Looking Forward: Expected Returns
To estimate future real expected returns, a common method used by financial economists (as opposed to the crystal ball method used by “gurus”) is the earnings yield, or E/P, the inverse of the more commonly used price-to-earnings (P/E) ratio. The E/P produces an expected real return for U.S. stocks of about 5.3% compared with an expected real return for emerging market stocks of 7.8%.
For value investors, the case for emerging market investing is even more compelling. The table below shows the same metrics for Vanguard’s Value Index Fund (VIVAX) and DFA’s Emerging Markets Value Fund (DFEVX).
Shiller’s CAPE 10
Another commonly used metric to forecast returns is the Shiller cyclically adjusted price-to-earnings, or CAPE 10, ratio. This metric uses the last 10 years of earnings and adjusts them for cumulative inflation. The S&P 500 Index currently has a CAPE 10 of about 29.2, producing an earnings yield of 3.4%. At year-end 2016, the CAPE 10 for the emerging markets was just 12.5, producing an earnings yield of 8.0%.
We’ll pick up this discussion later in the week by looking at the importance of book-to-market ratio with a new study from Michael Keppler and Peter Encinosa, and making a case for global diversification.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.