U.S. Stock Market Returns: What's In Store?
Prieur du Plessis
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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. Has the market started bottoming out, or are bourses still in the grip of the bear? Or, is a “muddle-through” trading range in store?
It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people 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, “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 October 2008 and used the S&P 500 (and its predecessors prior to 1957). In essence, P/Es based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.
In the first analysis the P/Es and the corresponding 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% per annum, whereas the most expensive quintile had an average P/E of 22.6 with an average ten-year forward real return of only 3.1% per annum.
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 were therefore more volatile and less predictable. Interestingly, given that the current 10-year normalized P/E of 14.9 falls in the middle of this range, the exceptional volatility being experienced at the moment is consistent with historical patterns.
As a further refinement, holding periods of one, three, five and 20 years were also analyzed. 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 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 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 14.9 and ten-year normalized dividend yield of 3.1%, investors should be aware of the fact that the market is by historical standards still only in “average value” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a “muddle-through” trading range for a number of years to come.
Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current ten-year normalized valuation levels. In fact, there is a distinct possibility of some negative returns.
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This article has 7 comments:
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Bubba Gump
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2 Comments
Dec 03 07:33 AMLet's see. Does the price you pay for an investment have any impact on total return? The author seems to have put a lot of energy into answering that question. Why did it only take me 2 seconds to answer, DUH!
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Chris B
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555 Comments
Dec 03 09:56 AM"Based on the above research findings, with the S&P 500 Index’s current ten-year normalized P/E of 14.9 and ten-year normalized dividend yield of 3.1%, investors should be aware of the fact that the market is by historical standards still only in “average value” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a “muddle-through” trading range for a number of years to come"
This conclusion seems a bit disturbing to equity investors as it implies that bonds or other investments will probably outperform stocks for the next decade. Based on previous patterns, we're looking at 5-6% returns and moderate volatility in a future environment that will likely include high inflation and/or taxes (The baby boomers will vote for high taxes once they aren't earning money any more and have exhausted their own investments - typical baby boomer selfishness.).
I would like to see a follow-up study analyzing the 10 year performance of the 5 quartiles for individual stocks within each year, rather than the S&P average between years. That would tell me whether the value strategy should be based on individual stock opportunities or the broader S&P level - that is, should I be buying low PE stocks now or waiting for the S&P to fall farther?
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John Lounsbury
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624 Comments
My Website
Dec 03 10:27 AMSome might say this work offers no more than the adage: buy low, sell high. My view: that attitude is similar to someone taking a long hike through the wilderness without a map and compass. Things may go well for a time, but when you become disoriented you will regret lack of reference. What is low and what is high? Refer to the map and compass.
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Smarty_Pants
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1115 Comments
My Website
Dec 03 02:17 PMOne possible extension which might be of some value would be to divide your data set into two groups based on changes in earnings (or dividends) in the year following entry. One group contains years where the earnings/dividend decreases the year following entry and the other group contains the remaining years.
Example: Stock ABC is paying a dividend of 4% and has a p/e of 15. Based on your charts one could expect a positive return after 10 years to be likely, but not certain.
What is the return for the years with 4% yield and p/e of 15 when the following year shows a reduction in earnings, a reduction in the dividend payment, or both as compared to years where the reductions do not occur?
In other words, is there any difference between buying when business performance is on the way down or waiting until financial performance settles down before entering?
One would assume that performance for purchases when conditions are deteriorating would be worse than for purchases where conditions had stabilized.
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Levin70
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22 Comments
Dec 03 04:22 PM-
oldgoldbug
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87 Comments
Dec 03 05:11 PM-
syndicat
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95 Comments
Dec 03 06:20 PMThe 10 Yr Tsy vs. Div yield is no longer valid because the 10 Yr Tsy is
now a deflation play.
If you compare 10 Yr A rated bonds to the dividend yield you will see a very different comparison. The current A rated bond average is around 6.25%. (throwing out the crazy stuff like AIG, etc.)
S&P 500 index yield is actually below average. This is quoted from their index website:
"From December 1936 through March 31 2008 the average yield for the S&P 500 was 3.828%..." As of Nov 28, 2008 the indicated yield on the S&P 500 index is 3.06%.