Forecasting long term index returns

[sinner]

The blogosphere is currently aflutter with this topic.

This is something that John Hussman has done consistently as part of his strategy since inception. There are many different formulae presented in his weekly notes that are good for valuation on stocks.

As an example, I provide the image from this article which uses dividend yield to forecast returns

www.marketwatch.com/story/getting-used-to-a-slow-growth-future-2013-04-10?siteid=rss

If you go check out John Hussmans writings, or stuff by Bill Gross, etc, they are all forecasting a very low 10Y CAGR in stock indices using these methods. (http://gestaltu.blogspot.com.au/2012/12/dont-take-our-word-for-it.html)

Here is, for example, the CAPE and dividend forecast valuation equation from Hussman

2) Shorthand Shiller Model – see The Siren’s Song of the Unfinished Half Cycle:

1.063 * (15 / ShillerPE)^(1/10) – 1 + Dividend_yield (decimal)

3) Dividend Model – see Estimating the Long-Term Return on Stocks (1998):

1.063 * (Dividend_yield / .037)^(1/10) - 1 + (Dividend_yield + .037)/2

There is an assumption of ~6% growth based on the peak-peak trend in SP500 earnings growth.

What I was wondering if is anyone uses similar methods here on the ASX, do they find valuation offers the same strong forecasting tool for long term returns on the ASX as it does in the US? My guess is yes but would love to see a chart or two.

 

[systematic]

Third chart down on this page might be worth a look.

Also, Australia (data back to 1979) was covered in Joachim Klement's paper, "Does the Shiller PE work in emerging markets?". Written 2012, it had Australia doing 40-45% (real return) over the next 5 years, about twice as good as the US. Of course, rising rates / weak growth sends that 'forecast' south. The author argues that the potential for risings rates and/or weak growth is strong enough to be more conservative in forecasting returns, and opts for an expectation of moderate returns despite seemingly fair values. There's also some charts in there

 

[sinner]

Really great stuff thanks systematic.

 

[MaxwellSmart]

Interesting - http://gallery.mailchimp.com/6750faf5c6091bc898da154ff/files/PIMCO_Asset_Allocation_Focus_November_2012.pdf

 

[sinner]

Hey MaxwellSmart,

Yep, I find it a really interesting topic. There are good studies out there by many people, including a really interesting one on global CAPE by Mebane Faber.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2129474

I also saw (can't remember where) recently a chart which showed (similar to the one in the PIMCO link you provided) the "total return" decomposition of stocks over the very long term (I think since 1800s?). They displayed that investing in stocks for capital gain was for a while the "new normal" and how before that the majority of returns were provided by dividend yields.

From the valuation forecast perspective, this makes intuitive sense, if your growth trend in earnings is 0% then you will likely only see returns provided by dividends. IIRC prior to the great "liquefaction" of financial assets which occurred after the inception of Central Banking and World Wars, the economy itself had pretty flat growth.

I would love to hear what the value investors of this forum have to say on the topic!

 

[McLovin]

Hey MaxwellSmart,

Yep, I find it a really interesting topic. There are good studies out there by many people, including a really interesting one on global CAPE by Mebane Faber.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2129474

I also saw (can't remember where) recently a chart which showed (similar to the one in the PIMCO link you provided) the "total return" decomposition of stocks over the very long term (I think since 1800s?). They displayed that investing in stocks for capital gain was for a while the "new normal" and how before that the majority of returns were provided by dividend yields.

From the valuation forecast perspective, this makes intuitive sense, if your growth trend in earnings is 0% then you will likely only see returns provided by dividends. IIRC prior to the great "liquefaction" of financial assets which occurred after the inception of Central Banking and World Wars, the economy itself had pretty flat growth.

I would love to hear what the value investors of this forum have to say on the topic!

I reckon if you went back and looked at the Dow components from say 100 years ago, it would probably, at least in part, explain why yield was a higher portion of return. I'm thinking they'd be high capex, commodity type businesses, or railroads with very few consumer good type companies, not as easy to scale as things like Intel, Microsoft, McDonalds, American Express etc.

Also don't forget that in the US, there are tax advantages in not paying dividends but delivering capital gains to shareholders through buybacks etc. I'm not sure when that tax arrangement came into being.

ETA: There's a list on Wiki!

http://en.wikipedia.org/wiki/Historical_components_of_the_Dow_Jones_Industrial_Average

Looks like what I describe....From 1912, the Dow components included American Smelting and Refining, American Sugar, Central Leather, Natiional Lead, US Rubber, US Steel.

 

[sinner]

I am not sure I agree about the commodity thing being the explanation, but it is an interesting point.

I definitely agree about the taxation thing, I have read about it previously too.

One thing which I didn't fully grasp until I read it in the PIMCO link provided by MaxwellSmart is that share buybacks and dividend payments are functionally equivalent.

 

[McLovin]

I reckon if you went back and looked at the Dow components from say 100 years ago, it would probably, at least in part, explain why yield was a higher portion of return. I'm thinking they'd be high capex, commodity type businesses, or railroads with very few consumer good type companies, not as easy to scale as things like Intel, Microsoft, McDonalds, American Express etc.

Just for the sake of clarity, my point here is that heavy manufacturing/capital intensive industries can't grow as fast with a given $ amount of capital as capex light/service companies can. So even holding dividend constant, growth will be faster in the company that can earn higher returns on incremental capital or looked at in reverse, the company that needs less capital for a given growth rate.

 

[MaxwellSmart]

USA Specific.

Some great information on PIMCO's site.

"We start by defining the expected secular real policy rate as the expected average rate of the fed funds rate after adjusting for inflation over the next 10 years.

Under our assumptions, we expect the secular real policy rate to average -1% per annum for the next decade, and if there are no major changes to our assumptions beyond that, to actually fall gradually towards -1.25% by 2030.



Hmmmm..

http://www2.pimco.com/asset-allocation-focus/infographic.html

I wonder by how much the U.S equity indices are going to outperform the U.S bond market (10 yr treasury bills) ???.

"If policy makers follow the optimal path of secular real policy rates from this point forward, the 10-year U.S. Treasury note (our proxy for the bond market) can be expected to deliver an average total return of about 2.0% to 3.0% per annum over the next five to 10 years".

FYI.. http://www.pimco.com/EN/Insights/Pages/AssetAllocationFocusOverview.aspx

Glimmers of Hope - http://www.pimco.com/EN/Insights/Pages/PIMCO-Cyclical-Outlook-Glimmers-of-Hope.aspx