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Forecasting Long-Term Portfolio Returns: The Efficient Valuation Hypothesis

Mar. 06, 2018 9:30 AM ETSPDR® S&P 500 ETF Trust (SPY)19 Comments
Niall Gannon profile picture
Niall Gannon


  • The study seeks to demonstrate that much of the long-term (20-year rolling periods) variability in stocks can be explained by the beginning-of-period earnings yield.
  • Much of the previous financial research suggests either forecasting future returns a futile exercise because returns are random, or that asset class performance tends to display mean reversion.
  • We aim to illustrate that starting earnings yields are similarly predictive of the future returns in an equity portfolio, over 20-year investment periods.

By Niall J. Gannon and Scott B. Seibert, CFA

Forecasting long-term asset class returns with reliability is an important component for matching a portfolio’s performance with its future liabilities. Whether one is an individual investor or a public pension fund, a reliable estimate of an asset’s minimum expected return is critical for financial planning purposes. Using the United States public pension system as an example, the use of inflated return expectations has perpetuated a growing deficit. According to Moody’s, in 2017, US public pension plans had unfunded liabilities of over $4 trillion. A deficit this massive can only be rectified by either cutting previously promised benefits for current participants or having future generations pick up the difference through higher contributions, sacrificing their standard of living. Most investors have an understanding that inception yield is predictive of the future returns of a fixed-income (bond) portfolio. We aim to illustrate that starting earnings yields are similarly predictive of the future returns in an equity portfolio, over 20-year investment periods.

Much of the previous financial research suggests either that forecasting future returns a futile exercise because returns are random, or that asset class performance tends to display a reversion to the mean of its historical observations. Eugene Fama, known for developing the Efficient Market Hypothesis, famously stated:

Most simply the theory of random walks implies that a series of stock price changes has no memory-the past history of the series cannot be used to predict the future in any meaningful way. The future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers.

- Random Walks in Stock-Market Prices, Eugene Fama (1965)

Among those who adhere to the theory of mean reversion, Jeremy Siegel wrote in Stocks for the Long Run

This article was written by

Niall Gannon profile picture
The lead member of the Gannon Group, Niall’s role is Private Wealth Advisor to ultra-high-net-worth investors. Niall manages a group of five professionals that have extensive experience assisting Forbes 400 families, C.E.O.s and other investors of substantial means. Niall has been recognized as one of the nation’s top 100 Financial Advisors by Registered Rep. Magazine (2003), Barron's (2004), and ‘The Winner’s Circle’ by RJ Shook (2005). Niall’s first major book: Investing Strategies for the High Net-Worth Investor: Maximize Returns on Taxable Portfolios, published by McGraw-Hill in December 2009, has received recognition among investing and business media including: Forbes, Morningstar, the Institute for Private Investors (IPI)4, the St. Louis Business Journal, and has been featured in an article published in BusinessWeek (2009). Niall has appeared on CNBC and National Public Radio. In addition, he has been quoted in the New York Times, Wall Street Journal, Barron’s, and BusinessWeek. In 2009, Niall was featured in Curtis Faith's book, Inside the Mind of the Turtles: How the World's Best Traders Master Risk (2009) and Mebane Faber's The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (2009). In 2008, his academic work was featured in Eric Falkenstein & Eric W. Richardson's Finding Alpha (2008). In 2012, he was quoted in Andreas Schyra’s book Indices as Benchmarks in Portfolio Management with Special Consideration of the European Monetary Union. In 2014, Niall’s research was featured in Paul Watkins’ book, Portfolio Management 186 Success Secrets and in Charlotte B. Beyer’s book Wealth Management Unwrapped. In 2015, he was quoted in Marc Engelbrecht’s book Asset Allocation in Private Banking. Niall is an active member within the Institute for Private Investors and during 2008-2010, served on the CFA® Institute Committee for the development of Investment Policy Statements for high net worth investors. Niall also serves as an Investment Committee member for the Papal Foundation, a Board of Trustees member for the Roman Catholic Foundation of Eastern Missouri and an Advisory Board member for Cor Jesu Academy, a Catholic girl’s school in St. Louis, MO. In addition, he has made enduring commitments to professional and civic associations in the St. Louis region and the State of Missouri. Niall is a former Board of Directors member of the Junior Achievement of Mississippi Valley and a past Director of Connections to Success and St. Louis Variety. He was also former President of the St. Louis Irish Arts and former Chairman of the 2006 Annual Catholic Appeal. For his work in these and other areas, Niall received the Silver Congressional Award and is a four-time recipient of the President’s Volunteer Service Award in 2004, 2005, 2006 and 2007. In 2008, he received the Bill Eager Portfolio Manager of the Year Award from the Portfolio Management Institute. Niall completed The Wharton School, University of Pennsylvania’s ‘Institute for Private Investors: Private Wealth Management Professional Track Program’ in 2005. He received his undergraduate degree from The Citadel Military College of South Carolina and subsequently held the rank of lieutenant in the U.S. Army Reserve as an M1 Abram’s tank platoon commander.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Comments (19)

