Models tell us equities are still the best game in town

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While we’re not saying they are quite up to Benjamin Franklin’s famous line ‘nothing is certain in this world but death and taxes’, recent academic papers claim that two approaches to forecasting equity market returns do have solid predictive power. So we assessed the expected 12-month returns on equity markets based on a combination of  these academic approaches with recent data updates.

The first approach, ‘sum-of-the-parts’, proposed by Ferreira and Santa-Clara[1], is based on the fact that equity market returns can be broken down into three elements: earnings growth, dividend yield and the expected changes in the price/earnings ratio (P/E). Ferreira and Santa-Clara propose the current dividend yield as the best forecaster of future dividend yields and say that earnings growth can be best forecast by its long-term trend, so they propose the use of a 20-year historical average. Since the P/E is hard to predict, Ferreira and Santa-Clara propose that it is kept constant.

The second approach is based on a dividend-discount model as proposed by Binder, Nielsen and Oppenheimer[2] and by Daly, Nielsen and Oppenheimer[3]. The model breaks down equity market returns into two elements: the expected price return and the expected dividend yield. The expected dividend yield over the coming year is estimated from analyst forecasts. The expected price return is obtained from the fair value price in one year from now compared with today’s price. The fair value price in one year is found by discounting the expected future cash flows. Important inputs to the model are the discount rate, the sum of bond yields and the equity risk premium.

As suggested by Daly, Nielsen and Oppenheimer, we use an equity risk premium that changes with the economic cycle as this reflects the fact that in poor economic climates, investors are risk averse and demand a higher equity risk premium. In such times, the discount rate is higher and the fair value of equities lower. The cyclical equity risk premium is derived from the output gap.

In this table, we show the expected returns obtained from these two approaches using earnings and dividend yield data from the I/B/E/S database and the most recent International Monetary Fund forecasts for the output gap[4].

Raoul-equity

Although these models show more modest forecasts than two years ago, the expected equity market returns remain positive despite the recent bull market. The models suggest that investors should remain invested as a continuation of the bull market is still the most probable scenario.  IMF forecasts for the output gap continue to point to a better economic outlook.

[1] Ferreira, M.A., and P. Santa-Clara. “Forecasting stock market returns: The sum of the parts is more than the whole.” Journal of Financial Economics, Vol. 100 (2011), pp. 514-537.

[2] Binder, J., E.A.B, Nielsen, and P. Oppenheimer. “Finding Fair Value in Global Equities: Part I” The Journal of Portfolio Management, vol. 36, No. 2 (2010), pp. 80-93.

[3] Daly, K., E.A.B, Nielsen, and P. Oppenheimer. “Finding Fair Value in Global Equities: Part II” The Journal of Portfolio Management, vol. 36, No. 3 (2010), pp. 56-70.

[4] Remarks: the dividend-discount model, which accounts for the cyclicality of the equity risk premium, shows higher expected returns than the sum-of-the-parts model, which does not. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performances or achievement is not indicative of current or future performance.

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Raul Leote de Carvalho

Deputy Head of Financial Engineering

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