Market Valuation vs. Real Returns
By Prieur du Plessis Dec 03, 2008 10:45 am
"Muddle-through" trading range for years to come.
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's 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 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 (PE) 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, PEs based on rolling average 10-year earnings were calculated and used together with 10-year forward real returns.
In the first analysis the PEs and the corresponding 10-year forward real returns were grouped in 5 quintiles (i.e. 20% intervals).
The cheapest quintile had an average PE of 8.5 with an average 10-year forward real return of 11,0% per annum, whereas the most expensive quintile had an average PE 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.
No positions in stocks mentioned.
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Reply
2008-12-03 12:07:59
Excellent analysis
Prieur,
I just have to say this is excellent analysis. It is very useful, and practical information.
Keep up the good work.
I just have to say this is excellent analysis. It is very useful, and practical information.
Keep up the good work.
2008-12-03 18:26:23
Consistent with academic research but an easier read
Published research showed many years ago that low P/E stocks provided higher returns (Fama French). Other research demonstrates the importance of dividends; presumably because dividends cannot be paid with air dollars.
Prieur's short article is easier to read and understand. Who needs regression models anyway?
Prieur's short article is easier to read and understand. Who needs regression models anyway?
2008-12-04 02:21:45
What years are in the distribution
I like the analysis, but I think it would also be interesting to know which years occur within each quintile. Is there a heavier weighting in the top quintiles for post WWII or for post 1982 or surrounding the 1920s or are the distributions roughly equal throughout the time series? Since I'm not sure rolling average P/E ratios have consistently been above 20 other than in the 20s and in the 90s I think it would offer interesting perspective.
2008-12-04 22:24:27
Share Buybacks
I believe there is a study which shows shareholder yield (dividend + share repurchase + debt repayment) has a positive correlation to out performance. The thought is that dividend yields declined over the years and were replaced by share buybacks (options dilution not with standing). If this study is correct then wouldn't buybacks add a few percentage points to the current yield and make the valuation of the market slightly more positive?
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