Notwithstanding the comments that suggest this hasn't worked recently for John Hussman or is not useful for one to five year periods, it seems this would be an excellent tool for longer term planning, particularly for investors who are managing to a goal or against a set of liabilities (as opposed to a benchmark). Would be interesting to see what might have happened to all the underfunded state and local pension plans during various time periods, in terms of contributions and asset allocation, if they had used this approach to return assumptions instead of the historic 8% forever. Well done!
it begs the question what "did not work"? Hussman has been bearishly pounding the table about overvaluation for years - and stayed mostly out of the stock market. And lost because of it. So he has been wrong (in hindsight). If the market suddenly tanks >20%, he will have the opportunity to say he was right; but even a stopped clock is right twice a day.

Nothing about this research says the stock market can not become even more overvalued. All it is saying is to expect lower forward returns, and by implication, this isn't a great time to invest new cash in US stocks from a "buy low" perspective.

If you have high credit card debt, paying it off is a better option - at the moment.
If you are interested in more stable returns, buying short to intermediate term corporate bond/bond funds is a better option - at the moment (assuming interest rates don't triple in the next couple of years).
Learner16 profile picture
Thank you, Mr Gannon, As joesmith323 says, this is very similar analysis to Hussman's. Can you explain to us why the results would be different in this case, please?

It looks like it should work in theory, but it did not work for Hussman in practice. Do you happen to know why?
Really solid, concise article. Thanks!
Without comparing the 20 year periods to interest rates and inflation we have only part of the picture. There is some real useful data in the article but without interest rates there is less than half a tale being told.

Could we please have an article that shows the 10 year treasury yield besides the earnings yield.
We can not assume the current 20 year period will be having low returns in a growing GDP environment with little competition from bond rates.

If you look at around 6% in the 90s for 10 year treasury rates and sometimes P/E higher or lower, it makes our times look like a good time to invest.
Though I am a bull I think demographics matter and aging in japan and other countries has to be balanced with the problem of aging workers but better workers in developing countries vs a generation ago. When I lived in India decades ago the workers were almost all terrible, but nice. Now they can usually speak English and kids use computers.

The world is always changing and in recent decades changing faster . "This time is different" applies in both positive and negative ways. Few articles begin to address the complex issues most investors have barely considered if at all. Thank you for this one. Overall I am long.
Niall Gannon profile picture
Chris, thank you for the question. I am going to refer you to the reader supplement for my first book: Investing Strategies for the High Net Worth Investor in which you will be able to see the 20 year treasury rates for each year back to 1957. The data goes through yr. end 2015 but will be updated shortly http://bit.ly/2DejzfI

So you know our thinking: the initial research stemmed from a Journal of Wealth Management paper in 2006 studying the after-tax returns of equities versus bonds. For that paper, we used the Bond Buyer GO index (a 20 year duration index) as it had a data set going back to 1957. It was in reviewing and updating that research that we found a remarkable correlation at the 20 year period and chose to add the 20 year treasury for application to non-taxable investors.

The inflation question is one that must be dealt with for both stock and bond investors, but you will see from the early 1980s data points, the bond market compensated investors for more than the inflation that they would ultimately receive. In 1981, for example you’ll see that the 20 year treasury traded at a yield of 13.29% and the S&P traded at an earnings yield of 10.99% (a P/E ratio of 9.1x). At the end of the 20 years, the buyer of a 20 year treasury strip earned exactly 13.29% and the equity portfolio produced 15.42%. Here we observe that there was indeed a tight correlation between the two.

