Forecasting Equity Returns in the New Normal - Pimco

Asset Allocation FocusNovember 2012

Saumil H. Parikhi

Your Global Investment Authority

Forecasting Equity Returns in the New Normal Our clients consistently ask us for our views not only on individual asset classes, but also on how we think about different assets in overall portfolio terms. As part of our ongoing commitment to better serve our clients, PIMCO is introducing “Asset Allocation Focus.” The quarterly article will draw on the combined resources of the firm’s asset allocation team and be lead-researched and written by Managing Director Saumil H. Parikh, a generalist portfolio manager focused on asset allocation strategies who also serves on the firm’s Investment Committee and leads our cyclical economic forums. This inaugural edition of “Asset Allocation Focus” lays out PIMCO’s framework for understanding and forecasting U.S. equity returns in a changing world.

PIMCO’s founding investment philosophy and process are grounded

by three basic principles.

1) Investing is a long-term, value-oriented endeavor, which requires

discipline and patience

2) Successful investment processes focus on both top-down,

macroeconomic drivers of returns as well as bottom-up, microeconomic

drivers of returns

3) Commonsensical risk management is critical for avoiding “left tail”

portfolio outcomes and managing portfolio volatility

i I wish to thank my fellow members of PIMCO’s asset allocation team, Mohamed El-Erian, Vineer Bhansali and Curtis Mewbourne, for their inputs in developing this framework of analysis. I would also like to thank my fellow members of PIMCO’s Investment Committee, as well as PIMCO’s equity portfolio management teams, for their critique of this framework as well as for providing the basic inputs necessary to arrive at actionable conclusions for asset allocation strategies.

2 November 2012 | Asset AllocAtion FocUs

No financial asset class exemplifies the need for an

investment manager to abide by these three basic principles

more so than equities.

By and large, the universe of financial assets (stocks,

bonds and cash alternatives) derives its returns from the

performance of real economic factors (capital, labor, materials

and multi-factor productivity, the last being a measure of

productivity that captures changes in the volume of goods

and services produced with a combination of multiple

“inputs” such as labor, materials and capital). Gross domestic

product (GDP) and its growth rate are ultimately the source

of all cash flows and returns that trickle down into various

financial assets based on their individual seniority and place

in the economic capital structure.ii

In this fundamental macroeconomic regard, equities are

no different than bonds. A successful approach to secular

equity investing must include a long-term view toward

deriving forward value, an investment process that

incorporates the roles of both macroeconomic growth as

well as microeconomic change in producing returns, and

a similar, intense focus on risk management, particularly

when it comes to embedded leverage, optionality and the

permanent loss characteristic of the asset class.

Equities provide unique risk factors

From an economic perspective, equities derive their unique

risk factor from the ups and downs of multi-factor

productivity growth. Within the universe of traditional

financial assets, equities are the only asset class that can

theoretically provide investors with the unlimited upside

potential of the basic creative-destruction process that

generates multi-factor productivity (see Figure 1). This is

because equities are the most “junior” financial asset class

in the economic capital structure and also because corporate

profits are a residual with embedded costs of labor, materials

and credit being relatively rigid in the short run. Equities are,

therefore, the recipient of all “excess product” or cash flow

when economic growth surprises to the upside.

FigurE 1: EquitiEs DErivE uniquE risk Factor/rEturn charactEristics From ProDuctivity

3.0

2.5

2.0

1.5

1.0

0.5

0.01300 1400 1500 1600 1700 1800 1900 2000 2100

Source: Robert Gordon (2012)

Note: Real Gross Domestic Product (GDP) is an inflation-adjusted measurethat reflects the value of all goods and services produced in a given year,expressed in base-year prices.

Perc

ent

per

year

(%)

Year

Growth in real GDP per capita

Actual U.S.Actual U.K.

But, as one might expect, unlimited upside potential comes

with substantial downside risk. Negative surprises in

economic growth (among other influences), especially

unanticipated economic contraction, can impart significant

downside risks and permanent loss on equity returns as well.

