Estimating Future Returns – Stocks Look Decent, But Bonds Do Not

Another quarter goes by, the market rises further, and the the 10-year forward return falls again.  Here are the last eight values: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%.  At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.

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Future Stock Returns

At the end of June the figure was 4.58%.  Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.  The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.

Let me explain the adjustment calculations.  In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.  Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)

The mean-reversion calculation is a little more complex.  I use a 10-year horizon because that is the horizon the fits the data best.  It is also the one I used before I tested it.  Accidents happen.  Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.

Beyond 10-years, though, the model has no opinion.  It is as if it says, past mean returns will occur.  So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.  That is the mean reversion effect.

Going Forward

Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.  That’s not a lot of compensation for risk versus investment-grade bonds.  We are at the 94th percentile of valuations.

Now could we go higher?  Sure, the momentum is with us, and the volatility trade reinforces the rise for now.  Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.

Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.  It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.

And so I say, keep the rally hats on.  I will be looking to hedge around an S&P 500 level of 2900 at present.  I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.  They never learn… far better to stop and wait than make things happen too fast.  But they are omnipotent fools.  Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.

Who can tell?   Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.  Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.

PS — think of it this way: it should not have gone this high, therefore it could go higher still…

Article by David J. Merkel, CFA- The Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.