Larry Swedroe's latest market returns forecast

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MikeMak27
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Larry Swedroe's latest market returns forecast

Post by MikeMak27 »

"Many investors are questioning the benefits of international diversification at a time when U.S. equity valuations are now quite a bit higher than international valuations. And because current valuations are the best predictor we have of future returns, international investments now have higher expected returns. At the end of September 2016, the Shiller CAPE 10 ratio for the S&P 500, which uses the last 10 years' earnings (adjusted for inflation), produced an earnings yield (or E/P, the inverse of the P/E ratio) of about 3.7%.
To adjust for the fact that real earnings grow over time, and for the fact that we are looking at earnings on average five years old, we need to multiply the earnings yield by 1.1, producing a new earnings yield, and a forecast of expected real return, of about 4.1% for the S&P 500. The CAPE 10 ratio for the MSCI EAFE Index produces an earnings yield of about 6.7%, resulting in an expected real return for the stocks in that index of about 7.4%. And the CAPE 10 ratio for the MSCI Emerging Markets Index produces an earnings yield of about 7.3%, resulting in an expected real return for the stocks within that index of approximately 8.0%." -Larry Swedroe from the article ‘Free Lunch’ Investing Takes Time To Cook

http://www.etf.com/sections/index-inves ... nopaging=1

This research and article on expected future returns contradicts Bogle's most recent statement that he "wouldn't risk investing outside the U.S."
For those of you who have been struggling with sticking with international stocks in their allocation, this helps support our view on stock diversification. Don't let the recency bias affect your decision making.

Special thanks to Larry for his yeoman's work on research!
Mak 3 fund portfolio: 50% US small cap value & US Small cap (IJS, IJR), 40% Emerging Markets (IEMG, VWO, FPADX), 10% US REIT (VNQ)
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warowits
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Re: Larry Swedroe's latest market returns forecast

Post by warowits »

My concern with emerging markets is China makes up such a large part of vwo that it really isn't all that diversified across countries.

Say hypothetically you have a 30 year time horizon and a slightly above average need to take risk. Would you go 50% total US market, 30% international and 20% emerging markets?

If 4% real returns persisted wouldn't that torpedo most people's retirement plans who are in their accumulation phase? I certainly have never run the numbers assuming 4% from stocks.
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MikeMak27
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Re: Larry Swedroe's latest market returns forecast

Post by MikeMak27 »

I don't think it is mentioned in this specific article, but when Larry previously gave the expected return for the S&P 500 of 4.1%, it was for the next decade, not for the next 30 years. That said, if a 4.1% annual S&P 500 return does happen over 10 years, that certainly would be a blow for many a retirement and pension funds.
Mak 3 fund portfolio: 50% US small cap value & US Small cap (IJS, IJR), 40% Emerging Markets (IEMG, VWO, FPADX), 10% US REIT (VNQ)
JoinToday
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Re: Larry Swedroe's latest market returns forecast

Post by JoinToday »

Vanguard's recommendation is 40% of equity is international.

I am sitting at 30% of equity in international.

Last time I took Larry Swedroe's advice, I made a killing. I bought a bunch of TIPS based on his recommendation, and sold when the rates dropped and went negative.

I may have to increase my international based on his recommendation.
I wish I had learned about index funds 25 years ago
tbradnc
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Re: Larry Swedroe's latest market returns forecast

Post by tbradnc »

Whatever happened to "The forecasting skills of gurus."?

(respectfully)
BrklynMike
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Re: Larry Swedroe's latest market returns forecast

Post by BrklynMike »

Great and timely article. After listening to Bogle's recent speach, it really had me questioning why I was investing partially in international. This article makes a compelling case.
"In a world of uncertainty, one should focus more on the consequences than the probabilities." - Benjamin Graham
Beliavsky
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Re: Larry Swedroe's latest market returns forecast

Post by Beliavsky »

MikeMak27 wrote:I don't think it is mentioned in this specific article, but when Larry previously gave the expected return for the S&P 500 of 4.1%, it was for the next decade, not for the next 30 years. That said, if a 4.1% annual S&P 500 return does happen over 10 years, that certainly would be a blow for many a retirement and pension funds.
Don't forget his "real" qualifier. A 4.1% real return means about 6.1% nominal.
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

couple of things
The forecast of real returns is referred to as unconditional. Doesn't matter the term. Now obviously at shorter horizons it will not have as much predictive power.

Also the forecast must be treated as only the mean of a very wide potential dispersion of returns. Even at 10 years you need to add and subtract about 8% on either side to cover all past outcomes. That's RISK.

As to forecasts of gurus, that refers to people who forecast based on OPINIONS, like the P/Es will change, or whatever. The type of formulistic approach, whether Gordon or CAPE 10 model is different. They have explanatory powers, though with still wide ranges.

Larry
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GreatOdinsRaven
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Re: Larry Swedroe's latest market returns forecast

Post by GreatOdinsRaven »

Another great article from Larry.

I was checking my Vanguard accounts last night using the phone app and I noticed that Vanguard is now recommending 30-50% international equities when using their portfolio analysis tool. The last time I checked they were recommending up to 40% (though that is probably stale info- I don't check very often). I'm at 40%, myself.

We all know how Jack feels.

At Bogleheads we also heard Bernstein and even Gus Sauter shy away from such high allocations (specifically the 40% and ~market cap 50% allocations) citing most of our future liabilities are payable in USD.

Does DFA recommend something similar in their model portfolios?

I realize there's no "right" answer, but does Vanguard (and ?DFA?) recommend true world equity market cap weighting because of higher expected returns or is it because they are striving to have truly market cap weight portfolios for the sake of having total equity portfolios that won't lag the returns of a world market cap index?
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SeeMoe
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Re: Larry Swedroe's latest market returns forecast

Post by SeeMoe »

I often wonder why old man Bogle is so down on international stocks when they make up about 55% of the world markets? What does he say about the international bond market which, I think, is even a bigger share of the world markets? Plus he is in total contrarian mode to his beloved Vanguard Group model who recommends 40% of a folio being international stocks! My folio was positioned by Vanguard between 30%|40% international and is currently just over 38%. Larrys comments per international stocks are encouraging for this old investor, and appreciated.

