Estimating Future Stock Returns, March 2016 Update

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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.

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 12 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.

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.

Disclosure: None