Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Forward-looking measures of asset returns

• Value and carry indicators can be useful predictors of future asset returns, especially over longer horizons, even if we do not know the underlying reason for the generic cheapness.

• Popular indicators include earnings yields and dividend yields for equities, real yields and yield curve steepness for Treasuries, and various credit spreads for non-government bonds.

• Prospective real long-term returns can be compared across asset classes (apples with apples).

• In a building block approach, each asset’s or strategy’s prospective return is expressed as a sum of carry, expected cash flow growth, and expected valuation change. This framework could be useful for assessing the prospects of several asset classes in a consistent manner.

Forward-looking return signals are surprisingly good indicators of long-term return outlook. Here, I review popular value and carry measures for major asset classes. They have their shortcomings but these are partly compensated by their simplicity and real-time observability. More complex value indicators exist but involve more specific assumptions (model specification risk), more elaborate statistical estimation (estimation risk), and often more hindsight bias. Carry and value indicators can usefully (if noisily) predict future returns even when we don’t understand the reason for the risk premium and even when we don’t know whether the source of predictability is a rational risk premium or irrational mispricing. ...