SeeMoe.. :D
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GreatOdinsRaven
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Re: Larry Swedroe's latest market returns forecast

Post by GreatOdinsRaven »

SeeMoe wrote:I often wonder why old man Bogle is so down on international stocks when they make up about 55% of the world markets? What does he say about the international bond market which, I think, is even a bigger share of the world markets? Plus he is in total contrarian mode to his beloved Vanguard Group model who recommends 40% of a folio being international stocks! My folio was positioned by Vanguard between 30%|40% international and is currently just over 38%. Larrys comments per international stocks are encouraging for this old investor, and appreciated.

SeeMoe.. :D
And, at least on the Vanguard app they're saying up to 50% Intl is recommended...
"The greatest enemies of the equity investor are expenses and emotions." -John C. Bogle, Little Book of Common Sense Investing. | | "Winter is coming." Lord Eddard Stark.
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matjen
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Re: Larry Swedroe's latest market returns forecast

Post by matjen »

GreatOdinsRaven wrote: Does DFA recommend something similar in their model portfolios?

I realize there's no "right" answer, but does Vanguard (and ?DFA?) recommend true world equity market cap weighting because of higher expected returns or is it because they are striving to have truly market cap weight portfolios for the sake of having total equity portfolios that won't lag the returns of a world market cap index?
I just quickly popped DFA's 2050 Target Date Fund into Morningstar. Dimensional 2050 Target Date Retirement Income Fund Institutional Class DRIJX. It is 35% International 58% US and the rest bonds/cash.

http://portfolios.morningstar.com/fund/ ... ture=en_US
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Random Walker
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Re: Larry Swedroe's latest market returns forecast

Post by Random Walker »

Markets have been generous last 7 or 8 years. It's a good time to take a look at ones AA and decide if it's a good time to take some chips off the table. If so, I think a rational thing to do is take from the US equity allocation and add to fixed income. Assuming most of us are less than 50% equities international, this will achieve a few different things. It will move ones equity allocation closer to the world market cap weighting of 50% US / 50% International, it will increase expected returns of the equity portion of the portfolio, it will increase diversification of the equity side, it will decrease overall portfolio risk and expected return. Overall I would expect this adjustment to increase portfolio efficiency. I recently did this when I moved from about 70/30 to 60/40.

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Re: Larry Swedroe's latest market returns forecast

Post by garlandwhizzer »

Great article, Larry, thanks for posting. I completely agree that INTL diversification is likely to pay off in the future. I believe that INTL and EM in particular are very likely to outperform US including US SCV, US MOM, and US multi-factor funds in the future. Much discussion occurs in this Forum on US centric factor investing as a prime potential source for future outperformance. I may be wrong but I believe this focus misses what is by far the best chance to substantially outperform the S&P 500 going forward. It is not by active management or factor approaches for US based equities but by increased exposure to asset classes that are markedly undervalued at this time, INTL and even more so, EM. I think a rational argument for 50% US and 50% INTL in the equity space can be made at this time and in fact that is where my allocation is. Furthermore I overweight EM in INTL (50% EM 50% DM).

I believe there is a serious and under-appreciated long term risk for those who have loaded up very heavily on assets that have not only outperformed but have been less volatile and less risky in recent years, areas like US LC dividend stocks, Low Vol, Utilities, and Treasuries. Such a portfolio has provided emotional balm plus robust returns in the recent past. It's risk lies hidden far in the future: running out of money late in retirement due to lower expected future returns and longer longevity. It is important to recognize that although inflation is modest and expected to remain so for years, health care and long term care costs have increased at about twice the inflation rate for a long time and these two areas can soak up a lot of retirement assets. For those who have an asset base sufficiently large that expected low returns will not be a problem should they live to be 95 and require years of long term care, a conservative low risk approach is entirely appropriate. For the rest of us, as I view it, the question is: Do you choose to take your risk now with what appear to be riskier assets or defer your confrontation with risk into the distant future?

Garland Whizzer
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Garland
I agree with the caution that I would not want to lose the diversification benefits of US stocks. So I'm sticking with my roughly 50/50 allocation, as that is way world allocates capital. With that said in early this year I made my first new allocation to equities in about 20 years, when looked to me that EMV and ISV had gotten really cheap especially relatively. So I added some significant investments to DISVX and DFEVX--but keep in mind that I have a very low equity allocation. There's also a reason for the lower valuations of international stocks--they are viewed as more risky, so not a free lunch.
But yes clearly they have much higher expected returns, much higher.

And here's the point so many investors miss, including Saint Jack, those higher expected returns allows you to hold less market beta risk, reducing your exposure to global systemic risks and significantly cutting your tail risks. Avoiding or minimizing international equities comes with a cost of greater downside risk.

Larry
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Re: Larry Swedroe's latest market returns forecast

Post by dabblingeconomist »

I think this is a very good heuristic for forecasting long-term market returns.

That said, there a few complications. The underlying assumption here is that equities' total real return will equal their earnings - which will either be paid out via dividends and buybacks, or reinvested at the same rate of return in the company.

But there are all kinds of distortions that make "accounting earnings" different from true economic earnings. For instance, earnings largely ignore the effects of inflation. This means that historical-cost depreciation overstates earnings (because historical costs < current costs due to inflation), while deducting nominal interest on debt understates earnings (because the capital gain from the declining real value of debt is ignored). Fortunately, these effects seem to mostly cancel out.

More importantly, earnings exclude many unrealized (real) capital gains and losses within the firm. Rising land values, rising values of an entrenched market position, rising values of intellectual and organizational capital, etc., mostly don't appear on an income statement yet reflect an increase in the true value of a firm. Overall, these are probably positive in the aggregate, and if US has 2.5% trend real GDP growth I wouldn't be surprised if they amount to at least 1%. Thus, I might bounce up the real return estimate for the US to 5%.

Other countries, especially developing countries, have much sketchier accounting conventions for corporate earnings than the US, which means that the headline E/P can actually overstate their earnings. (One notable piece of evidence: the US somehow has much higher payout ratios despite having lower E/P! For rapidly growing countries, this makes sense due to high reinvestment rates, but more stagnant countries don't have this excuse.) This is offset in some cases by higher expected real capital gains within firms, but overall it makes forecasting returns quite difficult.

A few other medium-term considerations:
  • All else equal, international equities are a bit better than they look because the dollar's recent rise will likely mean-revert over time.
  • High valuations today partly reflect very low short-term bond yields, and they will fall as bond yields rise. This means that the expected return over the next few years may well be below 4% real - maybe, say, 2% real (which still handily beats the -1% real yields on bonds). But this expected decline in valuations will boost the long-return return from stocks and be a boon to long-term investors who are still in the accumulation phase, or who are implicitly accumulating through the reinvestment of dividends and buybacks.
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Re: Larry Swedroe's latest market returns forecast

Post by juliewongferra »

JoinToday wrote:
Last time I took Larry Swedroe's advice, I made a killing. I bought a bunch of TIPS based on his recommendation, and sold when the rates dropped and went negative.

I may have to increase my international based on his recommendation.
Well, then you better NOT take his advice this time, because instead of making a killing, you will get killed. Humans (and computers!) can't predict the future with any accuracy--it's a 50/50 coin flip. Consider yourself lucky that you won the last recommendation; but Larry's due to be wrong!

cheers!
jwf
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Re: Larry Swedroe's latest market returns forecast

Post by Northern Flicker »

warowits wrote:My concern with emerging markets is China makes up such a large part of vwo that it really isn't all that diversified across countries.
The better way to think about it is that if you diversify int'l to include emerging markets, you are reducing the concentration of allocation to countries like Japan and UK in your int'l holdings. Market weight of vwo (EM index fund) is about 20% of int'l (probably closer to 18.5%). That puts China at a much lower concentration in the total int'l allocation than several DM countries.

Also vwo now tracks an index that includes China A-shares. Total int'l indices have not (yet) added China-A exposure, so just holding a total int'l fund will lower exposure to Chinese equities relative to a market weight allocation to vea (DM index fund) and vwo. But if you want to hold EM equities and aren't sure about the allocation, it is probably a good idea to stick to a market cap weight allocation.
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Re: Larry Swedroe's latest market returns forecast

Post by FIREchief »

Since nobody ever found a consistent way to accurately forecast returns in the past, I'm just not buying in to any of this. Stick with a reasonable asset allocation, don't react to the market's short term volatility and, when it comes to foreign, either "in or out of the water." 8-)
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patrick013
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Re: Larry Swedroe's latest market returns forecast

Post by patrick013 »

garlandwhizzer wrote:Furthermore I overweight EM in INTL (50% EM 50% DM).
Who can say if Intl will repeat last year's performance. But if earnings
and growth and then increased valuations are seen as being favorable
by analysts that can see them and investors then your AA looks in sync
with analysts' foresight. I might go for 33% DM 33% EM and 34% ISC but
be sure the ISC has ample or even 100% EM exposure in the Intl stock AA.
Perhaps recent Intl optimism especially EM will leave value prices behind
and growth prices to the forefront. I'd be aggressive to a small degree.
garlandwhizzer wrote: Do you choose to take your risk now with what appear to be riskier assets or defer your confrontation with risk into the distant future?
I don't think they're risky they just don't return as much. So you really want more
stocks but enough bonds to survive a financial crisis, even one of several years.
The dividend stock funds are just a retirement play, sure, for stable income, but
in a flat market with low interest they do what they're predicted to do. When
earnings rise and stocks rise we'll have better choices for withdrawals then.
age in bonds, buy-and-hold, 10 year business cycle
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Firechief
What we do know is that the research, from both Vanguard and Professor Damadoran and AQR team among others is all consistent. The best way to forecast returns is to use current valuations (either spot or CAPE 10 produce roughly same explanatory power, about 40%). Obviously it is NOT going to be a very high number because the SPECULATIVE return (the change in the P/E) cannot be forecasted, at least there is no evidence that it can. That's because it's dominated by surprises which by definition cannot be forecasted. With that said you have to forecast returns with the information you have that is the best, because otherwise there is no rational way to decide how much risk you need to take. So we use the BEST tool we have while understanding that it gives only a mean of a very wide potential dispersion of returns, and thus we must be humble about the forecast. It's why one should use MCS to show you the estimated ODDS of success, and not use any point estimates.
larry
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

larryswedroe wrote:So we use the BEST tool we have while understanding that it gives only a mean of a very wide potential dispersion of returns, and thus we must be humble about the forecast.
A tool can be the BEST tool of all the tools at your disposal, but still be a terrible tool.

For instance, if you have a hammer, a saw, and a forklift, the hammer can be considered the BEST tool to use with screws, but it is still a pretty ill-suited tool for the task.

A forecast of 4.1% with an error band of 8% is not worth much. -4% to 12% long-term is a pretty safe estimate since that covers most of the past hundred years actual returns.

Note your tool forecast a little over 4% six years ago in 2010 as well. And instead we've gotten around 12%... lucky you have that plus or minus 8% band... so technically your estimate was still correct!!

It is good that you are humble about the forecast. I respect that.
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Re: Larry Swedroe's latest market returns forecast

Post by malabargold »

Guess Bogle is right: Doing nothing is the hardest thing
for investors to do.
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FIREchief
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Re: Larry Swedroe's latest market returns forecast

Post by FIREchief »

HomerJ wrote:
larryswedroe wrote:So we use the BEST tool we have while understanding that it gives only a mean of a very wide potential dispersion of returns, and thus we must be humble about the forecast.
A tool can be the BEST tool of all the tools at your disposal, but still be a terrible tool.

For instance, if you have a hammer, a saw, and a forklift, the hammer can be considered the BEST tool to use with screws, but it is still a pretty ill-suited tool for the task.

A forecast of 4.1% with an error band of 8% is not worth much. -4% to 12% long-term is a pretty safe estimate since that covers most of the past hundred years actual returns.

Note your tool forecast a little over 4% six years ago in 2010 as well. And instead we've gotten around 12%... lucky you have that plus or minus 8% band... so technically your estimate was still correct!!

It is good that you are humble about the forecast. I respect that.
+1. There is no science here, despite all the calculations and data. It is just speculation and guessing. To me, "humble about the forecast" would be a clear acknowledgement that "we just don't know" (just as Homer humbly admitted to using a hammer as a screwdriver!) :D :sharebeer

jk Homer...
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Homer
Sorry I totally disagree with you because there is huge value in knowing say that the mean is 8% or 4%. And it's also important to know how wide the band is. Note very simply that you have a much greater chance of achieving an 8% return when the forecasted mean is 8% than when the forecasted mean is 4%. And you have a much greater chance of having negative returns when the forecasted mean is 4%. Investing will always be about uncertainty because we cannot know what risks will show up, but we know that valuations matter and they matter a great deal.

And I would add that there is no speculation or guessing, it's just math.

Best wishes
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by Johnnie »

FIREchief wrote: Stick with a reasonable asset allocation, don't react to the market's short term volatility and, when it comes to foreign, either "in or out of the water."
Sounds right to me. As a comparatively new buy-hold-rebalance investor I am still transitioning from my old mess of portfolio to a disciplined slice-and-dice including international and EM. The only decision left - to be made and excecuted no later than mid-January - is how much international.

I'm at 40 percent now - should I go to 50? It's just an amusing a parlor game, because no one can say, and 10 percent one way or t'other won't mean squat. Hey, I'm having fun.

But as Firechief says, once that decision is made it will be "in the water" for good for me - that will be the allocation for the long haul and no messing with it later (aka 'timing').
"I know nothing."
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

larryswedroe wrote:And I would add that there is no speculation or guessing, it's just math.
You don't have enough data points. It can indeed be math, but without enough data points, it absolutely can also be speculation and guessing.

And it's not like we're talking about a closed static system. We may NEVER have enough data points, because things change. Data points from 1913 or 1943 or even 1973 may not apply to today.

The Schiller CAPE 10 (invented in 1988) has been absolutely terrible at forecasting returns almost immediately after its invention. In 1996, Schiller used his model to forecast 0% long-term real returns. Instead they have been 7%-8%. How many decades can a model fail before one begins to question the model?
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Homer
You don't even need many data points here, it's simply common sense, like with using the Gordon model which doesn't require any data points at all.
Think of it this way, do you need data points to predict bond returns? No you know the yield is the expected return. Well the same is basically true with stocks, the earnings yield is the expected return, assuming valuations don't change, which is the best you can do. We know they will change, but not when or in what direction. That is what you use MCS for, to give you estimate of the odds of success based on the earnings yield and then of course you have to make assumptions about the SD and there we have to rely on history, which is pretty long enough at now over 90 years.
So we'll just disagree here.
Note all over the world companies are required to use this type method to forecast returns to determine their funding of pensions. So most of the world disagrees with you.
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by nedsaid »

larryswedroe wrote:Homer
You don't even need many data points here, it's simply common sense, like with using the Gordon model which doesn't require any data points at all.
Think of it this way, do you need data points to predict bond returns? No you know the yield is the expected return. Well the same is basically true with stocks, the earnings yield is the expected return, assuming valuations don't change, which is the best you can do. We know they will change, but not when or in what direction. That is what you use MCS for, to give you estimate of the odds of success based on the earnings yield and then of course you have to make assumptions about the SD and there we have to rely on history, which is pretty long enough at now over 90 years.
So we'll just disagree here.
Note all over the world companies are required to use this type method to forecast returns to determine their funding of pensions. So most of the world disagrees with you.
Larry
I am of the strong opinion that valuations matter and matter a whole lot. There are always those who disagree and I see the usual suspects from other threads debating the issue here. I agree with Larry here, forecasts of future expected returns based on valuations give us some idea of the returns we might get in the future. In your retirement planning, you have to use some sort of assumptions, no model will work if there are no numbers to plug in. Numbers are pretty useless if you don't know the assumptions behind them.

What Larry is doing is a conservative approach to future estimated returns, he is saying that US Markets will likely have subdued returns in the future because of their higher valuations. To me, this is a whole lot better than just assuming historical returns. When I had Ameriprise do some financial planning for me, they assumed historical returns which I think is overoptimistic.

John Bogle does exactly the same thing, I have seen him on Morningstar making similar forecasts. I suggest we follow the example of our mentor.
A fool and his money are good for business.
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

I would add this ---Shiller didn't "discover" this idea of smoothing earnings by using a longer term average. The credit goes to Graham and Dodd who said this like 80 years ago. They thought that earnings were too volatile to use just a single current year's earnings to forecast returns. So they suggested a longer term average. Note you get almost the same results whether you use 7,8, 10 or 12 years. Which I would add gives you confidence that you are not data mining. And I would add that you get similar results even using current year earnings.
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by GreatOdinsRaven »

larryswedroe wrote:I would add this ---Shiller didn't "discover" this idea of smoothing earnings by using a longer term average. The credit goes to Graham and Dodd who said this like 80 years ago. They thought that earnings were too volatile to use just a single current year's earnings to forecast returns. So they suggested a longer term average. Note you get almost the same results whether you use 7,8, 10 or 12 years. Which I would add gives you confidence that you are not data mining. And I would add that you get similar results even using current year earnings.
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

nedsaid wrote:What Larry is doing is a conservative approach to future estimated returns, he is saying that US Markets will likely have subdued returns in the future because of their higher valuations. To me, this is a whole lot better than just assuming historical returns.
But in 1996, we had high valuations. And people (not just people, the AUTHOR of the model) predicted subdued returns. Yet instead, we got historical returns over the last 20 years.

Look, you guys are probably right... Trees don't grow to the sky. Markets can't go up forever. But we are talking long-term returns. I see no problem with predicting a crash or a long 5-10 year sideways market, but then it could be followed by another bull market... which means maybe we'll find ourselves with an average 20 or 30 year return that matches historical returns again.

