Sunday, August 28, 2011

The Predictive Power of "Stocks as Bonds"

My recent post Corporate Profits, Economic Growth, and Equity Valuation outlined that equity performance can be quite volatile, but over the long-run tends to mean revert back to its underlying factor... economic growth.

Which brings me to a model created by the great Eddy Elfenbein (of Crossing Wall Street), which I initially came across in his post What if the Stock Market Were a Bond, back in October 2010. Eddy's explanation of that concept:
I took all of the historical market performance of the S&P 500 (including dividends) and invented a hypothetical long-term bond that matched the market’s monthly gains step-for-step.

I assumed that it’s a bond of infinite maturity and pays a fixed coupon each month.
The result, which starts December 1925, is the following (reproduced) chart.

Crossing Wall Street Model for Stocks (12/1925 - 8/2011)

While I expected a strong relationship between the above chart with forward equity returns (the model is driven by equity performance, but accounts for the market being rich / cheap to its long-term trend and normalizes returns using backward and forward looking performance), I was surprised by how closely it tied (data was pulled from Irrational Exuberance).

Crossing Wall Street Model vs Ten Year Forward Equity Returns

Same Chart, but a Change in Scale to the Right Hand Side

The likely question is how well this model will predict the future as it shows a 12%+ annualized ten year forward return. My initial thought is don't read too much into the model for predictive power UNLESS the underlying factors that drove the last 85 years of equity performance are expected to continue (and at the same level). In addition, Eddy lays out one more issue:
There’s one hitch, though. I have to choose a starting yield-to-maturity for the beginning of the data series in December 1925. So this isn’t a completely kosher experiment because the starting point is based on my guess.
This issue can be seen in the below model which goes back further... all the way to 1871. Rather than predict a forward ten year equity return of more than 12+%, the model predicts returns of less than 5% (due to lower equity returns between 1871 and 1925).