Evaluating Estimates of Future Stock Market Returns

A number of analysts are estimating that investment returns over the next 10 years will be less than the long-term average, perhaps considerably less. They estimate annualized returns from stocks of 3% to 4% in many cases. Among the most prominent is John Hussman of the Hussman funds. This post pulls apart Hussman’s methodology and explains in some detail why you shouldn’t rely on his forecast of 10-year returns. It is long and somewhat detailed. But if you are familiar with and concerned about Hussman’s analysis, you should give it a look.

Using insights discussed in the prior piece, I’m now in a position to offer a more specific and compelling challenge to John’s chart.  I believe that I’ve discovered the exact phenomenon in the chart that is driving the illusion of accurate prediction.  I’m now going to flesh that phenomenon out in detail.

Three Sources of Error: Dividends, Growth, Valuation

There are three expected sources of error in John’s model.  First, over 10 year periods in history, the dividend’s contribution to total return has not always equaled the starting dividend yield.  Second, the nominal growth rate of per-share fundamentals has not always equaled 6.3%.  Third, valuations have not always reverted to the mean.

We will now explore each of these errors in detail.  Note that the mathematical convention we will use to define “error” will be “actual result minus model-predicted result.”  A positive error means reality overshot the model; a negative error means the model overshot reality.  Generally, whatever is shown in blue on a graph will be model-related, whatever is shown in red will be reality-related.