Look, I could be wrong. Maybe indeed we'll see 4% real returns over the next 30 years as the model has predicted.

BUT SO FAR THE MODEL HAS BEEN WRONG.

So I can't figure out why you guys are so sure it's right. 1996 predictions were way off... not a little... WAY OFF... Larry's 2010 predictions, so far, have been way off... not a little... WAY OFF... When you predict 4% a year in 2010, and we get 12% a year instead since then, I find it absolutely ridiculous that you can claim your model should absolutely be trusted as "math".

But again, I could be wrong. I just wish you guys would admit you too, could be wrong.
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Re: Larry Swedroe's latest market returns forecast

Post by Rainier »

Anyone who thinks valuation doesn't matter can buy my house. Price is $2m. 3 beds, 2.5 baths, great schools. Nothing else matters, cause you're never selling.
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Re: Larry Swedroe's latest market returns forecast

Post by nedsaid »

HomerJ wrote:
nedsaid wrote:What Larry is doing is a conservative approach to future estimated returns, he is saying that US Markets will likely have subdued returns in the future because of their higher valuations. To me, this is a whole lot better than just assuming historical returns.
But in 1996, we had high valuations. And people (not just people, the AUTHOR of the model) predicted subdued returns. Yet instead, we got historical returns over the last 20 years.

Look, you guys are probably right... Trees don't grow to the sky. Markets can't go up forever. But we are talking long-term returns. I see no problem with predicting a crash or a long 5-10 year sideways market, but then it could be followed by another bull market... which means maybe we'll find ourselves with an average 20 or 30 year return that matches historical returns again.

Look, I could be wrong. Maybe indeed we'll see 4% real returns over the next 30 years as the model has predicted.

BUT SO FAR THE MODEL HAS BEEN WRONG.

So I can't figure out why you guys are so sure it's right. 1996 predictions were way off... not a little... WAY OFF... Larry's 2010 predictions, so far, have been way off... not a little... WAY OFF... When you predict 4% a year in 2010, and we get 12% a year instead since then, I find it absolutely ridiculous that you can claim your model should absolutely be trusted as "math".

But again, I could be wrong. I just wish you guys would admit you too, could be wrong.
John Bogle in 1999 noted how high P/E ratios got and he projected a 2% return for stocks and 6%-7% return for bonds and wondered why he should own stocks at all. He does 10 year forecasts and in this case was eerily accurate. The US Stock Market was pretty much flat from 2000 through about 2012 and bonds did great. Bogle also noted that if the forecast is wrong for one decade, the market will make up for it during the next decade.

These are approximations and educated guesses. We can more accurately predict the business or economic return of the markets as they are based on economic and corporate earnings growth. Historically, corporate earnings growth is about 5% a year. Though predictions of future earnings are certainly not infallible, they can be based on history. What makes future stock prices hard to predict is what the market will pay for a dollar of earnings. Historically, that number is about 16 or 17. During my lifetime, that has ranged from about 8 to 45, which pretty much is a measure of investor enthusiasm. Human emotion is almost impossible to predict.

Bogle breaks this down into business return and speculative return. Business return is much easier to predict than speculative return. Business return reflects actual business results and speculative return measures human emotion.

We have been saying that future expected returns are inexact but they give you some idea of what an investor should expect. Your argument is simply a dismissive "it is all bunk."

In 1995, it could have been argued that P/E's were too high. A chart that I have of historical P/E's show that they were about 25 in 1995 and went to about 45 in early 2000. The 1996-early 2000 market move up was mostly speculative return. An investor was willing to pay $25 for a dollar of earnings in 1995 and $45 in early 2000. Seeing the average P/E ratio for stocks zoom up and up and up should have given investors pause.

As I recall, corporate earnings pretty much doubled during the 2000's but P/E ratios fell from 45 down to about 15. So the fall in what investors were willing to pay for a dollar of earnings just about matched the increase of actual earnings. So from 2000 through 2012, the US Stock Market was essentially flat though we saw nice increases in earnings.

So Homer, would you rather pay $45 for a dollar of earnings rather than $8 per dollar of earnings? I think you would pick $8 rather than $45. If my local store advertises toilet paper 50% off, I will stock up and not write essays about the efficiency of toilet paper markets.

What you are reacting to is the change of speculative return which no one could predict. You are 100% correct on this. But if the average P/E is 16 and the market P/E is at 8, the odds are pretty good that speculative return will enhance stock returns above the business return. If the average historical P/E is 16 and the market P/E is 45, odds are pretty darned good that speculative return will be a drag on stock performance and perhaps cancel out your business return. It is just putting the odds in your favor.

If a guy on a street corner is offering to buy toilet paper rolls for $10 each when I can buy them for $1 a piece at the store, it doesn't take a genius to figure out what I will do. I will happily do my part to arbitrage the toilet paper markets and make a killing. Again if toilet paper is marked down from $1 a roll to 50 cents when all the other stores sell them for $1, I will stock up.

So when you say that stock market forecasts are flawed, I am with you 100%. When you say it is all bunk, you have lost me 100%. Pretty much what you are saying is that markets don't revert to the mean when clearly they do.
A fool and his money are good for business.
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Homer
First you state that we have had historical stock returns since 1995. That is incorrect. Returns have been below historical returns. Through 1995 the return to the S&P 500 was 10.7%. And real return 7.6%. Since then below historical at 8.7%. That's 2% below the nominal historical return. Also the real return was 6.1, also below by 1.5%. So the high valuations did accurately forecast less than average returns, and did so pretty well as the forecast using the CAPE 10 at end of 1995 would have been real return of 4.4%, so we are off just 1.7%. Certainly well within the expected range around the MEAN return expected by using the CAPE 10.And fairly close the mean expected return.

