Forecasting Stock Returns

November 26, 2012

Before we get to this week’s piece some quick housekeeping.  Many readers are not aware that we archive all of the old emails and newsletters on The Idea Farm website.

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We received the below research piece from a reader (and we encourage you to send us what you’re reading!).  Vanguard takes a look at many popular stock market indicators to test their predictive ability in forecasting future stock returns.  They look at such fundamental indicators as trailing P/E ratios, dividend yields, corporate earnings growth, GDP growth, the Fed Model, and others.

From the piece:

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EXECUTIVE SUMMARY:  “Some say the long-run outlook for U.S. stocks is poor (even “dead”) given the backdrop of muted economic growth, already-high profit margins, elevated government debt levels, and low interest rates. Others take a rosier view, citing attractive valuations and a wide spread between stock earnings yields and Treasury bond yields as reason to anticipate U.S. stock returns of 8%–10% annually, close to the historical average, over the next decade. Given such disparate views, which factors should investors consider when formulating expectations for stock returns? And today, what do those factors suggest is a reasonable range to expect for stock returns going forward?”…….

and here is a good chart from the paper:

and a few words from the summary:

…”We’ve shown that forecasting stock returns is a difficult endeavor, and essentially impossible in the short term. Even over longer time horizons, many metrics and rough “rules of thumb” commonly assumed to have predictive ability have had little or no power in explaining the long-run equity return over inflation. Although valuations have been the most useful measure in this regard, even they have performed modestly, leaving nearly 60% of the variation in long-term returns unexplained. What predictive power valuations do have is further clouded by our observation that different valuations, although statistically equivalent, can produce different “point forecasts” for future stock returns.

This underscores a key principle in Vanguard’s approach to investing: The future is difficult to predict. As such, we encourage investors not to focus on the “point forecasts” that result from various forecasting models and instead turn their attention to the distribution of potential future outcomes.

Once future prospects are viewed in a distributional framework, the benefits of strategic asset allocation become clear. A focus on the distribution of possible outcomes highlights the benefits and trade-offs of changing a stock allocation: Stocks have a higher average expected return than many less-risky asset classes, but with a much wider distribution, or level of risk. Diversifying equities with an allocation to fixed income assets can be an attractive option for those investors interested in mitigating the “tails” in this wide distribution, and thereby treating the future with the humility it deserves.”

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Download the full 20 page PDF here: