 12% return. Bull: earnings up 15% and the multiple up to 24, about plus 25.5%. Bear: earnings up only 5% and the multiple down to 18, about minus 14.1%. Notice how much of the swing is the multiple: in the bear case, earnings still grow and the index still falls.

The relationship
r=(1+g) PE1PE0−1bear: 1.05×1822−1=−14.1%r = \frac{(1+g)\,\text{PE}_1}{\text{PE}_0} - 1 \qquad \text{bear: } \frac{1.05 \times 18}{22} - 1 = -14.1\%
gearnings growth over the year
PE_1the multiple a year from now
PE_0today's multiple, 22
What it says in wordsThe index return is earnings growth combined with the change in the multiple the market is willing to pay.
One year ahead: earnings times multiple, three ways-14.1%Bear, 25% weightEPS +5%, P/E 18+12.0%Base, 50% weightEPS +12%, P/E 22+25.5%Bull, 25% weightEPS +15%, P/E 24bond 7.0%Weighted+8.8%
The bear case, earnings up 5% at 18 times, gives about minus 14.1%; the base case, earnings up 12% at 22 times, gives plus 12.0%; the bull case, earnings up 15% at 24 times, gives about plus 25.5%; weighted 25, 50 and 25, the middle is about 8.8%, above the 7.0% bond.
Step 4So how should the client be positioned?

Translate the range into a stance, not a call. With a weighted outcome about 1.8 points above the bond and a bear case of minus 14%, the reward for extra equity is thin, so hold the client at the 60% target rather than stretching to 70%. If equity rallies to the top of the range, rebalance back to target, and lock in some 7% bond yield for the debt sleeve. Close by naming what would change your view: earnings missing 12%, or the bond yield rising, which would pull the fair multiple down.

Where candidates lose it

The first loss is answering with a level or a direction: the market will go up. The interviewer at this stage is testing whether you can build a view, not whether you can guess, and a guess with no structure scores nothing.

The second is forgetting the multiple. Candidates who say earnings grow 12% so the market rises 12% have given one of three cases and missed the lever that moves the most.

What the interviewer asks next

  • The bond yield rises to 8%. Which scenario does that make more likely, and why?
  • How would you explain this range to a client who asks for a simple yes or no?
  • What would make you move the client to the bottom of the equity range?

Asked at BNY Mellon, Private Wealth Management, New York, 2022 (Wall Street Oasis): one technical question of tell me where you think the market is headed

Company names and figures are illustrative.