Now take the data since March 2000 when the market peaked. The S&P returned just 4.8% nominal and just 2.7% real. The CAPE 10 would have predicted a real return of 2.6%. Still think the data is USELESS as you say? How much more accurate can you have been? Now no one expects or should not expect that kind of accuracy. It's meant as I said to just be the mean of a wide possible dispersion.

Best wishes
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by FIREchief »

larryswedroe wrote:Homer
You don't even need many data points here, it's simply common sense,
Very little about predicting the future is "simply common sense." It might be nice if it was!
larryswedroe wrote: assuming valuations don't change, which is the best you can do. We know they will change, but not when or in what direction.
Which invalidates any assumption that anybody will make.
larryswedroe wrote: then of course you have to make assumptions about the SD and there we have to rely on history
Relying on history to predict the future is extremely risky.
larryswedroe wrote:Homer
Note all over the world companies are required to use this type method to forecast returns to determine their funding of pensions. So most of the world disagrees with you.
If our pension systems were robustly funded, then this might be a valid argument. Most are far from it.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

larryswedroe wrote:Homer
First you state that we have had historical stock returns since 1995. That is incorrect. Returns have been below historical returns. Through 1995 the return to the S&P 500 was 10.7%. And real return 7.6%. Since then below historical at 8.7%. That's 2% below the nominal historical return. Also the real return was 6.1, also below by 1.5%. So the high valuations did accurately forecast less than average returns, and did so pretty well as the forecast using the CAPE 10 at end of 1995 would have been real return of 4.4%, so we are off just 1.7%. Certainly well within the expected range around the MEAN return expected by using the CAPE 10.And fairly close the mean expected return.
You are correct that the return has been slightly lower than historical. I stand corrected. My apologies.

You are incorrect that the forecast in 1996 was for a real return of 4.4%. Shiller himself, the man who won a Nobel Prize and the man who created the CAPE model that you are using, wrote a paper in 1996 predicting a 0% real return, not a 4.4% return...

http://www.econ.yale.edu/~shiller/data/peratio.html

He, at least, stated this in his paper...
The conclusion of this paper that the stock market is expected to decline over the next ten years and to earn a total return of just about nothing has to be interpreted with great caution.

Our search over economic relations that us to study the price divided by 30-year moving average of earnings may have stumbled upon a chance relation with no significance. In other words, the relation studied here might be a spurious relation, the result of data mining. Neither the statistical tests nor the monte carlo experiments take account of the search over other possible relations.
He did not state... "It's 100% true. It's just simple math!"
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Re: Larry Swedroe's latest market returns forecast

Post by Kevin M »

HomerJ wrote: The Schiller CAPE 10 (invented in 1988) has been absolutely terrible at forecasting returns almost immediately after its invention. In 1996, Schiller used his model to forecast 0% long-term real returns. Instead they have been 7%-8%. How many decades can a model fail before one begins to question the model?
Hmm. I calculate the 20-year real return of S&P 500 for period ending June 2016 as 5.9% using Shiller data, so closer to 6% than to 7-8%. CAPE in July 1996 was 24.86, which if inverted gives a CAPE earnings yield of 4.02%. Given the uncertainty of the expected return estimate based on earnings yield, as Larry has explained, this seems reasonable (it would seem reasonable even if it were much further off).

Similarly, dividend yield in July 1996 was 2.24%, so using a simple dividend discount model with 1.5% real earnings dividend growth gives an expected return of about 3.7%, so same as the earnings yield estimate to one significant figure (which is probably as much as we should use), and same comments about the uncertainty of the estimate apply.

There is large dispersion in the distribution of realized returns compared to the expected return estimates using either earnings yield or dividend yield plus real earnings growth, so it shouldn't be at all surprising to see the most recent 20-year realized return we've seen given the starting valuations.

Kevin
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Re: Larry Swedroe's latest market returns forecast

Post by caliguy1 »

Larry,

Do you also take into account where we are in the credit cycle? Ray Dalio thinks we're at the end of the long term debt cycle, similar to the mid-1930s, where the central banks are running out of tools and pushing on a string. If it's similar to the mid-1930s we could have ~20 years with zero to negative gains (at today's extremely high US valuations). So there could be a 40-50% drop in equities soon.

I found this article quite illuminating: http://www.cmgwealth.com/ri/radar-end-l ... ebt-cycle/

I listened to a podcast where they said Warren Buffett and other top investors take into account where we are in the credit cycle when deciding how much to buy into equities.
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

Kevin M wrote:
HomerJ wrote: The Schiller CAPE 10 (invented in 1988) has been absolutely terrible at forecasting returns almost immediately after its invention. In 1996, Schiller used his model to forecast 0% long-term real returns. Instead they have been 7%-8%. How many decades can a model fail before one begins to question the model?
Hmm. I calculate the 20-year real return of S&P 500 for period ending June 2016 as 5.9% using Shiller data, so closer to 6% than to 7-8%. CAPE in July 1996 was 24.86, which if inverted gives a CAPE earnings yield of 4.02%.
You are using ex post facto data. In 1996, Shiller did not have 20 years of data where equities have been overvalued pretty much all the time.

In 1996, a CAPE of 25 was the highest it had been since right before the Great Depression in 1929. It was ridiculously high, scary high. And Shiller himself forecast 0% real returns. I love the fact that you guys can argue against Shiller's own predictions.

Sure, you can look at data since then, and see that a CAPE of 25 hasn't returned 0%, and then GO BACK and state that in 1996, the prediction should have been 4% or 5% real.

Here's an interesting thing I read from Jeremy Siegel (not sure how accurate it is).
Between 1981 and 2015, the CAPE ratio signaled that equities were overvalued in no fewer than 416 of 422 months.
If true, how useful is that?

What have been the returns investing money in any year since 1981 and 2015? How many good years? How many very good years? Even investing in the absolute worst years like 2000 have still given positive, if mediocre, long-term real returns.
Last edited by HomerJ on Sat Oct 22, 2016 9:06 pm, edited 2 times in total.
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Homer
Sorry but you are not using the data correctly. Shiller made a PERSONAL forecast based on his opinion, not the model's, that there would be RTM of valuations leading to the 0 return. The way you forecast using the model is the way I explained it. You take the CAPE 10, which at the time was 25 and invert and multiply by 1.1, that gets you 4.4%.

