Jeremy Grantham's firm GMO makes a monthly “7-year Forecast” which has been reasonably accurate over the years.  It is primarily valuation based.  For example, here's the most recent one:

These are estimates of the annualized after-inflation return for a particular asset class over the 7 years beginning 1 November 2011.  Some of the asset classes are pretty self-explanatory, such as US Large stocks, or the S&P 500.  Others, a little less clear, such as index-linked bonds or timber.  Finally, the US High Quality stocks (which seem to always have a high predicted return BTW) are anyone's guess as to what Grantham/GMO means.  Here is the explanation from the website:

How do you define “quality” stocks?

GMO defines quality companies as those with high and stable profitablility, and low debt.

Sounds good right?  But in reality, the definition is simply the stocks GMO selects for its US equity funds. Taking a look at their “Quality VI” fund using Morningstar, you see this that the fund is mostly giant growth stocks such as Pfizer, Microsoft, Coke, Johnson and Johnson, Phillip Morris etc.  Interestingly enough, they didn't use the “quality stock” asset class in their predictions 7 years ago.

Benefits of the GMO Forecasts

The thing I like about GMO Forecasts is that they seem pretty reasonable most of the time.  But the truth is you shouldn't take someone's current forecast, without looking at their past forecast.  So let's do that too.  Here are the predicted returns from May 31, 2004, or about 7 years ago.  One of their assumptions is 2.2% inflation, so in parentheses, I've put the predicted nominal return.  The reality was that inflation, at least measured by the CPI-U, was 2.5% per year over the last 7 years.

Equities

  • US Large Cap: -1.6% (0.6%)
  • US Small Cap: -1.3% (0.9%)
  • Intl Large: 3.2% (5.4%)
  • Intl Small: 3.8% (6.0%)
  • Emerging Markets: 6.4% (8.6%)

Fixed Income

  • Treasury Bonds: 2.2% (4.4%)
  • International Govt Bonds: 2.5% (4.7%)
  • Emerging Market Bonds: 4.7% (6.9%)
  • TIPS: 2.2% (4.4%)
  • Cash/Treasury Bills: 1.4% (3.6%)

Other

  • REITs: 3.7% (5.9%)
  • Managed Timber: 7.0% (9.2%)

So what were the actual returns for these asset classes, both real and nominal over the last 7 years?  To make things easy, let's use July 1, 2004 to June 30, 2011.  Some of the asset classes are easy to replicate, some a little more tricky.  4 of the asset classes have an index or an index fund now available, but the data isn't readily available for the full 7 year period, so I unfortunately have to omit these from the analysis.  If you have access to this data, please forward me a link.

Asset Class Vehicle Predicted Rank Actual Rank Predicted Real Return Actual Real Return Diff
US Large Cap VG 500 Index 8 7 -1.60% 1.70% -3.30%
US Small Cap VG Small Index 7 3 -1.30% 5.20% -6.50%
Intl Large VG Dev Mkt Index 3 4 3.20% 4.04% -0.84%
Intl Small No 7-year data N/A N/A 3.80% N/A N/A
Emerging Markets VG Em Mkt Index 1 1 6.40% 14.84% -8.44%
Treasury Bonds VG Int Treas Fund 4 5 2.20% 3.43% -1.23%
Intl Govt Bonds No 7-year data N/A N/A 2.50% N/A N/A
Em Mkt Bonds No 7-year data N/A N/A 4.70% N/A N/A
TIPS TIP ETF 4 6 2.20% 3.29% -1.09%
Cash VG Treas MM 6 8 1.40% -0.30% 1.70%
REITs VG REIT Index 2 2 3.70% 6.48% -2.78%
Managed Timber No 7-year data N/A N/A 7.00% N/A N/A

 

Here we see a few things.  First, GMO underpredicted returns by an average of 2.8% per asset class.  Second, subjectively, they really missed the boat with small US stocks (predicted a loss, but they had a large gain) and emerging market stocks (severely mispredicted the magnitude of the gains).   Last, with the exception of small cap stocks, they correctly predicted the rank of the other asset classes.

 

Predicting the Future is Hard

No matter what method you use, there is no such thing as a clear crystal ball.  There are two things you can do to improve your accuracy.  First, use a long time period.  Predicting returns in the next few months or years is particularly difficult.  Second, use valuations.  Over the long term, Bogle's “speculative return” from the excessive greed and excessive fear of market “emotions” cancels itself out.  We end up being left with the fundamental return.  So to predict that return, you should naturally use fundamentals.

It also becomes obvious that some areas are very hard to predict.  Cash, for instance, is heavily dependent on government-set interest rates.  The government sets rates based mostly on political and economic events you cannot readily predict years out.  I would take any prediction of short term interest rates with an entire shaker of salt.  Longer-term bonds, however, are much easier to predict.  The best prediction of the return of a bond is its current yield.  The yield on 7 year treasuries in mid-2004 was about 4.5%.  Subtracting out 2.5% for inflation, that leaves with an expected return of 2%.  What was the actual return?  3.4%.  A little higher than expected due to the falling interest rate environment, but still pretty close.  Likewise, the 7-year TIPS yield was 1.8%.  Actual return was 3.29%, again a little higher due to falling interest rates, but close.

 

How Does The GMO Focast Impact Your Portfolio?

So how can you use these predictions in managing your portfolio? First of all, I would caution against market-timing, even in the long-term.  For the most part I recommend you stick with a fixed asset allocation and rebalance each year.  Second, if you choose to make some adjustments based on valuations and long-term predicted returns, do so with a small percentage of your assets.  This concept of “tactical asset allocation” should be limited.  For example, if your plan calls for 50% stocks, you might bump that up to 55% if you expect high returns from stocks, and down to 45% if you expect lower returns.  It's okay to make a bet, but be sure to consider the consequences of being wrong.  Third, diversify, diversify, diversify.  Just because EM, small stocks, and timber are the asset classes predicted to do well, you don't want a portfolio composed only of these classes.  Not only will it be (likely) intolerably volatile, but if the prediction is quite wrong (like the small stock prediction noted above), your returns will take a beating.  Lastly, consider adding new asset classes to the portfolio from time to time, especially when valuations suggest strong future returns.  GMO has been predicting strong returns from timber for years.  But the ETFs CUT and WOOD only became available in 2008 and 2009 respectively, and have shown quite high correlation with the overall stock market.  Vanguard didn't come out with a small international stock index fund until 2009 and their actively managed fund was closed to investors off and on prior to that.  Predicted returns can give the investor some guidance about adding a new asset class when there isn't much of a track record to consider, and also provide some caution when there is an impressive track record behind the asset class.

In conclusion, crystal balls are always cloudy, but Jeremy Grantham's is clearer than most. If you want to check out another opinion, take a look at Mauldin's book with the link below. You might also take a look at Ed Tower's paper about the GMO forecasts.


Bull's Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market