To gain a better quantitative understanding of the trade-off

between equity risk and return, a useful starting point in our

journey to forecasting equity returns in what we at PIMCO

call the New Normal is the historical experience of the equity

asset class. The last 110 years of U.S. economic history and

asset returns can be characterized as fairly all-encompassing

(with one possible exception that we will return to in the

known unknowns section later). There has been no shortage

of wars, deflations, inflations, currency regime shifts,

leveraging, deleveraging, productivity booms, financial fraud,

manias, panics and crashes during this illustrious era.iii The

“ex post” U.S. capital markets line (see Figure 2), derived

from historical returns and return volatilities of this period,

shows precisely the average trade-off between risk and

return investors have encountered across asset classes and

will most likely continue to encounter going forward over

secular time horizons.

ii See Benjamin Graham and David L. Dodd, Security Analysis, 1934iii See Charles P. Kindleberger, Manias, Panics, and Crashes, 2000

Asset AllocAtion FocUs | November 2012 3

Over the last 110 years, the U.S. “market portfolio”

represented in Figure 2 has delivered a return per unit of risk

ratio of approximately 35%. That is, for every 1% increase in

portfolio volatility (risk), the market portfolio delivered a

0.35% increase in return. Further, the upside and downside

risk/return profiles of the market portfolio were uneven across

both assets, as well as across measurement horizons.

Lower volatility assets, such as cash alternatives and Treasury

bonds, provided limited upside as well as limited downside

with fairly symmetric distributions of returns over both

short- and long-term measurement periods. In contrast,

higher volatility assets such as equities provided substantial

upside over both short- and long-term measurement periods,

but provided substantial down-side only during short-term

measurement periods. This asymmetric time-dimensional-

return characteristic of equities informs both the value

derivation framework we use here as well as the risk

management objective we described at the onset. In

PIMCO parlance, equities are a secular asset class that

demands a value orientation, discipline, patience and

active risk management.

FigurE 2: historical rEturns From EquitiEs arE high anD volatilE

32

28

24

20

16

12

8

4

0

-4

-8

-12

-16

Source: Dimson et al., Triumph of the Optimists (2000), Ibbotson Associates (2012), PIMCO calculationsNote: Cash equivalents = 3-month Treasury bills; Inflation = U.S. CPI; Treasury bonds = 10-20 yrs. maturity Treasuries; Equities = S&P 500

Ann

ualiz

ed r

etur

ns (%

)

Risk = Standard deviation of annual returns (%)

Historical U.S. capital markets line

0 5 10 15 20 25

Geometric average (1900 to 2011) Best half-decade (1900 to 2011) Best decade (1900 to 2011) Worst decade (1900 to 2011) Worst half-decade (1900 to 2011)

Cashequivalents Inflation

Equities

TSYbonds


Deriving components of secular equity returns

We begin our journey into the New Normal for U.S. equity

returns with a derivation of the major components of returns

over the long run (see Figure 3). Equity total returns can be

decomposed into 1) returns from income, 2) returns from

growth and 3) returns from valuation changes.iv

FigurE 3: thE sourcEs oF sEcular Equity rEturns arE incomE, growth anD valuation

Source: Robert Shiller Data, PIMCO calculationsNote: Shiller equity data based on S&P 500, S&P 90, and priorto 1926 Cowles and Associates.

Con

trib

utio

n to

tra

iling

10-y

r to

tal r

etur

n (%

)

Principal components of secular equity total returns

-12.5 -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5

10.0 12.5 15.0 17.5 20.0 22.5

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Trailing 10-yr valuation return Trailing 10-yr total return Trailing 10-yr earnings growth return

Trailing 10-yr income return

Over the past 100 years, nominal total returns were sourced

almost equally between returns from income (~5% per

annum) and returns from growth (~5% per annum), with net

returns from valuation changes over this time horizon being

essentially zero.v Over shorter time horizons, however, market

inefficiencies and fluctuating “animal spirits” created

significant opportunities for disciplined value investors to

effectively capture the fluctuations in the returns from the

valuation component, and we will attempt to calibrate for

these inefficiencies in the forecast section.

FigurE 4: incomE rEturns arE DrivEn by DirEct DiviDEnDs anD sharE rEPurchasEs

Source: Robert Shiller Data, PIMCO CalculationsNote: Shiller equity data based on S&P 500, S&P 90, and prior to 1926Cowles and Associates.

