Our First Crystal Ball?

 

Source: Shiller Data, JQR Capital

Earnings Drive Prices

Last week we introduced data from Yale University Professor Robert J. Shiller that went all the way back to 1871 - a whopping 148 years. One of the important ingredients of this data set is the inclusion of corporate earnings to augment the price history. This allows us to begin forming return expectations models using something (anything, please!) other than past performance. The general conclusion from the chart shown below is that corporate earnings may drive future stock prices.


Source: Shiller Data, JQR Capital

Our First Crystal Ball 

We now turn the tables back to the bond side of our asset allocation pie to see if we can have any chance at predicting the future. The bond data from Professor Shiller is the 10-year US Treasury bond. He provides current (from 1871) bond interest rates (yields) and future bond returns. Our expectation is that the former of these two should provide predictive power for the latter of these two. One of the benefits of being a bond investor is that we should (unless there is complete default) recover our principal at the maturity of the bond. Because US Treasury bonds are backed by the full faith and credit of the US Government, the risk of default should be miniscule. The chart below shows that the correlation of returns peaks at 0.98 at year 10 - or 120 months - in the future. This should be no surprise for the 10 year US Treasury bond.


Source: Shiller Data, JQR Capital

Our Last Crystal Ball?

Wow! We are on a roll. Let us now turn the tables back and see if a similar correlation holds when we look at our stock history and the predictive power of our earnings data. We first introduce a metric called the price to earnings ratio - or PE. This is simply the ratio of the corporate earnings divided by the current price for a given stock or (in this case) a big basket of stocks in an index. When flipped upside down, the PE is called the earnings yield and we hypothesize it may have some predictive value. The chart below shows a similar correlation trend between the earnings yield and the stock returns over various investment horizons.


Source: Shiller Data, JQR Capital


This chart looks a little bit less “predictive” for two main reasons: (1) the overall correlations are much lower than those for the bond side of the allocations and (2) they seem to have a “local” peak around the 24 month mark in the future. Next time we will resize the horizon scale and throw in another term often reserved for discussions by hedge fund managers - the information coefficient. Please stay tuned!

 

Most of the important things in the world have been accomplished by people who have kept on trying when there seemed to be no hope at all. -

Dale Carnegie


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Disclaimer

Past performance is no guarantee of future results. Any investment involves some amount of risk and may not be suitable for all — or any — individuals. You should consult with your investment advisor before acting on this — or any — financial information.

References

http://www.econ.yale.edu/~shiller/data.htm

https://www.jqrcapital.com/channels/blog

https://www.brainyquote.com/


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Location: 23 Foxridge Rd, West Hartford, CT 06107, USA

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