“Mankind are so much the same, in all times and places, that history informs us of nothing new or strange in this particular. Its chief use is only to discover the constant and universal principles of human nature.”–David Hume

- People who are approaching retirement need to estimate probable returns in order to budget how much they need to save.
- A retiree’s level of sustainable income is largely dictated by expected returns over the early years of retirement.
- Investors of all types must make an informed decision about how best to allocate their capital among various investment opportunities.

*inflation-adjusted*stock returns including reinvested dividends over subsequent multi-year periods. Our analysis provides compelling evidence that future returns will be lower when starting valuations are high, and that returns will be higher in periods where starting valuations are low.

*Traditional investment planning does not account for whether markets are cheap or expensive. An investor who visited a traditional Investment Advisor at the peak of the technology bubble in early 2000 would, in practice, be advised to allocate the same proportion of his wealth to stocks as an investor who visited an Advisor near the bottom of the markets in early 2009. This despite the fact that the first investor would have had a valuation-based expected return on his stock portfolio from January 2000 of negative 2% per year, while the second investor would expect inflation-adjusted compound annual returns of 6.5%. For an investor with $1,000,000 to invest, this would represent a difference of more than $1.26 million in cumulative wealth over a decade.*

*meaningful*historical precedents, markets are currently expensive and overbought by all three measures, indicating a strong likelihood of low inflation-adjusted returns going forward over periods as long as 20 years.

Source: Vitaly Katsenelson (2011) The profit margin picture is critically important. Jeremy Grantham recently stated, “Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” On this basis, we can expect profit margins to begin to revert to more normalized ratios over coming months. If so, stocks may face a future where multiples to corporate earnings are contracting at the same time that the growth in earnings is also contracting. This double feedback mechanism may partially explain why our statistical model predicts such low real returns in coming years. Caveat Emptor.

### Modeling Across Many Horizons

**Table 1. Factor Based Return Forecasts Over Important Investment Horizons**

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

### Process

**Matrix 1. Explanatory power of valuation/future returns relationships**

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

### Forecasting Expected Returns

**Matrix 2. Slope of regression line for each valuation factor/time horizon pair.**

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

**Matrix 3. Intercept of regression line for each valuation factor/time horizon pair.**

**Matrix 4. Modeled forecast future returns using current valuations.**

**Chart 2. 15-Year Forecast Returns vs. 15-Year Actual Future Returns**

### Putting the Predictions to the Test

**Table 2. Comparing Long-term average forecasts with model forecasts**

*433% more error*than estimations from our model over these 15-year forecast horizons (1.28% annualized return error from our model vs 5.55% using the long-term average). Clearly the model offers substantially more insight into future return expectations than simple long-term averages, especially near valuation extremes.