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…




About the Author

Wesley R. Gray, Ph.D.

Dr. Gray has been an active participant in financial markets for over 15 years. His experience includes positions as a Captain in the United States Marine Corps, as a finance professor at Drexel University, and as a portfolio manager for a special-situations hedge fund. Education and entrepreneurship has been the focus of his professional endeavors and his research interests are focused on the performance of portfolio managers and behavioral finance. Dr. Gray is currently the Executive Managing Member of Alpha Architect, an SEC-Registered Investment Advisor. Dr. Gray has published two books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army and QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. His work has been highlighted on 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.