The famous American baseball coach Yogi Berra is often quoted as saying “It is difficult to make predictions, especially about the future”. But any investment decision is inherently a prediction about the future. By buying one asset over another you are predicting that that asset will outperform the other. But predicting the future is hard, so can we make forecasts, without making forecasts?
One way to do this is to merely rely on historic data and assume that some relationship that has been predictive of the returns of an asset in the past is going to be predictive of future returns. The most common and economically sound way of doing this is based on valuation.
Across time and asset classes, buying assets that are cheap tends to lead to higher forward returns than buying assets that are expensive, either across time or compared to other assets (in the cross section).
This is one of our favoured approaches to asset class valuation. We look for valuation metrics that have historically had a statistically significant relationship with subsequent returns and fit a simple regression model to that data. This allows us to say that if the same relationship continues to hold, what would we expect the return of that asset class to be over the next three years.
We show four of these models for the JSE All Share Index and their current output. In each case there is a linear relationship between the valuation metric and subsequent equity returns. But these relationships are quite weak, they give the average tendency of returns, but with quite a wide error range around them.
In each instance, if these relationships continue to hold, and based on current valuations, the average return expectation for the next three years is between 17% and 23% per annum. The actual outcome over the next three years could differ quite substantially from this central tendency (to the upside or the downside) but based purely on historic data the odds seem to be skewed towards attractive returns for SA Equity.
Source: Bloomberg, Mergence
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