At the beginning and in the middle of each year, we publish an update of our estimates of medium-term total return forecasts for various financial assets. Here we assume a basic return power for each financial asset and adjust this by assuming that its current valuation will revert to its mean. We refrain from using economic scenarios; instead, we assume in the conservative scenario that a typical economic cycle lasts seven years, while in the progressive scenario we assume 14 years. We also create a progressive scenario because there are increasing signs that economic cycles have become longer since World War II.
From 1802 to 2012, investors in US equities generated an average real total return of about 6.6%1 per annum. Based on this and other studies, we assume a uniform return on equity of 6.0% for all equity markets considered. In order to arrive at a total return forecast for equities, two adjustments must be made: one for the valuation of the equity market (price-earnings ratio) and one for the level of corporate profit margins. Here, we assume that both factors – the valuation of the equities market and corporate profit margins – are making a steady reversion to their historical averages.
For the bond market, we assume that the real interest rate is the yardstick for valuation. However, in this case, we do not assume the real interest rate will revert to its historical mean value in the medium term; instead we assume it will draw near to the growth trend in the respective economy. This is because the growth trend forms the basis for generating the income needed to service the real interest burden in the medium term in the first place. For corporate bonds, high-yield bonds and emerging market bonds, however, we expect spreads to return to historical averages. We also take average default rates and recovery rates into account.
Finally, we estimate the costs of currency hedging in order to convert the expected return on financial assets denominated in foreign currencies into euros. As a rule, a currency hedge is concluded for a period of three months and then renewed regularly every three months for seven years. Thus, the costs of a currency hedge result from the average expected difference between the three-month interest rates over seven and 14 years. The uncovered interest rate parity also suggests that the performance of an investment in foreign currency with or without currency hedging is unlikely to differ significantly over the medium term.
The total return on an equity investment can be broken down into the following components:
- Change in the price-earnings ratio
- Change in earnings per share
- Sales growth
- Change in profit margins
- Increase/decrease in the number of shares out-standing (e.g. due to a share buy-back)
Companies can use their earned return on equity to pay dividends, buy back shares or to reinvest in the company in order to achieve higher sales. We expect companies around the world to generate a return on equity of 6% in the long term. Return on equity is a real figure. Moreover, the price-earnings ratio and profit margins of companies tend to move sideways over a very long period of time. Therefore, return from real sales growth, share buybacks and dividend yield must sum up to 6% in the long term. However, over seven or 14 years, profit margins and the price-earnings ratio are not constant; they fluctuate. For simplicity’s sake, we therefore assume that a deviation from the mean value observed today will correct itself again over a period of seven or 14 years.
1 Jeremy Siegel: Stocks for the Long Run
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