Con

trib

utio

n to

tra

iling

10-y

r to

tal r

etur

n (%

)

Ratio

of

divi

dend

s to

ear

ning

spe

r sh

are

(%)

Trailing raw and payout ratio adjusted dividend returns

0

50

100

150

200

250

300

350

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 -5-4-3-2-101234567

Trailing 10-yr spot dividend return (LHS)Trailing 10-yr payout adjusted dividend return (LHS)Spot dividend payout ratio (RHS)

returns from dividends and share repurchases

Speaking first to returns from income, this low volatility component of equity returns is predominantly driven by two factors (see Figure 4): the cash flow from dividends distributed to shareholders, and the cash flow from gross repurchases of equity by corporations distributed to shareholders. From an investor’s perspective, the two activities are the same; however, forecasting their influence on future returns requires analysis on whether actual returns from income are either being boosted via the use of financial leverage or being suppressed via the retention of excess earnings in the given environment. To avoid the cyclical volatility of these issues from a top-down perspective, we find that adjusting actual dividends by the fluctuation in the dividend payout ratiovi over time produces a more useful and long-term sustainable forecast for the income component of equity total returns that captures both the actual payment of dividends as well as the expected gross repurchase of shares over time. This payout-ratio-adjusted dividend yield is our preferred factor in the forecasting section below.

iv See Grinold, Kroner, and Siegel (2011)v Depending on the starting and ending valuation of your measurement period, the contribution of

net returns from change in valuation can be positive or negative, but over the long run it is zero.

vi The dividend payout ratio is measured as the ratio of dividends per share to reported earnings per share.


returns from gDP and earnings growth

Turning next to returns from growth, we find these are also driven by two main factors (see Figures 5 and 6). The first, and most important, factor is the growth rate of the overall economy as represented by nominal GDP. The relationship between nominal GDP growth and earnings growth is least stable over short-term periods (less than five years), but as we extend the comparison to secular periods (greater than five years and up to 20+ years), the relationship becomes much more clear, stable and consistent as expected. We expect nominal GDP growth, earnings growth and dividends growth

in aggregate to be equal to one another over a 10-year cycle.

FigurE 5: Earnings growth rEturns arE largEly DrivEn by sEcular gDP growth

Source: National Income and Product Accounts, PIMCO calculations

Geometric average growth rate of U.S. corporate profits and of nominal GDP

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Nominal GDP growth (10-yr trailing) Earnings growth (10-yr trailing)

Geo

met

ric a

vera

ge g

row

th r

ate

(%)

-10.0-7.5-5.0-2.50.02.55.07.5

10.012.515.017.5

FigurE 6: ProFits can grow FastEr or slowEr than gDP ovEr somE sEcular PErioDs, but in thE long run, ProFits’ sharE oF gDP is mEan rEvErting

Source: BCA Research (2012)

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

BCA national accounts* NBER macro history database S&P 400*** S&P 500

Cowles and Associates**

15

10

5

0

-5

-10Pe

rcen

t of

GD

P (%

)1900

U.S. corporate profits’ share of U.S. nominal GDP (after tax)

*After-tax national corporate profits as a percent of GDP** Scaled by GDP*** S&P 500 excluding financials, utilities and transports

As a corollary to these expectations, because returns from

growth are such an important component for the asset

class, and also because earnings can be very volatile over

measurement periods less than five years, we strongly

believe that equity portfolios and investment returns are

best judged for their performance over a minimum rolling

five-year measurement period. In fixed income space, we

tend to measure performance over rolling three-year

periods as a comparison.


importance and derivation of profits’ share of gDP

The second factor driving returns from growth, in addition to

the growth rate of GDP and earnings, is the share of GDP

going to aggregate corporate profits. Over the long run,

profits cannot outpace the growth rate of GDP, unless capital

miraculously gains the means to consume the product it is

being employed to produce. The secular nature of GDP

growth forecasting combined with the long-term mean-

reverting nature of profits’ share of GDP re-emphasizes our

initial point, that the equity asset class truly belongs more in

secular space and less in cyclical space from a risk, return and

performance measurement perspective.

It is worth discussing profits’ share of GDP in some more

detail,vii particularly as this measure is always an important

part of PIMCO’s secular and cyclical economic forecasting

process. Aggregate corporate income or profits (defined as

the sum of retained earnings and dividends) are simply one of

many financial balances that national income accounting

produces. National income accounts (GDP accounts) are

calculated on the foundation that total national income

equals total national expenditure.viii

Gross domestic product, which is simplistically the sum of all

consumption, all investment and net exports, is equal to gross

domestic income, which is the sum of household income,ix

corporate income and net national income from abroad.

