In May, the Global Market Index (GMI) expected long-run return increased slightly to an annualized pace of 6.0%, which is just above the previous month’s estimate. This forecast is based on averaging three different models and near the lower range for recent history based on a rolling 10-year return. GMI is an unmanaged portfolio that holds all the major asset classes, except cash, and is market-value-weighted. The components of GMI maintain relatively strong forecasts, while the US stock market is still projected to earn a significantly lower return compared to its previous decade’s performance. GMI’s forecast for a 6.1% annual return is slightly above its 10-year performance.
GMI represents a theoretical benchmark of the optimal portfolio for the average investor with an infinite time horizon. This benchmark’s usefulness lies as a starting point for research concerning asset allocation and portfolio design. GMI’s performance, according to its history, is competitive as a passive benchmark with most asset-allocation strategies, especially after considering the adjustments for risk, trading costs, and taxes.
While the GMI forecasts may be inaccurate in some degree, they are expected to be more reliable than estimates for individual asset classes. Predictions for specific market components like US stocks and commodities are more volatile and susceptible to tracking errors compared to aggregating forecasts into the GMI estimate, which can reduce some errors over time.
For context: on a rolling 10-year annualized basis, the chart below compares GMI’s performance to that of US stocks and US bonds. GMI’s current 10-year return stands at 6.1%. Although it had substantially decreased from recent levels, it has been relatively steady lately.
Rolling 10-Yr Annualized Total Return
Here is a summary of how the forecasts are generated, along with definitions of the other metrics in the table above:
BB: The Building Block model uses historical returns to estimate the future. A sample period starting in January 1998 is used for all the asset classes listed above. The procedure is to calculate the risk premium, compute annualized return, and add the expected risk-free rate to forecast total return. The latest yield on the 10-year Treasury Inflation-Protected Security (TIPS) is the expected risk-free rate, which is considered a market estimate of a “safe” asset’s risk-free, real (inflation-adjusted) return. Note that the BB model used here is based loosely on a methodology originally outlined by Ibbotson Associates (a division of Morningstar).
EQ: The Equilibrium model reverse engineers expected return by way of risk. This methodology relies on the relatively robust framework of using risk metrics to estimate future performance. Forecasting risk is slightly easier than projecting return, making this methodology more reliable. The three inputs are:
* A market price estimate of the overall portfolio’s expected risk, defined as the Sharpe ratio, the ratio of risk premia to volatility (standard deviation). Note: the “portfolio” here and throughout refers to GMI
* The expectation of volatility (standard deviation) of each asset (GMI’s market components)
* The expected correlation for each asset relative to the portfolio (GMI)
The Equilibrium model initially estimates a risk premium and then adds an expected risk-free rate to arrive at total return forecasts. BB above outlines the expected risk-free rate.
ADJ: This methodology is identical to the Equilibrium model (EQ) outlined above with one exception: the forecasts adjust based on a combination of short-term momentum and longer-term mean reversion factors. Momentum is defined as the current price relative to the trailing twelve-month moving average. Mean reversion factors estimate as the current price relative to the trailing sixty-month (5-year) moving average. Current-equilibrium prices are adjusted based on their relationship to these moving averages. If current prices are above or below the moving averages, unadjusted risk premia estimates decrease/increase accordingly. Adjustment calculation takes the inverse of the averages of current price to the two moving averages. For instance, if an asset class’s current price is 10% above its 12-month moving average and 20% over its 60-month moving average, the unadjusted forecast falls by 15% (the average of 10% and 20%). The basis of this adjustment is that, when prices are relatively high compared to recent history, the equilibrium forecasts reduce. On the other hand, when prices are relatively low compared to recent history, the equilibrium forecasts increase.
Avg: This column is a straightforward average of the three forecasts for each row (asset class).
10yr Ret: This column provides context for actual returns and illustrates the trailing ten-year annualized total return for asset classes. It is up to the target month.
Spread: The average forecast generated by the models, less the trailing 10-year return.