Blog - Investing Notes

July 5, 2006 - Worldwide Equity Returns in the 21st Century

In his June 2006 article entitled "Investing in the 21st Century: With Occam’s Razor and Bogle’s Wit", Javier Estrada evaluates the long-term forecasting abilities of two simple models over 10-year periods during 1973-2005. He then uses them to predict the returns for 12 country stock markets (Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Japan, Netherlands, Switzerland, UK, USA) for 2006-2015. He finds that:

The author's Returns Decomposition Model considers the following four variables: the initial dividend yield; the expected growth of dividends; the expected growth of earnings; and, the expected change in the price-earnings ratio (P/E). It assumes that the mean annual compound growth rates for earnings and dividends over each forecasted 10-year period revert to the rates experienced from 1973 to the beginning of each prediction period. For P/E, it addresses three scenarios: (1) P/E at the end of each forecasted 10-year period reverts to the average P/E between 1973 and the beginning of each prediction period; (2) P/E remains constant at each initial value throughout the prediction period; and, (3) P/E at the end of each forecasted period is the average of the mean P/E over the five years before the prediction is made, and the mean P/E between 1973 and the beginning of those five years.

The author's Price Decomposition Model simplifies the above approach, using only the expected growth of earnings; and, the expected change in P/E to predict equity returns. [Our Reversion-to-Value Model is very similar to this simplified model, but with a starting point of 1990 rather than 1973.]

• The Returns Decomposition Model produces somewhat more accurate in-sample forecasts than does the Price Decomposition Model.
• Forecasts assuming the mean reversion of P/E produce higher correlations with actual data, but also higher mean forecast errors and higher mean absolute forecast errors.
• The models work well in some countries (including the U.S.), but poorly in others (such as Japan).
• The nominal mean annual compound rates of return for the 12 countries predicted over 2006-2015 range from 4.8% (Japan) to 13.9% (Denmark), with an average of 9.3%. The expectation for the U.S. is 8.8%.

The following chart, constructed from data in the paper, shows the nominal mean annual compound rates of return predicted over 2006-2015 for all 12 countries.

Note that our Real Earnings Yield (REY) Model, which continuously discounts earnings using the concurrent inflation rate, seeks to forecast stock market behavior over shorter intervals than those used in this article. The REY Model assumes that both earnings shocks and discount rate (inflation rate) shocks affect valuation. A potential interpretation is that a rising (falling) inflation rate pushes the market P/E down (up). Long-term reversion of P/E is therefore a consequence of long-term reversion of the inflation rate. Including the inflation rate enables us to look inside of the long reversion periods.

In summary, the author forecasts annual worldwide equity returns in the high single digits over the coming decade.

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.