If one further simplifies this identity by saying all consumption

plus all investment equals household income plus corporate

income, and re-expresses the identity in terms of corporate

income, one arrives at the realization that corporate

income equals all investment plus all consumption less

household income.

Taking it yet one step further, with the added transformation

that household income less all consumption equals household

savings, and that households can be disaggregated into

private and public (government), and adding back the

difference between net exports and net national income from

abroad, one arrives at the following identity:

Total corporate income (profits) equals total investment

less household savings less government savings less

foreign savings (see Figure 7).

FigurE 7: rising ProFits’ sharE oF gDP comEs via Falling savings ElsEwhErE anD vicE vErsa


25

20

15

10

5

0

-5

-10

1952 1962 1972 1982 1992 2002 2012

Shar

e of

GD

P (%

)

Levy/Kalecki profits equation in shares of GDP (1943, 1952)

Investments' share Government savings' share Household savings' share

Foreign savings' share

Corporate profits' share

By definition, therefore, any one sector’s financial balance

improvement or deterioration must come at the cost or

benefit of another or other sectors. In an open economy like

the United States, the current account surplus or deficit would

represent the foreign savings component. Household savings

of course speak for themselves, and government savings are

represented by the consolidated surplus or deficit of all

branches of government (federal, state, and local).

vii See Levy (1943) and Kalecki (1952)viii For a detailed discussion of national income and product accounting, see McCulla and Smith,

A Primer on GDP and the National Income and Product Accounts, (2007)ix For simplicity, we include government in households here, but we disaggregate them as we

develop the derivation of profits’ share of GDP in terms of national savings.


In recent years, the rising corporate income (or profits’) share

of GDP (see Figure 8) has been produced despite a falling

investment share of GDP due almost exclusively to a large

reduction in government savings’ share of GDP. In other

words, the massive deficits being run by U.S. federal, state

and local governments in combination are directly responsible

for the outsized gains in corporate profits’ share of GDP this

economic cycle (to date). This is especially the case given that

the other major driver of high profits’ share of GDP, a high

investment share of GDP, is not the contributing factor today.

The deviations of shares of national savings from their

long-run averages are informative in forecasting what profits’

share of GDP is likely to do in the future. In this case, we

believe, the outlook for U.S. corporate profits’ share of GDP is

fairly predictable. If investment in the U.S. economy does not

pick up substantially over the next five to 10 years, the

unsustainability of large public sector deficits will put

tremendous pressure on corporate profits and their ability

to keep up with nominal GDP growth. We will return to

this important point in the forecasting section.

cyclically adjusted multiples and returns from valuation changes

The third component of equity returns is the return from

valuation changes. Over the long run, the net return from this

component should be zero. This is mainly because equity prices

have tended to keep pace with earnings (see Figure 9), giving

equity valuations (price-to-earnings ratios) their long-run

mean-reverting character (see Figure 10). Once we account for

income returns and growth returns independently, we find

that the residual equity total return over secular periods

(measured as five to 10 years) is very significantly driven by

fluctuations in what is essentially a long-run zero sum factor

we call “return from valuation changes.”

FigurE 8: toDay’s abnormally high ProFits’ sharE is suscEPtiblE to an unanticiPatED risE in govErnmEnt or housEholD savings


-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

1952 1962 1972 1982 1992 2002 2012

Shar

e of

GD

Pas

dev

iatio

ns f

rom

nor

mal

(%)

Levy/Kalecki shares of GDP expressed as deviations from “normal”

Investments' share Government savings' share Household savings' share Foreign savings' share Corporate profits' share


FigurE 9: ovEr timE, Earnings anchor PricEs, giving P/E multiPlEs thEir mEan-rEvErting charactEr

Source: Robert ShillerNote: Shiller equity data based on S&P 500, S&P 90, and prior to1926 Cowles and Associates.

