# Swedroe: Assessing Expected Returns

‘Past returns don’t guarantee future returns’ isn’t even the half of it.

‘Past returns don’t guarantee future returns’ isn’t even the half of it.

At a recent meeting with a nonprofit organization, my firm was asked to explain why we don’t consider historical stock returns the best estimator of future returns. They wanted to understand why we instead rely on our own forecasts.

Their request came in part because another firm had suggested in a previous pitch that forecasts using anything other than historical returns were nothing more than opinion.

I thought sharing our response to the question posed by the nonprofit would be helpful for investors in general. First, we completely agree that investors shouldn’t make decisions based on personal opinion. Rather, investment decisions should be grounded in applicable academic research.

But before discussing the literature, we should address the issue of whether using historical returns is a logical approach in the first place. The following example may provide some insight.

From 1926 through 1948, the S&P 500 produced an annualized return of 6.3 percent. Relying on the historical record would lead you to forecast a return of the same 6.3 percent going forward. From 1949 through 1999, however, the S&P 500 returned 13.7 percent. And the return over the full period, from 1926 through 1999, rose to 11.3 percent.

Common Sense?

Thus, relying on the additional information contained in the historical record would lead you to forecast a new current expected return of 11.3 percent. Let’s see if increasing your forecast from 6.3 percent to 11.3 percent because returns were 13.7 percent over the intervening period makes sense.

On Jan. 1, 1949, the price-to-earnings (P/E) ratio of the S&P 500 was 6.6. That’s an earnings yield (E/P) of 15.2 percent. On Jan. 1, 2000, the P/E ratio stood at 29.0, producing an E/P of 3.4 percent. Does it make sense to forecast a return of 6.3 percent when the E/P is 15.2 percent, and also to forecast a return of 11.3 percent when the E/P is 3.4 percent?

The answer should be obvious. Yet that’s what you would be doing if you relied on historical returns. Common sense—which is all too uncommon—should lead you to conclude that this isn’t logical. Higher prices paid for the same dollar of earnings should lead to a forecast of lower, not higher, returns. And the academic literature demonstrates that current valuations do, in fact, provide us with the best estimate of future returns.

The following is even a simpler and clearer explanation for why using historical returns is illogical. From 1926 through 2013, the return on long-term (20-year) Treasury bonds was 5.5 percent. At the beginning of 2014, the yield on the 20-year Treasury bond was 3.7 percent. Which is the best estimate of future returns, the historical return of 5.5 percent or the current yield of 3.7 percent?

Clearly, the answer is that the current yield remains the perfect predictor of the return over the next 20 years, at least in nominal terms.

The Literature On Expected Returns

Professors Eugene Fama, a winner of the Nobel Prize, and Kenneth French are two of the most respected names in finance. In a 2001 paper—“The Equity Premium,” which appeared in the Journal of Finance—Fama and French estimated the equity premium by using dividend and earnings growth rates to measure the expected rate of capital gain.

From the abstract: “Our estimates for 1951 to 2000, 2.55 percent and 4.32 percent, are much lower than the equity premium produced by the average stock return, 7.43 percent. Our evidence suggests that the high average return for 1951 to 2000 is due to a decline in discount rates that produces a large unexpected capital gain. Our main conclusion is that the average stock return of the last half-century is a lot higher than expected.”

In short, Fama and French determined that using the historical return gave you a misleading estimate of future returns.

In the 2013 version of “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” author Aswath Damodaran examined three approaches to estimating returns: a historical approach, a survey approach and a current valuation approach.

Damodaran, a professor of finance at New York University’s Stern School of Business, explained the problem with using the historical approach: “When stock prices enter an extended phase of upward (downward) movement, the historical risk premium will climb (drop) to reflect past returns. Implied premiums will tend to move in the opposite direction, since higher (lower) stock prices generally translate into lower (higher) premiums. In 1999, for instance, after the technology induced stock price boom of the 1990s, the implied premium was 2 percent but the historical risk premium was almost 6 percent.”

Overoptimistic?

He then explained the problem with using the survey approach: “Survey premiums reflect historical data more than expectations. When stocks are going up, investors tend to become more optimistic about future returns and survey premiums reflect this optimism.

