Hi Guys,
The saying that “Everything should be made as simple as possible, but not simpler” is often but not universally attributed to Albert Einstein.
Regardless of who actually made that pithy proclamation, it is especially applicable when making investment forecasts. Uncertainty dominates any forecasting, and complexity only increases the odds of introducing extraneous and erroneous factors.
I particularly favor a short and simple set of rules when forecasting longer-term market returns. I am not in any way motivated to travel to Chicago to attend a Morningstar convention where invited experts offer no more illuminating projections than I can painlessly glean from these simple rules.
What is my simple rule set? For the equity portion of my portfolio, I use a 10-year equity returns correlation that deploys the Bob Shiller Cyclically Adjusted Price to Earnings ratio (CAPE) as the entry parameter. Its current value is about 26; its historical mean value is roughly 17. So, today, the equity marketplace has a cautionary higher than normal risk level.
Future equity returns are negatively correlated with CAPE. A correlation that I like projects the following 10-year annual real returns (inflation subtracted) of 11%, 8%, 5%, 3%, and 1% as CAPE groupings increase from below10, 10 to 15, 15 to 20, 20 to 25, and greater than 25, respectively. These 5 groupings project a sad story for the current CAPE level. Please take note: This table is the primary insight and tool.
Above a CAPE of 30, equity returns have been historically negative for the upcoming 10 year period. One reason I like the above correlation is the timeframe balance of its components. Both CAPE and the equity market returns forecast are for a 10-year time horizon.
Projecting the next 10-year bond return likelihood is an even easier task. Simply use the current yield of the 10-year treasury bond. If you are a more aggressive corporate bond holder, you might consider adding 0.8% to the government value.
Given today’s market conditions and the S&P 500 CAPE valuation, I anticipate an equity annual real return of 1.0%, and a bond return of 2.5% (mix of treasury and corporate holdings) over the next 10-year time horizon.
Add another 2.5% for inflation. I presently expect a 60/40 equity/bond mixed portfolio to generate an actual return of 0.6 X 1.0 + 0.4 X 2.5 + 2..5 (inflation) = 4.1% annual average actual return for the next 10 years. Given the crudeness of the analyses, the projection is 4% annually. Quoting anything more accurate is misleading.
If you are a neophyte investor and expecting a portfolio return that is north of 8% annually over the upcoming 10 years, forget-about-it. It is not now in the cards given the present high value of CAPE. Naturally, these forecasts change as the input parameters get revised.
Well, this forecast is not rocket science and it did not need a visit to the Morningstar clambake. It has taken a complex forecasting problem and has simplified to allow a rapid and respectable estimate that does not depart too radically from those made by the professionals with their complex computer models. That complexity adds little.
Returning to the Einstein quote, I hope my approach has not crossed the overly simplified boundary. I also hope that a few MFO members find this simple forecasting tool useful. I realize that many MFO members use similar simplified methods in making their own projections. I thank these members for their patience with this submittal.
Best Regards.
Comments
Do you invest only in US-centric (CAPE) investments? I would think a diversified portfolio should also have a good slug of non - US investments. A globally diversified portfolio might fair quite well over the next ten years.
Maybe the next ten years will be less about US - CAPE weightings and more about being diversified globally.
Is there Global CAPE data available to compare Schiller's CAPE?
Thanks for your thread.
Thank you for reading and replying to my post.
Our family portfolio does indeed have many more components than are reflected in the simplified forecasting tool that I proposed. The portfolio includes Foreign Developed Equities, Emerging Market units, REITs, Commodity holdings, and government TIP positions. It is much more diversified than my simple model might suggest.
To respond to a second question that you asked, if a foreign equivalent to Shiller’s CAPE formulation exists, I am not familiar with it. Sorry, I can’t help in that area.
The issue you raised with regard to the inclusion of more investment categories to complete the forecasting tool is very pertinent. That’s why I started and ended my submittal by referencing Einstein’s simplicity caution. The utility of the forecasting tool can be corrupted by over simplification. That danger is real.
Probably no final answer exists. Much depends on the accuracy, the load that the simplified tool is expected to carry. My target goal was dominated by simplicity considerations, and I was prepared to sacrifice some accuracy. Although I did not do a formal analysis, I did scan the historical returns for other sub-group categories. Yes, they depart from US Equities and Bonds, but not that dramatically over the long haul.
For my purposes, I concluded that ignoring these other categories would not compromise the model too drastically. Also, finding simple ways to project returns for these categories (if they exist) is a daunting challenge that I was not prepared to accept. Complexity would quickly multiply. So I punted.
I’m in the diversified marketplace regardless of the model projections. I’ve mostly used it as a tool to dampen the overly optimistic expectations of bushytailed new investors. I try to balance expectations with real world likelihoods.
Although US Equities are likely to deliver muted returns over the next few years, I am not convinced that non-US positions will do much better. In many ways, global problems are as complex, interactive, and deep as those we face. A butterfly flaps its wings in New York, and the world feels its amplified effects. That’s just me talking glittering generalities. I surely am not an expert on the prospects of the global marketplace.
Best Wishes.
It is probably too complicated for most investors.
http://www.dailymail.co.uk/money/investing/article-2738966/How-use-CAPE-beat-market-global-CAPE-values.html
Thanks for this link. From this article:
"...the (Faber CAPE) strategy all hinges on your definition of worst. Mr Faber argues that the worst places to invest in are not the cheap markets belonging to troubled economies, but the investors’ darlings that have been chased to heady valuations."
The Schiller CAPE index points out that one of these worst markets are US markets.
The hard question is when will expensive markets crash and will they remain out of favor for long periods of time (a lost decade) and conversely when will cheap market rebound and how long will they remain in favor? Both trends can go on for longer than one is willing to wait.
Waiting for cheap assets to rebound can be more easily tolerated if the cheap asset pays a solid growing dividend. If the dividend payment can resemble an income stream the waiting might be very tolerable.
theres-a-new-kid-on-the-global-dividend-block-mebane-fabers-cambria-foreign-shareholder-yield-etf
A very nice find. Thank you for the reference. I'm not too familiar with Faber's total work product, but based on a few of his articles, I believe he does excellent research and his interpretions of that work is solid. He generates actionable recommendations.
Best Wishes.
I wonder if anyone has ever thought of starting up a global CAPE fund? There is DSENX for the U.S. markets but I could not find anything for international other than the ETF example above which would be time consuming for most investors.
I don't have any positions in DSENX but have it in my watchlist.