1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2006 2011

Price per share of S&P500 index (LHS) Earnings per share of S&P500 index (RHS)

2,048

1,024

512

256

128

64

32

16

8

4

128

64

32

16

8

4

2

1

0.5

0

Principal components of secular equity total returns

FigurE 10: valuation rEturns arE DrivEn by thE mEan-rEvErting naturE oF P/E multiPlEs

12.5

10.0

7.5

5.0

2.5

0.0

-2.5

-7.5

-5.0

-12.5

-10.0

25

20

15

10

5

0

5

15

10

25

20

1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Source: Robert Shiller, PIMCO calculationsNote: Shiller equity data based on S&P 500, S&P 90, and prior to 1926Cowles and Associates

Change in P/E m

ultiple over trailing 10-yr periodCon

trib

utio

n to

tra

iling

10-

yr t

otal

ret

urn

(%)

Trailing 10-yr valuation return Change in cyclically adjusted P/E multiple

Valuation returns come from mean reversion

Robert Shiller, in his book Irrational Exuberance (2000), used

theory from Graham and Dodd’s seminal 1934 work Security

Analysis to expound on this very concept and on the use of

cyclically adjusted P/E multiples in managing equity

portfolios. The basic theory is simple: Since earnings are very

volatile from year to year (over the last 110 years, reported

earnings have been twice as volatile as equity prices), and

equity prices derive their valuation anchor from said volatile

earnings, a cyclical adjustment is useful in removing/reducing

volatility from earnings so that they become a more useful

anchor for prices. Shiller’s preference was to use a trailing

10-year average of reported earnings as a cyclically adjusted

measure. We have chosen to use a trailing 10-year plus a

forward 10-year average of reported and realized/forecasted

earnings in our efforts to produce a more stable and practical

measure in the forecasting section below.

In either case, the usefulness of a cyclically adjusted P/E

multiple in forecasting return vectors is clear (see Figure 11).

Both cyclical and secular mean returns are dominated by the

initial cyclically adjusted valuation of equities, and we find no

better and more commonsensical tool for capturing residual

returns from valuation changes than our variant of Shiller’s

cyclically adjusted P/E.

FigurE 11: initial valuations ProviDE an imPortant vEctor to rEalizED rEturns

<5 25.4% 19.1% 21.2% 16.0% 5 to 10 14.5% 12.7% 12.2% 11.5% 10 to 15 10.6% 8.1% 7.0% 7.9% 15 to 20 6.4% 4.9% 5.3% 5.5% 20 to 25 1.6% 5.6% 8.4% 2.5% 25 to 30 1.3% -0.5% -1.2% 3.0% 30 to 35 1.9% 0.0% -1.5% -0.7% >40 -12.5% -17.3% -5.4% -3.9%

Initial cyclicallyadjusted P/E

valuation

1-yr forwardreal return


(CAGR)


(CAGR)


(CAGR)

Today’smarket

value

Cyclically adjusted P/E multiples and realized returns

Source: Robert Shiller, PIMCO Calculations.

Data as of 31 December 2011.

Note: Shiller equity data based on S&P 500, S&P 90, and prior to 1926Cowles and Associates. Data shows mean Compound Annual GrowthRate (CAGR) of total returns for various periods based on starting valueof cyclically adjusted P/E. CAGR is the year-over-year growth rate of aninvestment over a specified period of time. The compound annual growthrate is calculated by taking the nth root of the total percentage growthrate, where n is the number of years in the period being considered.


FigurE 12: valuations arE highEst whEn growth anD volatility oF gDP arE low anD PositivE

40

35

30

25

20

15

10

5

0

16

14

12

10

8

6

4

2

0<-2 -2

to 00

to 22

to 44

to 66

to 88

to 1010

to 12>12

Source: Robert Shiller, PIMCO calculations. Data range is 1910 - 2010.Note: Shiller equity data based on S&P 500, S&P 90, and prior to 1926Cowles and Associates

Growth rate of nominal GDP (%)

Stand

ard d

eviation

of G

DP g

row

th (%

)

Ave

rage

P/E

mul

tiple

Cyclically adjusted P/E (LHS)Max P/E (LHS)

Min P/E (LHS)GDP volatility (RHS)

P/E multiples in varying growth and volatility regimes

We have shown initial valuations drive forward returns due to

the mean-reverting nature of prices to earnings over time. But

are there other factors that drive valuations too? A historical

analysis of P/E multiples (see Figure 12) shows that equity

investors are most exuberant during periods of low but

positive nominal GDP growth (greater than 2% but less than

6% per annum) but quickly become more pessimistic when

nominal GDP growth either falls below 2% per annum or

rises above 6% per annum. This is partly explained by the

fact that the volatility of GDP and earnings is higher in the

wings of the growth distribution, but is also driven by the

fact that negative growth is associated with permanent

losses and double digit growth is associated with rising

costs of credit/discount rates. The growth and discount

rate factors discussed above will also be critical in

forecasting returns below.

