Long ‐ Term Trends (III): Forecasting Javier Estrada ADFIN – Winter/2014 1. Motivation • Investing v . speculating 2. The Model • The RDM (Returns Decomposition Model) 3. Forecasts • USA and the World market Motivation – Warren Buffett Javier Estrada IESE Business School “I never had the faintest idea Barcelona Spain what the stock market is going to do in the next six months, or the next year, or the next two. But I think it is very easy to see what is likely to happen over the long term.” ADFIN Winter/2014 1
Motivation – John Bogle Javier Estrada IESE Business School “The performance of individual Barcelona Spain securities is unpredictable …, the performance of portfolios of securities is unpredictable on any short-term basis … Yet when we look at portfolios of securities on a longer-term basis, the unpredictable becomes far more predictable …” ADFIN Winter/2014 Motivation – John Keynes Javier Estrada IESE Business The activity of forecasting School Enterprise the prospective yield of Barcelona Spain assets over their whole life The activity of forecasting Speculation the psychology of the market ADFIN Winter/2014 2
Motivation – John Bogle Javier Estrada IESE Business Initial dividend yield Investment School + Barcelona Return Spain Earnings growth Speculative Variation in the P/E Return ADFIN Winter/2014 Motivation – John Keynes Javier Estrada IESE Business School “It is dangerous … to apply Barcelona Spain to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was” ADFIN Winter/2014 3
Motivation – Paul Samuelson Javier Estrada IESE Business School “You are a fool if you wake up each Barcelona Spain morning and say that the universe was born anew today with new rules. You are also a fool if you think that history can be read to teach necessitous lessons. The art of practical decision-making is to try to glean from experience what aspects of it are likely to have relevance for the future” ADFIN Winter/2014 Motivation – Mark Twain Javier Estrada IESE Business School Barcelona Spain “History does not repeat itself, but it does rhyme” ADFIN Winter/2014 4
The RDM Javier P –1 P 0 P 1 Estrada E 0 , D 0 E 1 , D 1 IESE Business –1 0 1 School Period 1 Barcelona Spain ADFIN Winter/2014 The RDM Javier E 0 = $10.0 E 1 = $10.6 Estrada D 0 = $4.0 $100 D 1 = $4.2 $107.8 IESE Business School –1 0 1 Period 1 Barcelona Spain ADFIN Winter/2014 5
The RDM This is the RDM forecasting expression Javier Estrada IESE Business School Barcelona Spain And this is a very good approximation In the previous example ADFIN Winter/2014 The RDM This approximation highlights the distinction Javier Estrada between investment and speculative return IESE Business School Barcelona Spain Investment return Speculative return Where do long ‐term returns come from? Go Optimism/pessimism largely offset each other Returns are ultimately determined by DY and g E Go ADFIN Winter/2014 6
USA ($) – 2014 ‐ 2023 Javier Estrada 1900 ‐ 2009 Jan/1/14 IESE Growth earnings 4.5% D/P 1.9% Business School Average P/E 15.8 P/E 18.9 Barcelona Spain Growth earnings 4.5% Assumptions ΔP/E (MR) −1.8% ΔP/E (RW) 0.0% MR 1.9%+4.5%−1.8% = 4.6% R 1 5.5% RW 1.9%+4.5%+0.0% = 6.4% R 1 Historical (1900 ‐ 2009): 9.4% ADFIN Winter/2014 USA ($) – 2014 ‐ 2023 Javier Jan/1/14 Estrada D/P 1.9% IESE MR = 4.6% P/E 18.9 R 1 Business School 1900 ‐ 2009 Growth E 4.5% Barcelona 5.5% Spain Avg P/E 15.8 Avg D/P 4.2% Next 10 Years RW = 6.4% R 1 Growth E 4.5% Δ(P/E) −1.8% or 0.0% Don’t like it? Make your case … R 1 = 1.9% + ? + ? = ? D 0 / P 0 = 1.9% E = g 1 ? Δ (P/E) 1 =? Is it reasonable? ADFIN Winter/2014 Go 7
USA ($) – 2014 ‐ 2023 Javier Estrada IESE Business School Barcelona Spain If you have an expectation for returns E and Δ(P/E) would yield that return Ask what g 1 ADFIN And ask whether those values are reasonable Winter/2014 World ($) – 2014 ‐ 2023 Javier Estrada 1973 ‐ 2013 Jan/1/14 IESE Growth earnings 7.8% D/P 2.4% Business School Average P/E 16.9 P/E 16.4 Barcelona Spain Growth earnings 7.8% Assumptions ΔP/E (MR) 0.3% ΔP/E (RW) 0.0% MR 2.4%+7.8%+0.3% = 10.5% R 1 10.3% RW 2.4%+7.8%+0.0% = 10.2% R 1 Historical (1973 ‐ 2013): 10.1% ADFIN Winter/2014 8
Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 USA (S&P) – Nominal Returns Javier Estrada IESE Business Avg: 9.4% School Barcelona Spain 158 53 303 − 1 137 482 111 75 400 433 − 9 ADFIN Winter/2014 9
USA (S&P) – Starting D/P Javier Estrada IESE Business Avg: 4.2% School Barcelona Spain ADFIN Winter/2014 USA (S&P) – Growth in Es & Ds Javier Estrada IESE Business School Barcelona Spain Avg(E): 4.5% Avg(D): 4.4% ADFIN Winter/2014 10
USA (S&P) – Change in P/E Javier Estrada Avg: 0.5% IESE Business School Barcelona Spain ADFIN R = 4.2% + 4.5% + 0.5% = 9.2% ≈ 9.4% Winter/2014 Back The RDM Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 11
The ‘Building Blocks’ Model Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Expectations Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 12
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