Newfound Research 2016 Market Valuations And Expected Returns.
Long-Term Return Forecasts
Equity Valuations
Shiller Cyclically Adjusted Price-to-Earnings Ratio (“CAPE”): Price divided by 10-year average of earnings, adjusted for inflation.
Current ShillerCAPE is in 89th percentile of historical readings, implying that U.S. large-cap stocks are currently expensive.
Equity Valuation Return Implications
Historically, valuations have been a strong predictor of long-term forward returns.
With a ShillerCAPE reading of 26.03, 10-year annualized real returns are expected to be 4.9%.
Another Way Of Evaluating Returns
Total Return = Investment Yield + Speculative Re-Pricing
Investment Yield: Dividend Yield + Earnings Growth
Speculative: Price change pressures due to over- or undervaluations; e.g. “reversion to the mean” of P/E ratios
Other Experts On Equity Valuations
Bond Valuations
10-Year U.S. Treasury rates sit near all-time lows.
Bond Valuation Return Implications
Starting yields are a great predictor for ending returns in a constant maturity bond index.
At 2.2%, we can expect a 2.2% annualized return over the next decade from a constant maturity 10-year Treasury index. If we assume inflation is 2%, then this is a 0.2% real return.
60/40 10-Year Real Return Forecast
INVESTMENT IDEAS
Idea #1: Diversify Your Approach
Much like asset classes, different investment strategies will perform well in different market environments.
Diversifying across multiple strategies has historically increased risk-adjusted returns. Chasing the recent performance of the best performing strategies, on the other hand, has proven to be destructive to risk-adjusted returns.
Idea #2: Actively Manage Risk
10-Year periods with poor returns tend to have a higher frequency and severity of drawdowns. A focus on reducing the impact of these drawdowns can help increase total return.
Idea #3: Go Global
Valuations are the biggest drag on forward looking returns for U.S. equities.
Many foreign markets are much more fairly priced and offer higher expected returns.
Idea #4: Pursue Alpha
Equity factor exposures have historically outperformed the broad market and are widely used by institutional investors to increase risk-adjusted returns. Accessing a diversified basket of factors can help smooth out short-term under-performance of a single factor allocation.
Idea #5: Seek Higher Yields
One way to increase total return is to increase yield.
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