Aug 17, 2012 | Post by: Roman Chuyan, CFA Comments Off on Expected Return For U.S. Equities Remains Positive, 3.8%

Expected Return For U.S. Equities Remains Positive, 3.8%

As of July 31, 2012

Our quantitative forecasting model continues to point to a positive 6-month expected return for the S&P 500 (SPY) of 3.8%, despite economic headwinds. Accordingly, we recommend that investors areoverweight equities relative to their benchmark weight.

“Active management is forecasting” – Grinold and Kahn, Active Portfolio Management (1999). In order to achieve alpha from active asset allocation, the manager has to have a model that forecasts expected returns with reasonable degree of accuracy. Many authors provide an opinion on where stocks are going to go next, but not many have a model that does such forecasting accurately. What follows is a general description of how our model works, followed by the description of some of the most important factors that are responsible for this positive result of 3.8%.

Our forecasting model (the “PAR Model” as we call it) is a factor model that estimates expected equity return over a six-month period. The model is based on a dynamic multi-factor regression of S&P 500 returns over economic, valuation, and market variables. Factors are chosen automatically each month based on their statistical significance from the initial set of 22 factors that have proven to be significant over time.

The model provides the answers that investment managers need:

– What’s the expected return for equities right now?

– What factors that really affect equities should we be looking at?

Significant Factors

The graph below summarizes the factors that are currently included in the model, and contribute to the model’s output of the 3.8% forecast. There are currently 11 factors, which can be grouped into Valuation, Economic and Market-type factors. This matches most asset managers’ intuition that there is not one, but multiple factors that determine the expectation for equity return at any point in time.

Valuation: Net Positive

The P/E ratio continues to extend a significant positive contribution to the model’s expected return, at 0.8 standard deviations (“SD”) (see chart above). This is followed by the Price to Book ratio (0.3 SD), and is partly offset by the negative effect of Earnings Quality (-0.6 SD).

Price to earnings ratio is one of the key measures of index valuation in the model. The model is “re-trained” each month – factors are selected automatically based on their statistical significance – and P/E ratio has been included in the model in 97 months out of the last 120, an indication of the importance of the P/E ratio to modeling equity returns.

A healthy trend in U.S. corporate earnings has contributed to the below-average P/E ratio, and in turn to its positive contribution to the model’s expected return of around 1 SD in the previous two years (see graph above). The index rose in July by 1.4%, with the P/E ratio itself rising slightly to 14.0 from 13.7. This level remains very attractive by historical standards, still well below the five-year average of 15.6. This explains why P/E provides a significant positive contribution to the expected return as part of the our model (the green Contribution line on the graph).

Economic: Net Positive

We consider the ECRI Weekly Leading Index to be the most important economic indicator to watch this year. Though performing better now than at the start of the year, this index still has a negative influence on the model’s expected equity return (-0.4 SD). Now at 122.8, if the index improves to 126-128 it would be very positive for stocks.

Despite the pessimism regarding domestic manufacturing, the Federal Reserve’s Industrial Production index has climbed steadily since the Great Recession ended in 2009. Now at 97.4, this index has been higher only at its peak between June 2006 and July 2008. Industrial Production undeniably influences equity returns, as measured by our model. The index currently has a positive effect on the expected return of 0.7 SD, which improved considerably this year from 0.3 SD at the end of 2011.

Housing is also very significant in the model. Specifically, if the Median Home Sales Price continues the improvement started in the last two months, its negative contribution would reverse (currently -0.8 SD).

Market: Net Negative

Oil price has dropped to $88 per barrel (WTI crude) at the in July from over $100 earlier in the year (though it rebounded to $95 since then). Lower oil price is very positive for equities – even if oil stays at its current level of $95, the effect on expected return (-0.7 SD) will continue to improve in the coming months.

Commercial Bank Reserves is another market indicator that is significantly negative, at -1.7 SD contribution. Starting from 2008-2009, commercial banks have been growing their reserve ratios, which resulted in reduced lending. However, this changed recently for the better, and the contribution improved from -2.5 SD in March of this year. Knowing the importance of credit to the economy, we hope the recent improvement continues.

AAII Investor Sentiment is very bearish right now, which is positive for the expected return (1.1 SD). This indicator is quite volatile – and bearishness already started dropping as the market rallied in August. We will continue updating our model regularly and watching if the positive effect of this indicator diminishes.

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