The Underlying Difficulty in Forecasting Equity Returns

larry swedroeStarting valuations are the most reliable predictor of equity returns. But they are far from reliable, and investors must use those forecasts cautiously.

To build an investment plan, it’s necessary to estimate the return to stocks (as well as bonds and any alternative investments). The estimate of returns determines your need to take risk – how high an allocation to equities you will need to reach your goal. If your estimate is too high, it’s likely you won’t have sufficient assets to reach your retirement goal. If it’s too low, it could lead you to allocate more to equities, taking more risk than necessary. Alternatively, it could lead you to lower your goal, save more or plan on working longer.

Aswath Damodaran, one of the leading researchers on expected equity returns and author of the study, “Equity Risk Premiums (ERP): Determinants, Estimation, and Implications,” has found that the best predictor of future equity returns is current valuations – using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or for that matter, the CAPE 7, 8 or 9) or the current E/P – not historical returns. A review of the evidence led Damodaran to conclude: “Equity risk premiums can change quickly and by large amounts even in mature equity markets. Consequently, I have forsaken my practice of staying with a fixed equity risk premium for mature markets, and I now vary it year to year, and even on an intra-year basis, if conditions warrant.”