After I wrote the piece on momentum, I thought, “Wait a minute. Momentum and valuation are stronger together than separate — run the calculations and write a new piece.
That’s what led to this article. I added valuation metrics to the momentum regressions for one month and one year returns and found they were of little value.
Ouch. Not what I expected, so I tried momentum and valuation variables to predict ten-year returns. The results for the regression were significant.
- Last year: total return over the last year for the S&P 500
- Last month: total return over the last month for the S&P 500
- Last 10: total return over the last 10 years for the S&P 500
- DP: dividend yield
- EP: earnings yield
- Int: 10-year Treasury yield
- Inflation: trailing 12-month inflation from the CPI
- EP10: earnings yield using trailing 10-year earnings.
Trying to forecast ten years into the future, technical variables diminish and fundamental variables show their stuff. As I have stated before, both current period and long term earnings matter in estimating fair value. Though I am using Shiller’s data set, it shows that 10-year average earnings are not enough.
That is a big enough finding on its own, but I have something more: using this formula, stocks are expected to earn 2.26%/yr over the next ten years. After a pathetic decade, do we have another to come? I(Ask Japan, they have gotten zero over more than 20 years…)
Why might that low return be true?
- Bad momentum begets bad momentum.
- Government bond yields are low offering little competition to stocks.
- Earnings yields still are not high.
Valuations are better than when I wrote the piece, Kiss the Equity Premium Goodbye, but the same problem still exists to a lesser extent. Where are the projects with high returns on assets that can easily be invested in? At present, we are not seeing them in bulk.
That is what helps laed me to consider that corporate bonds and bank loans may still be better investments at this point in the cycle — less downside and perhaps a competitive upside.