Predicted 10-Year returns from the Shiller P/E

November 16, 2012 Brainwave
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A quick update on the Shiller P/E predictions–been a slew of articles/research on this recently:

We’ve written fairly extensively on the topic of predicting future returns:

Here is an article we wrote up describing Hussman’s model:

John Hussman has an interesting piece on predicting long-term market returns

The article is a bit dated (2005), but still fascinating.

In the short piece Hussman suggests that the projected annual total return on the S&P 500 over T years can be represented with the following equation:

  • Long term total return = (1+g)(future PE / current PE)^(1/T) – 1 + dividend yield(current PE / future PE + 1) / 2

He makes the following assumptions and plugs them into the equation above:

  1. Peak to Peak earnings growth, g=6%
  2. T=10 years
  3. future PE (E=Peak Earnings over cycle) range between 20 (major bull) and 7 (major bear)

Here are the results of our analysis of this model:

143
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.

Low-end prediction is -0.84% 10-Year CAGR; high-end prediction is 7.61% 10-Year CAGR

We also have a piece that is related to predicting 10-year returns with a simple regression model:

http://blog.alphaarchitect.com/2011/10/the-shiller-pe-ratio/

144
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.

The model is predicting a 3.31% 10-Year CAGR.

Summary

Expect 10-year returns to fall in the -.84% to 7.61% range over the next 10-years. Not too precise, but at least you can scratch off your prior expectation of 20% CAGR…

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees.

This information is not intended to, and does not relate specifically to any investment strategy or product that Alpha Architect offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.