A Framework for Equity Allocation
Sources: Yardeni (for consensus EPS forecasts); JPM Asset Management (for long-term average sector P/E ratios); NAREIT.
A “building block” approach has been shown to produce better results than other methods of forecasting long-term equity returns. The matrix incorporates the following variables:
Earnings growth — using the CAGR in forward earnings projections between 1995 to present for each sector
A reversion in multiple toward 20-year average levels
Income return — the forward estimated dividend yield
A cyclical adjustment to account for how the business cycle is expected to develop in the next 12 months (apply only 0.5x weight)
Finally, given that strategies that factor in risk outperform those that do not, the scores factor in volatility for each sector. The cycle adjustment is predicated on the observation that increases in inflation rates over time begin to affect the level of activity, as seen below.
The Inflation Composite Indicator uses three components (the ISM price survey; the NFIB price survey; and the y/y change in the CPI rate) which are converted into Z-scores and shown advanced 6 to 12 months, depending on the series.
I appreciate that there are idiosyncratic sector factors not taken into account with this approach (e.g. drug price negotiations; antitrust scrutiny of tech platforms). Further iterations of this model will also look to include these sector factors and the sensitivities to a change in money supply.
Disclaimer:
The content on this website is for informational and educational purposes only and does not constitute investment or financial advice. Consult your own financial advisor before putting any capital at risk. Nothing in this website should be construed as a recommendation to buy, sell, or hold any investment or security or to engage in any investment strategy or transaction. There is no guarantee that any targeted performance or forecast will be achieved. There is no obligation on behalf of the author to update or revise any forward-looking statements. Nothing herein constitutes an offer to sell or a solicitation of an offer to buy any security.