A recent article in The Economist discusses the difficulty analysts face in forecasting returns given the current market’s stretched valuations.
“Just as fund managers cannot be relied on to be consistent, returns from asset classes are highly variable. The higher the initial valuation of the asset, the lower the future returns are likely to be.”
The article offers GMO data showing, “The assets that GMO thought would yield a negative return of -10% to -8%, for instance, have in fact suffered average losses of only -2.8%.”
According to the article, the reason for the miss is that equity valuations have not seen the mean reversion that GMO anticipated, in part because U.S. companies are continuing to experience strong earnings growth. In addition, it argues, “with yields on cash and government bonds so low, investors are willing to pay a high price for equities because they represent their only hope for decent returns.” In order for this to continue, however, it asserts that profits will have to continue to increase as a percentage of GDP.
“That seems unlikely,” the article concludes, stating, “Either there will be a political reaction—governments will clamp down on firms in response to public unrest—or, more prosaically, tighter labour markets mean that wage growth will start to erode profits.”