A Lesson in Return Forecasting (Very Academic)

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A Lesson in Return Forecasting (Very Academic)

This post might be beyond many people (including myself) but looks to very informative/value added – check it out below.

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Valuation Present ValueMany value investors have given up on their strategy over the last 15 years amid concerns that value investing no longer worked. However, some made small adjustments to their strategy but remained value investors to the core. Now all of the value investors who held fast to their investment philosophy are being rewarded as value Read More

Investors are enamored with various investment houses and personalities who claim insight into the prospects for long-term market returns. Some classic examples include Nouriel Roubini, John Hussman, David Rosenberg, or Jeremy Grantham.

But have you ever asked “How” these folks came to their conclusions?

In most cases, the answer is probably “No” and the reason is because there is a lack of transparency from the author(s) and/or a lack of knowledge/understanding on behalf of the reader.

The point of this learning module is to educate the reader so they can make informed decisions about long-term return forecasting models.

Disclaimer: We recommend a realistic perspective on the viability of trying to predict market returns with quantitative models (we’ve written off the ability of “gut instinct” to forecast the future). The same holds for the complex model we outline below: 99% chance it doesn’t work any better than predicting the future based on astrology.

Summary:

We generate projected long-term forecasts for the S&P 500 using a variety of models ranging from simple (Bob Shiller Method) to medium complexity (Hussman Method) to relatively complex (Alpha Architect Method).

Core model inputs are as follows:

  • Current P/E: 18.10 (As of 7/7/2014)
  • Current Profit Margin: 13.35% (As of 7/7/2014)
  • Current Cyclically Adjusted Price/Earnings (CAPE  or Shiller P/E):  25.82 (As of 6/30/2014)

Shiller Method (Simple)

  • Regression approach
  • The current predicted 10-year Nominal Total Return: 6.06%. 

Hussman Method (mid range complexity)

  • Total return approach with assumptions on exit valuations.
  • The current predicted 10-year nominal total return ranges between: -4.16% and 5.52%. 

Alpha Architect Method (high complexity)

  • Simulation approach with dynamic revenue, profit margins, and valuations.
  • The current predicted 10-year nominal total return ranges between: 3.42% and 5.49%.
  • The top line is with average/good input assumptions.
  • The bottom line is with below average/poor input assumptions.

 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

See full A Lesson in Return Forecasting by Wesley R. Gray, Ph.D., Alpha Architect

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