Forecasting u.s. equity returns

As a first step to forecasting broad U.S. equity returns in this

environment, we have combined the three major components

of equity returns into a more sophisticated expression for

explaining equity total returns.

Trailing 10-year total return from equities =

1) Initial payout-adjusted dividend yield +

2) Beta (nominal GDP growth) +

3) Beta (annualized change in profits’ share of GDP) +

4) Beta (annualized change in cyclically adjusted P/E

multiple) +

5) Beta (annualized change in real long-term

Treasury yields) –

6) 1.8% (this represents an equity dilution factor that

generates growth)

In mapping this expression to the three components we

described above, the return from income is represented by

the initial payout-adjusted dividend yield. The return from

growth is represented by the nominal GDP growth rate, plus

the change in profits’ share of GDP. And the return from

valuation change is represented by the change in cyclically

adjusted P/E multiples as well as the change in real long-term

(20-year maturity) Treasury yields.

The addition of real long-term Treasury yields to the

expression is important. Because we are attempting to explain

equity total returns, and not equity excess returns, the

fundamental discounting factor for long-term financial assets

(such as equities) must be included and forecasted to produce

expected total returns. This departure from simply using a

mean-reverting cyclically adjusted P/E multiple will prove to

be informative, especially in the New Normal era of negative

real interest rates we currently find ourselves in – and expect

to stay in over the secular horizon.


FigurE 13: Equity Dilution Factor DrivEn by rising caPital to incomE ratio

1,000

100

10

1

01904 1916 1928 1940 1952 1964 1976 1988 2000 2012

Source: National Income and Product Accounts, Robert ShillerNote: Shiller equity data based on S&P 500, S&P 90, and prior to 1926Cowles and Associates

Dat

a in

dexe

d to

1.0

in 1

900

loga

rithm

ic s

cale

U.S. nominal GDP growth rate = +6.4% per annum

U.S. nominal GDP level

S&P 500 earnings per share level

S&P 500 earnings per share growth rate = +4.6 per annum

U.S. nominal GDP level outpaces S&P 500 earnings per share level

One interesting realization from this exercise is that the

growth rate of earnings per share does not keep pace with

that of aggregate corporate profits and GDP growth (see

Figure 13). We call this the “equity dilution factor” above.

This occurs mainly because economic development and

growth are increasingly capital intensive, such that capital-

to-income ratios at an economy-wide level need to rise to

generate the total factor productivity captured in equity

returns. It is also because capital does get destroyed from

time to time, due to natural disasters, wars and other known

unknowns, which eventually gets borne by equity. While this

equity dilution factor is a time-varying concept based on

changing phases of economic growth, the inclusion of this

factor is important particularly as we look to forecast equity

returns across both developed and developing economies

with different structures. So what are PIMCO’s main

assumptions for broad U.S. equity returns in the

New Normal?

First, we expect U.S. nominal GDP growth of between 4%

and 5% on average going forward (compared to 6.4%

average over the 110-year history). This expected reduction

in growth is dominated by two macroeconomic factors, a

demographic decline (see Figure 14) as well as a productivity

decline precipitated by reduced net new investment during

a period of debt deleveraging.

FigurE 14: DEmograPhic outlook PrEsEnts a growth anD valuation rEturn hEaDwinD

2.5

2.0

1.5

1.0

0.5

0

-0.5

-1.01950 1960 1970 1980 1990 1964 2000 2010 2020 2030

Source: Research Affiliates (2011)

One

yea

r U

.S. p

opul

atio

n gr

owth

, by

age

gro

up (i

n m

illio

ns)

The babyboom

The babybust

10x 10x

The boomersretire

Under 20 Working age 20-64 65 and over

Old-age, working-age, and young-age shares of U.S. population

Second, we currently see payout-adjusted dividend yields for

the broad U.S. equity market at 3.7% as measured by the

S&P 500 as of 31 October 2012.

Third, because of the unsustainability of U.S. government

deficits and the low likelihood of a surge in investments’

share of GDP, we expect corporate profits’ share of GDP to

revert to their long-term average over the next five to 10

years. This means an annualized decline in profits’ share of

GDP of between 0.25% and 0.5% per annum.