Also Homer you are incorrectly using the CAPE 10 which tells you by itself NOTHING about if market is overvalued or not. It just tells you if it is MORE HIGHLY valued than historical average. There are many reasons which I have written about which can easily explain why valuations should be higher than historical. Among them are stronger regulations making investment safer, stronger accounting rules, an SEC which didn't exist, a Federal Reserve which didn't exist and has gotten better at smoothing out economic volatility and thus stock volatility and thus justifying higher valuations, the US is much wealthier so capital is less scarce, dividends much lower and accounting rules have changed that lead to higher looking valuations due to faster write offs of intangibles. That's the mistake people like Grantham and Hussman himself have been making. The CAPE 10 only tells you how high valuations are, but nothing about whether it's overvalued. Need to compare it to some risk free rate to say it's overvalued, which it clearly was in 2000 when the CAPE 10 produced a forecast below riskless TIPS.

If Shiller made a forecast that didn't use his own model blame Shiller, not the model.

Kevin. My data comes from DFA's return program from January 1996 through September 2016.

And you don't just invert you have to multiply by 1.1 to account for the average lag of 5 years. Also earnings growth has been higher for S&P than 1.5% and should be higher than historical because dividend payouts MUCH lower and higher retention of dividends should produce higher G. So I use 2%. But you can use what you like. If you use the Gordon Model Asness calculated that what worth 1 in the CAPE 10.

Larry
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Caliguy
No I don't take that into account. And Dalio's just an opinion which I would recommend ignoring. No one has that clear crystal ball. If investors thought he was right the market would be 40-50% lower.

And this is NOTHING like the 1930. First we have not had anything close to the loss of industrial capacity nor the deflation we had then. Second the banking system is dramatically stronger. And could add other things. Now does that mean we cannot get that 40-50% drop? Of course not, but I seriously doubt if it happened it would be for the reasons stated. But mine is just an opinion like his, which I too ignore (:-))
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Re: Larry Swedroe's latest market returns forecast

Post by HomerJ »

larryswedroe wrote:Also Homer you are incorrectly using the CAPE 10 which tells you by itself NOTHING about if market is overvalued or not. It just tells you if it is MORE HIGHLY valued than historical average. There are many reasons which I have written about which can easily explain why valuations should be higher than historical. Among them are stronger regulations making investment safer, stronger accounting rules, an SEC which didn't exist, a Federal Reserve which didn't exist and has gotten better at smoothing out economic volatility and thus stock volatility and thus justifying higher valuations, the US is much wealthier so capital is less scarce, dividends much lower and accounting rules have changed that lead to higher looking valuations due to faster write offs of intangibles.
Okay, I'll take your word for it... So you are basically confirming that there are DOZENS of other variables that affect the returns going forward.

Doesn't sound like easy common sense or easy math to me.
larryswedroe wrote:The way you forecast using the model is the way I explained it. You take the CAPE 10, which at the time was 25 and invert and multiply by 1.1, that gets you 4.4%.
(1) Wait. Do the dozens of other variables matter or not?

(2) Is that how they did it in 1996, using the data from 1920s-1996? Invert and multiple by 1.1? Or is that something new, using data from the past 20 years to make the model work?
And you don't just invert you have to multiply by 1.1 to account for the average lag of 5 years. Also earnings growth has been higher for S&P than 1.5% and should be higher than historical because dividend payouts MUCH lower and higher retention of dividends should produce higher G. So I use 2%. But you can use what you like.
We can use what we like? This is how to predict expected returns?

I promise I'm done in this thread... We will have to agree to disagree.
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Homer
Now I have no clue what you are talking about. There are no other variables to use. Those facts I mentioned help explain why valuations have drifted higher and thus returns higher than would have been forecasted, since the forecasts assume unchanged valuations.

Now of course you need to choose the growth rate of real earnings to make the adjustment because the CAPE 10 shows earning from an average of 5 years ago. I use 2% a year for real g which IMO is quite reasonable. But if you want to use even 1.5% you don't change the figure much.

Now what returns WILL actually turn out to be is of course impacted by what the G actually is, and of course any change in the speculative return, the change in valuations itself. Which must be unforecastable or there would be no risk. That again is why you have to consider the forecast only as the mean of a wide POTENTIAL dispersion. But we do know that higher valuations forecast lower means and vice versa.

The factors I noted are EXPLANATIONS for why the CAPE is now higher, because risks are lower, and accounting rules have changed and dividend policies have changed. But that doesn't change the fact that when risks are lower and thus valuations higher that now you have lower expected returns due to the lower risks. Again simple common sense.

And how much easier math can you get than take E/p and multiply that by 1.1? My 9 year old grandson has been able to do that for years already.
If you took the E/p and multiplied by 1.075 using that 1.5% g you would have virtually the same forecasted real returns

Think you are trying to make this more complicated to justify your position. At least that is what it seems to me.
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by caliguy1 »

larryswedroe wrote:Homer
Now I have no clue what you are talking about. There are no other variables to use. Those facts I mentioned help explain why valuations have drifted higher and thus returns higher than would have been forecasted, since the forecasts assume unchanged valuations.

Now of course you need to choose the growth rate of real earnings to make the adjustment because the CAPE 10 shows earning from an average of 5 years ago. I use 2% a year for real g which IMO is quite reasonable. But if you want to use even 1.5% you don't change the figure much.

Now what returns WILL actually turn out to be is of course impacted by what the G actually is, and of course any change in the speculative return, the change in valuations itself. Which must be unforecastable or there would be no risk. That again is why you have to consider the forecast only as the mean of a wide POTENTIAL dispersion. But we do know that higher valuations forecast lower means and vice versa.

The factors I noted are EXPLANATIONS for why the CAPE is now higher, because risks are lower, and accounting rules have changed and dividend policies have changed. But that doesn't change the fact that when risks are lower and thus valuations higher that now you have lower expected returns due to the lower risks. Again simple common sense.

