Equity Forecasting

When looking at a very long time horizon—over 100 years—mean real returns of equity markets in various countries do not show statistically meaningful differences. These sample averages tend to be imprecise, unless the volatility of the data is small. As we saw, shrinkage estimators are typically more reliable as predictors of equity returns.

Discounted Cash Flow Approach

For equity markets, the most common application of DCF models is the Gordon growth model, or constant growth model. It is most commonly used to back out the expected return on equity and is often applied to entire markets.

Grinold and Kroner (2002) take this model one step further by including a variable that adjusts for stock repurchases—which companies use to transfer cash to shareholders—and changes in market valuations as represented by changes in the price-earnings (P/E) ratio.

The Grinold-Kroner model states that the expected return of a stock is its dividend yield, plus the inflation rate, plus the real earnings growth rate, minus the change in stock outstanding, plus changes in the P/E ratio

Risk Premium Approach

The equity risk premium is generally defined as the amount by which the equity return exceeds the risk-free rate. However, the same term is sometimes used to refer to the amount by which the expected return on equities exceeds the expected return on default-free bonds (“equity versus bonds”).

Forecasting the equity premium is generally quite challenging, regardless of the approach selected. An analyst must therefore supplement her forecasts with other methods of analyses.  These historical premiums are subject to substantial estimation error. Statistically, there is no meaningful difference among them. Thus, the long-run cross section of returns/premiums provides virtually no reliable information with which to differentiate among countries.

Equilibrium Approach

The Singer–Terhaar model is actually a combination of two underlying CAPM models. The first assumes that all global markets and asset classes are fully integrated. The second underlying CAPM assumes complete segmentation of markets such that each asset class in each country is priced without regard to any other country/asset class.

Emerging Market Equity Risk

Emerging markets are often characterized by fragile economies, political and policy instability, and weaker legal protections, including weak property rights, and weak disclosure and enforcement standards. They tend to exhibit idiosyncratic risks where local country effects tend to be more important than global effects. Emerging markets tend to be less fully integrated than developed markets.

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