Saturday, December 1, 2012

Vanguard's Long-range Forecast for U.S. Stocks: "Forecasting stock returns: What signals matter, and what do they say now?"

From Vanguard:
What's the long-range outlook for stocks? It depends on whom you ask.

Given the backdrop of muted U.S. economic growth, already-high corporate profit margins, elevated government debt levels, and low interest rates, some observers say the outlook is bleak. Others take a rosier view. They cite attractive valuations and a wide spread between stock earnings yields and Treasury bond yields as reason to anticipate equity returns of 8%–10% annually—close to the historical average—over the next decade
Of course, forecasting stock returns is difficult, and it's essentially impossible in the short term. That's why Vanguard encourages investors not to focus on "point forecasts" that set specific targets and instead consider the likelihood of a range of potential outcomes.

With that in mind, our long-range expectations for U.S. stocks are generally positive. Recent analysis based on the Vanguard Capital Markets Model, our proprietary financial simulation tool, projects that nominal returns in the 6–9% range are the most likely outcome for U.S. stocks over the next 10 years.
That's not to say that significantly lower or higher returns are out of the question, of course. Any such prediction would be foolish. Rather, in our view, those outcomes are statistically less likely based on current market conditions.

The chart below shows our projections for both nominal (unadjusted) and real (inflation-adjusted) stock returns for 1- and 10-year periods beginning in June 2012. We've assessed the probability of many different scenarios—from a painful downturn to an exuberant bull market—with what we feel are the most likely outcomes clustered in the middle:

Figure 1: Projected nominal U.S. stock returns, 2012–2022
Projected nominal U.S. stock returnsFigure 2: Projected real U.S. stock returns, 2012–2022 Projected real U.S. stock returns
Source: Vanguard. See below for a description of the Vanguard Capital Markets Model's methodology.
Here's the paper:

Forecasting stock returns: What signals matter, and what do they say now? (20 page PDF)

The authors show that P/E10 has the greatest predictive power:
and here is a good chart from the paper:

With trend earnings growth, 10-year Treasury yield. corporate profit margins. trailing one-year stock returns having almost zero predictive skill.

HT: Mebane Faber at The Idea Farm