Estimating Future Stock Returns, March 2016 Update

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Estimating Future Stock Returns, March 2016 Update

Estimating Future Equity Returns

Estimating Future Equity Returns ecphilosopher data 2015 revision_21058_image001
Estimating Future Equity Returns

You might remember my post Estimating Future Stock Returns, and its follow-up piece. If not they are good reads, and you can get the data on one file here.

The Z.1 report came out yesterday, giving an important new data point to the analysis. After all, the most recent point gives the best read into current conditions. As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.

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The sharp-eyed reader will say, “Wait a minute! That’s higher than last time, and the market is higher also! What happened?!” Good question.

First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends. But that would be enough to move the estimate on the return up maybe 0.10%. It moved up 0.64%, so where did the 0.54% come from?

The market climbs a wall of worry, and the private sector has been holding less stock as a percentage of assets than before — the percentage went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion. Some stock gets eliminated by M&A for cash, some by buybacks, etc. The amount has been falling over the last twelve months, while the amount in bonds, cash, and other assets keeps rising.

If you think that return on assets doesn’t vary that much over time, you would conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock. One year ago, the percentage the private sector held in stocks was 39.6%. A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.

Summary

As a result, I am a little less bearish. The valuations are above average, but they aren’t at levels that would lead to a severe crash. Take note, Palindrome.

Bear markets are always possible, but a big one is not likely here. Yes, this is the ordinarily bearish David Merkel writing. I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.

Estimating Future Equity Returns – Postscript for Nerds

One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961. There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge. I don’t know what the Fed’s statisticians are doing here, but I am going to look into it, because it is troubling to wonder if your data series is sound or not.

That said, the R-squared on this model is better than any alternative. Next time, if I get a chance, I will try to put a confidence interval on the estimate. Till then.

Updated on

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.
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