You correctly point out that using PAST CPI data to imply the additional forward looking return is not wise as the inflation, GDP, and political environment of the next 20 years will differ from the previous 20. For this paper, we wanted to study concrete data points that were available to the investor at the beginning of each period.
chrave1956 profile picture
Humans certainly are pattern seeking primates.
Nice work! I agree that inflation explains some of the outperformance of the stock market over the earnings yield. I would also suggest that the out performance of the stock market over earnings is due to real GDP increase. The companies that make up the stock market are worth more because of inflation and because the economy is larger. Thus for today, nominal return of entire stock market is roughly 5% earnings, plus 2% inflation plus 2% real GDP growth or ~9% a year.
Mount Dora Capital Management, LLC profile picture
Interesting analysis! John Hussman has also done some good research demonstrating that valuation measures are accurate predictors of returns 10-12 years into the future. But importantly, valuation tells you little about what path the market will take to get there. So in essence valuation provides no guidance about what will happen over the next 1-5 years. That is why we don't use valuation metrics in our trading models.
The real vs nominal returns is a valid point. In order to come up with a forecast (equation) for long-term real returns, we would have to have a forecast for long-term interest rates. When I added inflation into the regression I didn't see much pick-up in the coefficient of determination. Therefore, for this analysis we determined to let individual investors apply their own inflation scenarios to forecast long-term real returns.
joesmith323 profile picture
This is the type of analysis that John Hussman does.

It would be interesting if you had done the analysis using real rather than nominal returns.
chrave1956 profile picture
And it hasn’t help John predict much .
Thanks for the work here...very interesting read, which I'll be spending more time on.
Just a note: Prof. Siegel has an updated 5th edition (2014) of his "Stocks for the Long Run" available, which, of course, was published after the Great Recession. He added several interesting chapters- including his discussion of the financial crisis- worth a read for anyone so inclined.
That is extremely interesting. Have you done the exercise for other asset classes and/or other markets to test its viability?

It would have bern great to post the starting yields for 2000 and further as to get an idea of what to expect.

Thanks again...

We have not expanded the research into other asset classes or markets. I would imagine, depending on what asset class or market you choose, that a data feed going back to 1957 would be difficult to find.

One of the observations of an extreme high/low point mentioned in the paper was the year 2000 starting EY of 3.52%. The annualized return that we have achieved over the 18 year period (2000-2017) is tracking at 5.34%. The year 2000 vintage portfolio is on pace to produce a lower annualized return than any other observed period.

Beg. of Year E/Y P/E
1999 3.60% 27.8x
2000 3.52% 28.4x
2001 4.25% 23.5x
2002 3.38% 29.6x
2003 5.23% 19.1x
2004 4.92% 20.3x
2005 5.58% 17.9x
2006 6.12% 16.3x
2007 6.18% 16.2x
2008 5.62% 17.8x
2009 5.48% 18.2x
2010 5.10% 19.6x
2011 6.66% 15.0x
2012 7.67% 13.0x
2013 6.79% 14.7x
2014 5.81% 17.2x
2015 5.49% 18.2x
2016 4.92% 20.3x
2017 4.75% 21.1x
2018 4.68% 21.4x
why 20 year periods instead of some multiple of your avg cycle length? how predictive is ey for forward returns on 10 year rolling basis?
Niall Gannon profile picture
We chose 20 year periods to allow for multiple business cycles. The correlation between earnings yield and subsequent 10 year returns went down significantly compared to the 20 year periods. Seeing the subsequent performance of the 2000 vintage portfolio (as discussed in the conclusions) strengthened our belief that the 20 year was the most reliable period, specifically since the 2000 vintage had the lowest starting earnings yield and the lowest observed subsequent performance.
Sophocles Sophocleous profile picture
Nice job. What P/E are you showing? GAAP? Source of data?
We are using S&P Operating P/E's. Therefore, it is a non-GAAP P/E measure, in which the E excludes unusual (one-time) items.

The data was sourced from the S&P Dow Jones Indices website (http://bit.ly/1Ku5ObN) and Aswath Damondaran's S&P Earnings website (http://bit.ly/w4jRpw~adamodar/New_Home_Pag...
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