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Estimating Future Stock Returns, Follow-Up

Click to enlarge Idea Credit: Philosophical Economics Blog My most recent post, Estimating Future Stock Returns was well-received. I expected as much. I presented it as part of a larger presentation to a session at the Society of Actuaries 2015 Investment Symposium, and a recent meeting of the Baltimore Chapter of the AAII. Both groups found it to be one of the interesting aspects of my presentation. This post is meant to answer three reasonable questions that got posed: How do you estimate the model? How do we understand what it is forecasting given multiple forecast horizons seemingly implied by the model? Why didn’t the model forecast how badly the market would do in 2001 and 2008? And I will add 1973-4 for good measure. Ready? Let’s go! How to Estimate In his original piece , @Jesse_Livermore freely gave the data and equation out that he used. I will do that as well. About a year before I wrote this, I corresponded with him by email, asking if he had noticed that the Fed changed some of the data in the series that his variable used retroactively. That was interesting, and a harbinger for what would follow. (Strange things happen when you rely on government data. They don’t care what others use it for.) In 2015, the Fed discontinued one of the series that was used in the original calculation. I noticed that when the latest Z.1 report came out, and I tried to estimate it the old way. That threw me for a loop, and so I tried to re-estimate the relationship using what data was there. That led me to do the following: I tried to get all of them from one source, and could not figure out how to do it. The Z.1 report has all four variables in it, but somehow, the Fed’s Data Download Program, which one of my friends at a small hedge fund charitably referred to as “finicky”, did not have that series, and somehow FRED did. (I don’t get that, but then there are a lot of things that I don’t get. This is not one of those times when I say, “Actually, I do get it; I just don’t like it.” That said, like that great moral philosopher Lucy van Pelt, I haven’t ruled out stupidity yet. To which I add, including my stupidity.) The variable is calculated like this: (A + D)/(A + B + C + D) Not too hard, huh? The R-squared is just a touch lower from estimating it the old way… but the difference is not statistically significant. The estimation is just a simple ordinary least squares regression using that single variable as the independent variable, and the dependent variable being the total return on the S&P 500. As an aside, I tested the variable over other forecast horizons, and it worked best over 10-11 years. On individual years, the model is most powerful at predicting the next year (surprise!), and gets progressively weaker with each successive individual year. To make it concrete: you can use this model to forecast the expected returns for 2016, 2017, 2018, etc. It won’t be very accurate, but you can do it. The model gets more accurate forecasting over a longer period of time, because the vagaries of individual years average out. After 10-11 years, the variable is useless, so if I were put in charge of setting stock market earnings assumptions for a pension plan, I would do it as a step function, 6% for the next 10 years, and 9.5% per year thereafter… or in place of 9.5% whatever your estimate is for what the market should return normally. On Multiple Forecast Horizons One reader commented: I would like to make a small observation if I may. If the 16% per annum from Mar 2009 is correct we still have a 40%+ move to make over the next three years. 670 (SPX March 09) growing at 16% per year yields 2900 +/- in 2019. With the SPX at 2050 we have a way to go. If the 2019 prediction is correct, then the returns after 2019 are going to be abysmal. The first answer would be that you have to net dividends out. In March of 2009, the S&P 500 had a dividend yield of around 4%, which quickly fell as the market rose and dividends fell for about one year. Taking the dividends into account, we only need to get to 2,270 or so by the March of 2019, works out to 3.1% per year. Then add back a dividend yield of about 2.2%, and you are at a more reasonable 5.3%/year. That said, I would encourage you to keep your eye on the bouncing ball ( and sing along with Mitch … does that date me…?). Always look at the new forecast. Old forecasts aren’t magic – they’re just the best estimate of a single point in time. That estimate becomes obsolete as conditions change, and people adjust their portfolio holdings to hold proportionately more or less stocks. The seven-year-old forecast may get to its spot in three years, or it may not – no model is perfect, but this one does pretty well. What of 2001 and 2008? (And 1973-4?) Another reader wrote: Interesting post and impressive fit for the 10-year expected returns. What I noticed in the last graph (total return) is, that the drawdowns from 2001 and 2008 were not forecasted at all. They look quite small on the log-scale and in the long run but cause lot of pain in the short run. Markets have noise, particularly during bear markets. The market goes up like an escalator, and goes down like an elevator. What happens in the last year of a ten-year forecast is a more severe version of what the prior questioner asked about the 2009 forecast of 2019. As such, you can’t expect miracles. The thing that is notable is how well this model did versus alternatives, and you need to look at the graph in this article to see it (which was at the top of the last piece). (The logarithmic graph is meant for a different purpose.) Looking at 1973-4, 2001-2 and 2008-9, the model missed by 3-5%/year each time at the lows for the bear market. That is a big miss, but it’s a lot smaller than other models missed by, if starting 10 years earlier. That said, this model would have told you prior to each bear market that future rewards seemed low – at 5%, -2%, and 5%, respectively, for the next ten years. Conclusion No model is perfect. All models have limitations. That said, this one is pretty useful if you know what it is good for, and its limitations. Disclosure: None

