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Wednesday, October 7, 2015

One Approach to Expected Future Returns

Research Affiliates runs a regular analysis of expected risk and return using valuations making use of the “Schiller CAPE”. For all its faults the Shiller P/E is the “best we have” in predicting long term returns. But not as a market timing tool. The basic premise is that high current returns which is accompanied in most cases by high valuations is a predictor of low future returns and vice versa.
Of course the model doesn’t have as an input forecasts of Federal Reserve Policy or other economic and political developments so it always makes sense to always ask “what can go wrong”.
As a short term predictive tool the model as not been particularly useful. It has produced an analysis of US stocks and bonds as highly valued and thus lower future returns for several years and the opposite for non US equities. Needless to say that did not turn out to be the case.
It is useful to note that the most widely cited reason for the ability of US stocks to produce high returns despite high current valuation is because of the low level of interest rates…raising a note of caution for those that expect US rates to rise in the near future.

Expectations for returns on US Treasuries are also predicted to be low going forward despite the fact that short term traders/investors have benefited from positions in long term bonds despite their past high valuation. With 10 Year Treasury Bond yields at 2% well below their long term average it is not hard to see why the analysis forecasts both low returns and high volatility for US long term bonds going forward.

Country data is included in this graph and shows US stocks with low expected returns relative to non US stocks. In terms of the “sweet spot” in terms of prospective risk and return the cluster would include emerging markets in Asia and Western Europe. Notably two members of the BRIC club….Russia and Brazil would be in the highly speculative category of high expected return and high risk…something not only justified “by the numbers” but also with regards to the political economic situation.
Of course China is the “elephant in the room” factoring in all the uncertainty not “in the numbers” it would probably be prudent to increase the volatility number in light of political and economic uncertainty for China.

It is also useful to have perspective on recent and historical returns for asset classes. While of course there is no guarantee there is a tendency for asset class returns to "revert to the mean".

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