PIMCO’s secular (five- to 10-year) forecast for broad nominal U.S. equity total returns

PiMco nominal equity returns forecast

nominal GDP growth

2% 3% 4% 5% 6% 7%

Ann

ual p

rofit

s’ s

hare

of

GD

P ch

ange

-1 1.8% 2.7% 3.6% 4.4% 5.3% 6.2%

-0.75 2.0% 2.9% 3.8% 4.7% 5.5% 6.4%

-0.5 2.2% 3.1% 4.0% 4.9% 5.8% 6.6%

-0.25 2.5% 3.3% 4.2% 5.1% 6.0% 6.8%

0 2.7% 3.6% 4.7% 5.3% 6.2% 7.1%

0.25 2.9% 3.8% 4.7% 5.5% 6.4% 7.3%

Source: PIMCO*Assumes +0.5% 20-year Treasury real yield and 16.7 cyclically adjusted P/E valuation destination.Note: Figure provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Numerous factors will affect actual results. There is no guarantee that actual results will be the same or similar to the above.

FigurE 15: Putting EvErything togEthEr: Pimco’s ForEcast anD rangEs (with Partial rEvErsion*)

Fourth, we expect cyclically adjusted P/E multiples to continue

on their past 10-year journey toward a partial mean reversion,

imparting a further reduction from current levels

of ~21 times cyclically adjusted earnings toward 17 times

cyclically adjusted earnings over the next five to 10 years.

And finally, we expect a very gradual rise in real, long-term

Treasury yields (10-year – 20-year maturity blend) from their

current −0.6% value back toward +0.5% over the next five to

10 years.

Our forecasts for the destination of cyclically adjusted P/E

and real long-term Treasury yields should be viewed in

conjunction with and not exclusive of one another. These

forecasts reflect the environment of financial repression the

U.S. economy finds itself in today due to deleveraging, and

one that we see persisting to some degree over the next five

to 10 years.

Under these baseline assumptions (see Figure 15), we forecast

the broad U.S. equity market to produce nominal annualized

total returns in the +4.0% to +5.1% compounded per annum

range over the next five to 10 years. These returns are far

below the S&P 500 historical long-term realized returns of

nearly 10% compounded per annum, but better than the

past decade of total returns delivering just over 2%

compounded per annum. A long-term history of our top-

down model for broad U.S. equity returns (as proxied by the

S&P 500 looking backward) suggests there is a ~68%

probability that realized returns will fall within +/- 2.5% of

estimated returns over the forecast horizon (see Figure 16).

Our forecast will change either if we expect nominal GDP

growth to accelerate or decelerate from our 4% to 5%

baseline assumption, or if we see a substantial shift in the

profits’ share of GDP forecast based on a productivity-

growth-based resurgence in investment in the U.S. economy,

as shown in the forecast table.


known unknowns for new normal forecast

We would like to leave you with some thoughts for further

research and consideration. These are all issues that have and

will continue to get significant air time at PIMCO’s annual

secular forums (led by Mohamed El-Erian).

On future economic growth assumptions, we believe the key

“right tail” unknown (i.e., potential upside surprise) is

productivity and the technological progress being made

predominantly in the fields of alternative energy sources and

molecular biology. Resource constraints in both energy and

food supply are likely to be hindrances to future economic

growth rates, and technological progress on this front will be

critical to analyze going forward.

On the profits’ share of GDP assumption, the U.S. “fiscal cliff”

as well as the longer-term treatment of unfunded liabilities

that are crystallizing on balance sheets at an accelerated pace

due to demographic decline will be cyclical and secular

unknowns for investors to digest. The more unfunded

liabilities that actually crystallize on balance sheets, the more

structural and less financially sustainable U.S. government

deficits become, imparting larger negative expectations on

equity total returns in the future.

On valuation change assumptions, there are two known

unknowns: The first is the longevity of current financial

repression, which might lead to even lower long-term real

interest rates sustaining high cyclically adjusted P/E multiples.

How long will the Federal Reserve stay at zero? The second is

the role demographics will play in reducing U.S. savings even

further. The national savings rate of the U.S. is already

negative after accounting for depreciation. This means the

FigurE 16: Pimco sEcular Equity rEturn moDEl: historical PErFormancE anD ForEcast

-10.0%

-7.5%

-5.0%

-2.5%

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 2021

Trai

ling

and

Mod

el T

otal

Ret

urn

Actual S&P 500 10-yr Total Return S&P 500 10-yr Total Return Forecast Model

Source: PIMCOHypothetical example for illustrative purposes only. S&P 500 10-yr Total Return Forecast Model is based on a PIMCO proprietary model. The model is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. The model is limited by a set of assumptions that may or may not collectively develop over time. There is no guarantee that the model return will be similar to actual returns and actual returns will vary.