In fact, the evidence that human beings overweight recent history (when making judgments) and overreact to information can lead to survey premiums overshooting historical premiums in both good and bad times. In good times, survey premiums are even higher than historical premiums, which, in turn, are higher than implied premiums; in bad times, the reverse occurs.”

Lastly, he provided the following assessment of the valuation approach: “When the fundamentals of a market change, either because the economy becomes more volatile or investors get more risk averse, historical risk premiums will not change but implied premiums will. Shocks to the market are likely to cause the two numbers to deviate. After the terrorist attack on the World Trade Center in September 2001, for instance, implied equity risk premiums jumped almost 0.50 percent but historical premiums were unchanged (at least until the next update).”

To determine the “right” approach, Damodaran studied the predictive powers of each. He examined the returns over a 10-year period following forecasts using the three approaches. The study covered the period from 1960 through 2012. Damodaran found that the correlation of the current implied premium to actual returns over the next 10 years was 0.43. On the other hand, the correlation of the historical premium to actual returns over the next 10 years was in the wrong direction—negative 0.48.

He concluded: “The implied equity risk premium at the end of the prior period was the best predictor of the implied equity risk premium in the next period, whereas historical risk premiums did worst…. If you believe that markets are efficient in the aggregate, or at least that you cannot forecast the direction of overall market movements, the current implied equity premium is the most logical choice, since it is estimated from the current level of the index…. Historical risk premiums are very poor predictors of both short-term movements in implied premiums or long-term returns on stocks.”

A 2014 paper—“A History of the Equity Risk Premium and its Estimation” by Basil Copeland of Chesapeake Regulatory Consultants—studied this issue and came to the same conclusion as did both Fama, French and Damodaran.

Overstating?

From the abstract: “There has been general acceptance, a consensus if you will, that historical equity return premia overstate what was anticipated or expected and that a large component of the historical equity return premium constitutes unanticipated capital gains.” He too concludes that current valuations are the best predictor of future returns.

Furthermore, Vanguard’s research team studied the issue of expected returns in their October 2012 paper, “Forecasting Stock Returns: What Signals Matter, and What Do They Say Now?” Vanguard found that “many commonly cited signals have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons. These poor predictors include trailing values for dividend yields and economic growth, the difference between the stock market’s earnings yield and Treasury bond yields (the so-called Fed Model), profit margins, and past stock returns.”

Consistent with the other research cited here, the paper’s authors found that P/E ratios explain about 40 percent of the time variation in net-of-inflation returns. Their results were similar whether or not trailing earnings are smoothed or cyclically adjusted, as they are in Robert Shiller’s CAPE 10. Shiller, by the way, was awarded the Nobel Prize the same year it was given to Fama.

And finally, we’ll look at research by Cliff Asness of AQR Capital. In a November 2012 paper, “An Old Friend: The Stock Market’s Shiller PE,” Asness found that 10-year forward average real returns fall nearly monotonically as starting CAPE 10 P/E ratios increase. He also found that as the starting Shiller CAPE 10 increased, worst-case scenarios get worse and best case scenarios get weaker. He further discovered that while the metric provided valuable insight, there were still very wide dispersions of returns. For example:

• When the 10-year CAPE was below 9.6, 10-year forward real returns averaged 10.3 percent. In relative terms, that’s more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation). The best 10-year forward real return was 17.5 percent. The worst was still a pretty good 4.8 percent real return, just 2.0 percentage points below the average and 29 percent below it in relative terms. The dispersion between the best and worst outcomes was a 12.7 percentage point difference in real returns.
• When the 10-year CAPE was between 15.7 and 17.3 (about its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward real returns were 15.1 percent and 2.3 percent, respectively. The dispersion between the best and worst outcomes was a 12.8 percentage point difference in real returns.
• When the 10-year CAPE was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was 8.3 percent, still above the historical average of 6.8. However, the worst 10-year forward real return was -4.4 percent. The dispersion between the best and worst outcomes was a difference of 12.7 percentage points in real terms.
• When the 10-year CAPE was above 25.1, the real return over the following 10 years averaged just 0.5 percent—virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year forward real return was 6.3 percent, just 0.5 percent below the historical average. But the worst 10-year forward real return was -6.1 percent. The dispersion between the best and worst outcomes was a difference of 12.4 percentage points in real terms.

Later this week, we’ll discuss what we should learn from the literature presented here and how best to apply it.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.