Finding Fair Value in Global Equities: Part II—Forecasting Returns

Abstract

This article is the second of a two-part series that develops a framework for comparative valuation of major equity markets around the world. In this article, the authors invert the dividend discount model (DDM) discussed in “Fair Value in Global Equities:Part I,” published in the preceding issue of this journal, in order to extract a time series of the implied equity risk premium (ERP) and the real required return (RRR).They estimate regression equations to find the macroeconomic drivers of these series. The ERP increases with the output gap at home and abroad, as well as with high past values of the ERP. This relationship allows for benchmarking the ERP and the RRR to the current economic environment and to forecasts of the future economic environment. The authors compare the use of these tools with other ways to forecast returns. At a five-year horizon, valuation alone is a good predictor of future returns, and the current value of the RRR works particularly well in this regard. At a one-year horizon, forecasts based on the benchmarking of the RRR to the future economic environment work significantly better than traditional valuation metrics, if the economic outlook is correct.