U.S. has to import almost all the financing needed to expand

investment above the rate of depreciation going forward.

Given the aging demographics we currently face, the pressure

on U.S. savings is going to increase, which will either lead to

a drop in investment (bad for profits) or a rise in costs of

capital (bad for P/E multiples).

And finally, the important known unknown of survivor bias in

our model and forecast. The past 110-year returns on U.S.

equities have been greater than those of other developed

and currently developing economies, mostly because the U.S.

economy has not encountered catastrophic destruction of

capital during this period, as other countries have. The U.S.

has not encountered a major domestic war during this period

of observation, and in fact it has benefited from the

widespread destruction of competing capital in other

economies over this period.

conclusions

Forecasting equity returns requires both a top-down view

of economics as well as a bottom-up view on the creative-

destruction process we encounter every day.

Equities as an asset class are a necessary component of

long-term portfolios, and unique in their ability to provide

significant upside over time through careful allocation

changes based on a framework of return forecasting we have

described above. Patience, diligence and the careful

avoidance of downside risks can greatly enhance the

experience asset allocation portfolios can achieve from this

volatile but infinitely interesting asset class.

In future editions of “Asset Allocation Focus” we will look at

PIMCO’s forecasts for total returns from other asset classes,

such as fixed income, commodities and inflation.

ReferencesBernstein, William J. and Arnott, Robert D. (2003). “Earnings Growth: The Two Percent Dilution,” Financial Analysts Journal, September/October.

Campbell, John Y. and Shiller, Robert J. (1998). “Valuation Ratios and the Long-Run Stock Market Outlook,” The Journal of Portfolio Management, Winter.

Dimson, Elroy, Marsh, Paul and Staunton, Mike (2002). Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton, N.J., Princeton University Press.

Gordon, Robert J. (2012). “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” NBER Working Paper 18315, August.

Gordon, Robert J. (2010). “Revisiting U.S. Productivity Growth over the Past Century with a View of the Future,” NBER Working Paper 15834, March.

Graham, Benjamin and Dodd, David L. (1934). Security Analysis. New York, The McGraw-Hill Companies, Inc.

Grinold, Richard C., Kroner, Kenneth F., and Siegel, Laurence B. (2011) . “A Supply Model of the Equity Premium,” Rethinking the Equity Risk Premium, Charlottesville, VA, Research Foundation Publications.

Ibbotson SBBI (2012). 2012 Classic Yearbook: Market Results for Stocks, Bonds, Bills, and Inflation, 1926-2011, Chicago, Morningstar Inc.

Kalecki, Michael (1952). Theory of Economic Dynamics, New York, Augustus M. Kelley.

Levy, Jerome (1943). Economics is an Exact Science, New York, New Economic Library.

Reid, Jim, Burns, Nick and Stakhiv, Stephen (2012). “A Journey into the Unknown, ” Deutsche Bank, LT Asset Return Study, September.

Sawyer, Malcolm C. (1985). The Economics of Michael Kalecki, Armonk, N.Y., M.E. Sharpe Inc.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investors should consult their financial advisor prior to making an investment decision.

No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Munich Branch (Company No. 157591), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam, Italy and Munich Branches are additionally regulated by the AFM, CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, and BaFin in accordance with Section 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Services Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #08-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd services and products are available only to accredited investors, expert investors and institutional investors as defined in the Securities and Futures Act. | PIMCO Asia Limited (24th Floor, Units 2402, 2403 & 2405 Nine Queen’s Road Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (120 Adelaide Street West, Suite 1901, Toronto, Ontario, Canada M5H 1T1) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2012, PIMCO.

12-0973-GBL

Newport Beach Headquarters840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000

Amsterdam

Hong Kong

London

Milan

Munich

New York

Rio de Janeiro

Singapore

Sydney

Tokyo

Toronto

Zurich

pimco.com

Forecasting Equity Returns in the New Normal - Pimco

Documents

Transcript of Forecasting Equity Returns in the New Normal - Pimco