Singapore ETFs In Focus Following Policy Easing

In a surprise move, the monetary authority of Singapore (MAS) eased policies on April 14, 2016. The step was taken to boost economic growth which halted in the first quarter of 2016. Notably, the Singapore Monetary Authority uses currency as a key tool to ease monetary policy rather than interest rates and resorted to a flat slope, budging from the prior target of a 0.5% annualized gain in the currency. However, no changes were made to the center of the band or the width, which is usually +/- 2%, per barrons.com. The preliminary estimates revealed that the economy grew 1.8% year over year in the first quarter of 2016, maintain the pace seen in the previous two quarters and slightly above 1.7% growth expected by the market. Sequentially, growth was flat on a seasonally-adjusted annualized basis, declining from 6.2% growth recorded in the fourth quarter and falling shy of the market expectation of 0.2% growth . MAS expects the economy to expand more moderately over the rest of the year. External shocks due to the slowdown in its major trading partners caused the worry. And if this was not enough, consumer prices in Singapore declined in February for 16 months in a row. So, the authority had to react to arrest the downtrend and revive this export-centric economy. The move instantly lowered the value of Singapore dollar which recorded the biggest plunge in eight months. Many analysts are speculating further policy easing given the dour economic scenario. Market Impact Though Singaporean stocks and the related ETFs have surged so far this year, the recent central bank comments point to the fact that the economy is reeling under pressure. China Renminbi devaluation and the recent weakness in the U.S. dollar also acted as headwinds to the Singaporean currency. Export-centric Asian economies like Singapore were thus forced to depreciate their currencies to stave off competitive pressure (probably) and rev up their exports while growth issues in China marred investing prospects of countries with close trade ties. However, the present situation is a bit dicey with the monetary easing opening room for growth while submissive central bank comments making investors wary. So, it is better to stay on the sidelines at the current level, wait for some definite improvement and obviously better entry points. The large-cap fund covering this economy’s equity market – iShares MSCI Singapore ETF (NYSEARCA: EWS ) – had a solid stretch in the last three-month period (as of April 14, 2016) gaining 16.9%. It has a Zacks ETF Rank #3 (Hold). We have briefly highlighted the ETF tracking the country below. EWS in Focus EWS is easily the most popular Singapore ETF on the market as it has about $550 million in AUM and an average daily volume of 1.8 million shares a day. The product charges 47 basis points a year from investors. With 28 stocks in its basket, this fund from iShares puts more than 50% of its total assets in the top five holdings, suggesting higher concentration risks. The financial sector actually makes up roughly half of the portfolio, leaving around 18% for industrials followed by 14.5% for telecommunication. EWS pays a solid yield of 4.06% annually (as of April 14, 2016), implying that it may be an income pick if payout levels hold. Original Post

Should Investors Take Notice When Reward Prospects Diminish?

The world’s central banks devise conventional and unconventional ways to depress interest rates. The impact? Consumers purchase goods and services on credit with favorable financing terms. Corporations issue low-yielding debt in order to buy back shares of their own stock. And governments issue low-yielding treasuries to continue spending far more than they generate in tax revenue. For some investors, then, the only thing that matters in the determination of whether to acquire assets like stock and real estate is ultra-low interest rate policy. On the other hand, what if the macro-economic environment is deteriorating? Should investors ignore wavering home sale trends, declining consumer sentiment, faltering retail developments, floundering total business sales, weakening economic growth on the domestic front as well as economic stagnation on the world stage? When things are getting worse, investors ought to take notice. Why? Because the central banks may not be capable of arresting the development of bear market declines indefinitely. In spite of ever-decreasing mortgage rates over the last year, do pending home sales appear to be accelerating or decelerating? They seem to be getting worse to me. Perhaps real estate asset prices have climbed to a level that even a 3.5% 30-year mortgage cannot fix. Surely, consumers are giddy about low gas prices and bountiful job opportunities, right? And yet, consumer sentiment has been trending lower and lower over the past 12 months. Perhaps consumers are spending more of their money from energy savings and fat paychecks at a variety of retailers. Nope, that’s not it. Maybe retailers are the only stragglers? Unfortunately, that’s not the case either. Corporations have been languishing to sell their goods and services since the business cycle peaked in July of 2014. Theoretically speaking, investors would want to be careful about owning companies that are selling less. One should feel more comfortable about paying up when sales per stock share are climbing. However, when revenue per stock share is wilting, one should recognize that he/she is paying an exorbitant price relative to those declining sales. The S&P 500 has not been this overvalued (1.86) since the dot-com tech wreck collapsed in the early 2000s. Well, it might be that corporate profits are all that matter. Earnings have been looking better, haven’t they? Hardly. The price investors have been willing to pay relative to GAAP S&P 500 earnings has been hitting extraordinary overvaluation levels (24x). What’s more, earnings per share have been falling each quarter since Q3 2014. Is it possible that some of these trends will reverse themselves if the underlying economics around the globe improves? After all, China may be stabilizing, Japan may be escaping its recession and the euro-zone may be gradually recovering. I am not sure there’s a whole lot of evidence for those suppositions. China’s economy just posted its slowest quarterly growth in seven years (6.7%). Japan and the euro-zone now rely on the lunacy of negative interest rate policy . The International Monetary Fund (NYSE: IMF ) just cut its global growth forecast. And world trade has not looked this anemic since the Great Recession. Bottom line? There will be a point where a lack of sales and a lack of profits will collide with the endless hope for central bank low rate manipulation. And the result is not likely to pretty. I am maintaining the lower-risk asset allocation that I have had in place for roughly a year. Specifically, we remain underweight equities for our moderate growth-and-income clients. Our current allocation of 45%-50% stock – only large-cap U.S. stock – is spread across ETFs holdings such as the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) and the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ). Our current allocation of 25%-30% to income holdings – only investment grade – is spread across ETF holdings such as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ), the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT ) and the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ). The remaining 20%-30% in cash equivalents continues to provide value as a buffer against downside volatility, as well as serve as a storage place until it is time to acquire assets at more attractive prices. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. 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