Market Valuation and Investment Returns: What's the Connection?

Stock market movements over the past few months have been characterized by increased volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly grappling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Are we still in a bull market, or perhaps experiencing a counter-trend rally in a bear market? Or, on the other hand, are we in-store for a “muddle-through” trading range?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with very few investors actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (P/E) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns. The study covered the period from 1871 to November 2007, and used the S&P 500 (and its predecessors prior to 1957). In essence, a total real return index and coinciding ten-year forward real returns were calculated and used together with P/Es based on rolling average ten-year earnings.

In the first analysis the P/Es and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

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The cheapest quintile had an average P/E of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average P/E of 22,0 with an average ten-year forward real return of only 3,2% p.a.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the P/Es divided into smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3).

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This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (P/Es of less than six) to the most expensive grouping (P/Es of more than 21). The second study also shows that any investment at P/Es of less than 12 always had positive ten-year real returns, while investments at P/E ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at P/Es between 12 and 17 had the biggest spread between minimum and maximum returns, and therefore were more volatile, and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to, and an extension of, an earlier study by Jeremy Grantham’s GMO, it was also considered appropriate to replicate the study using dividend yields rather than P/Es as a valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on P/Es.

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Based on the above research findings, with the S&P 500 Index’s current ten-year normalized P/E of 23.7 and ten-year normalized dividend yield of 1,6%, investors should be aware of the fact that by historical standards, the market is not in cheap territory, thereby arguing for luke-warm, long-term returns. Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, there is a distinct possibility of some negative returns.

It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns.”

Comments

[Fat Arby]

I think it's probably best to hire a mentor and have some sort of advisory.
Sure, my mentoring was way incomplete, which is why I've not known how to deal with the recent Bull rally, but when it falls it's sure good.
You can't expect to put your money in one date and take it out 12.01 months later and have a 20 or better percent return.
Tools are there for a reason, and my weak spot is not having paid for more tools when I had the surplus capital. I went on vacation instead and lived it up. Now, I'm feeling it cause I can't even afford wine cause I thought I knew it all!
TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS TOOLS

[locke]

This research suggests that it is a good time to buy banks.

[noneyour]

It is good to know that your research confirms the fact that if one buys low and sells high they make more money than buying high and selling later.
I think an extension of the research and position you take is that it would be a good idea to buy stocks when the S&P 500 is trading below a P/E of 15 and sell stocks when the S&P 500 is trading above 15. This strategy is straight forward and when test looking backwards works well. However, the down side of this strategy is that one would not be able to purchase stocks since 1995 as the S&P has had a P/E above 15 since then. That's a lot of movement to miss.
This strategy like yours doesn't help investors who want to invest in our lifetime.

[OscarBullFrog]

re: locke .... this is a good time to continue to LOOK at buying SOME stocks .... i am not convinced that the specific time to buy is RightNow (tm). imnsho, the diligent investor will identify certain issues which ought to be profitable and decide on a specific price at which to buy ... in increments ... and watch the price/dividend action from a respectable, emotionally disassociated, distance.

my own anticipation suggests that late 2q08 or mid 3q08 would be a better timing, as if timing could be predicted.

[jjason]

An excellent article. Fat Arby's comment is, well, dumb. Benjamin Graham, the father of value investing, would see the value in this research. It is important to understand that a dividend payout that is sustainable and increasing year over year from solid earnings, means a company is well run and cares about the shareholders. But,of course, the balance sheet and income statements need to be examined and analyzed, along with other fundamentals like pe ratios, price to book ratios, etc. The hot shots who talk of huge returns from high pe ratio companies may win or lose. I think it is better to win with a consistent ROI of 10% to 15% every year, over time, from a combination of dividends and capital gains. I my opinion, the research in this article bears this out.