And how much easier math can you get than take E/p and multiply that by 1.1? My 9 year old grandson has been able to do that for years already.
If you took the E/p and multiplied by 1.075 using that 1.5% g you would have virtually the same forecasted real returns

Think you are trying to make this more complicated to justify your position. At least that is what it seems to me.
Larry
Agree with Larry. I personally own no US equities and own only international (mostly emerging). The way I look at it is a game of blackjack. If you see the dealer has a 10 would you double down? No. But does that mean definitively you'd lose if you did? Not at all. It's all about a game of odds. I'd rather have better odds. If others want to have worse odds that's their own money.

My biggest worry though is that we're 7 years into this bull cycle and since the beginning of the republic we've had business cycles that have lasted something like 3-8 years, and we're near the end of this one. Could this be different and last several more years? yes. Likely? No. Again it's a game of probabilities.

If you look at household net worth as a % of GDP, which has an extremely high correlation to stock performance (even higher correlation than Shiller PE..from what I read somewhere it was like 90% vs. shiller was only 40%..but I haven't verified that myself), we're at all time highs.
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Re: Larry Swedroe's latest market returns forecast

Post by 209south »

Larry, I for one am grateful for your active and thoughtful involvement with this forum, and your patience in dealing with some stubborn Q&A - we are all better off for your presence.
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Re: Larry Swedroe's latest market returns forecast

Post by stlutz »

Markets trade low or high multiples for a reason. Low multiples indicate that the market believes there is a higher risk of loss, or that there is limited potential for appreciation, or both. Higher multiples indicate that the market believes that there is less risk.

The problem with these discussions is that they are based on the assumption that risk and growth potential never change. Sure, if I know the Dow is going be a at 36,000 in 2030, then I'd prefer for it to be at 8000 than 18,000 now. However, if the Dow dropped to 8000 over the next 6 months that would be because the market had judged that reaching 36,000 by 2030 was extremely unlikely, to say the least.

The US has had a pretty good record of dealing with it's problems. The infamous "Death of Equities" Business Week article was written at a time when PEs were low. The market did well after then not because the market was offering some type of free lunch (huge upside potential with almost zero downside potential), but because the problems that were identified in the article (mostly dealing with inflation) were solved.

When the economy was collapsing in 2008, we again solved things in such a way to preserve a free enterprise system. That frequently has not been the outcome when looking at world history. Prices in 2008 reflected the fact that making good, or at least not horrible, decisions was in no way inevitable.

The question really comes down to whether you think the market is generally right or generally wrong. Nedsaid and many other smart folks generally argue the later--that the market is not that smart overall. Others argue the opposite. I'm sympathetic to both ways of thinking. I at least like to start out by understanding what the market is saying. I think the market is saying a) that the US market is less likely to suffer a severe loss than international markets; b) that interest rates are likely to stay "low" for many years or even decades to come, and c) that there is still strong potential for US firms to grow earnings going forward. Is the market wrong on these points?
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Re: Larry Swedroe's latest market returns forecast

Post by sperry8 »

These return estimates are very comforting to hear. I understand they are estimates and not science, but nevertheless seeing that even US equities which seem so high will return 4% real over 10 years is comforting. That allows us retirees to continue to pull 4% annually without issue (assuming the volatility in those 10 years isn't an issue).
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Re: Larry Swedroe's latest market returns forecast

Post by larryswedroe »

Stlutz
The problem with these discussions is that they are based on the assumption that risk and growth potential never change.
To straighten this out, this is incorrect statement. The formula of course makes the assumption that the speculative part of returns will be unchanged. This is true whether using Gordon Model or the CAPE 10, or current yield. That is based on the assumption that the market's price is the best ESTIMATE of the right price (not that it's the right price).

As I have repeatedly stated we have to think of the expected return only as the MEAN, and that we understand that the risk and growth will likely turn out different so we treat it only as the mean of a wide potential dispersion of returns. Not as THE FORECASTED return, but the MEAN of potential outcomes.

So just to give example, not meant to reflect reality, if you have a mean of 8%, you should treat that as 1/2 the outcomes of an MCS will be above 8%, and maybe 40% will be above 9, and 20% above 10, and 10% above 11, and maybe 2% above 12, etc. And the other side is the same way, with maybe 40% below 7, and 20% below 3, and 10% below 2, etc.

The explanations for why IMO the CAPE 10 has drifted upward over time where not forecastable before they occurred, but they did happen and either reduced risk or made current earnings look less than they would have been if the accounting rules had not been changed, so you don't have an apples to apples comparison. So we have to adjust for that. But they do explain why the CAPE is higher now. And when you have events that make markets less risky due to more stable economy (the SD of economic growth is much lower than it was 100 years ago) or better regulation, more transparency, then you get higher valuations and also get then lower expected returns. That is just simple common sense ---you pay more for something you have lower future returns.

I hope this is helpful
Larry
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Re: Larry Swedroe's latest market returns forecast

Post by Johnnie »

caliguy1 wrote:
My biggest worry though is that we're 7 years into this bull cycle and since the beginning of the republic we've had business cycles that have lasted something like 3-8 years, and we're near the end of this one. Could this be different and last several more years? yes. Likely? No. Again it's a game of probabilities.
Are we in the seventh year?

From Josh Brown, "When did the bull market begin, IRL?"
...It’s become likely that we are in a secular bull market for stocks. We do not measure secular bull markets from the bear market low of the prior cycle. The 1982-2000 secular bull market is measured from the day in 1982 when stocks finally took out their 1966 high. It had been a 16 year secular bear market until closing above those highs, and stocks never looked back. We do not date that bull market from the lows of 1973-1974 that were the nadir of the prior bear. Nor should we use 2009 as our starting point for the current bull market. 2009 was merely the cycle low of the prior bear, not the starting point of the current bull.

The actual starting point of the current secular bull market is the spring of 2013, when we broke above the double-top record highs of 2000 and 2007. This means we’re only into the third year.
http://thereformedbroker.com/2016/10/13 ... begin-irl/
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