Multiples, Forecasting, And Asset Allocation

Javier Estrada

IESE Business School

April 15, 2015


Multiples such as D/P, P/E, and CAPE are useful when forecasting long-term returns, and largely useless when forecasting short-term returns. Given this mixed forecasting ability, the issue addressed in this article is whether these multiples can be used to devise successful asset allocation strategies in the sense of outperforming a simple static portfolio. The bulk of the evidence discussed here suggests that investors would be better off sticking with a simple 60-40 stock-bond portfolio.

Multiples, Forecasting, And Asset Allocation – Introduction

Multiples such as the dividend yield (D/P), the price?earnings ratio (P/E), and the cyclically?adjusted P/E ratio (CAPE) are typically viewed as useful tools to forecast long?term stock returns. In fact, the evidence does suggest that the more investors pay per dollar of a fundamental variable (dividends, earnings, or cyclically?adjusted earnings), the lower is the long?term return they get. The ultimate question considered here is whether multiples, which are useful tools to forecast long?term returns, can also be useful tools for asset allocation.

Assume for the sake of the argument that multiples are ‘strongly’ related to ten?year forward returns; that is, a high (low) P/D, P/E, or CAPE today unequivocally implies a low (high) return over the following ten years. If this were the case, an investor could increase his exposure to equity when a given multiple is low, hold the high exposure for ten years, and capture a high return. Similarly, he could decrease his exposure to equity when the multiple is high, hold the low exposure for ten years, and avoid a low return.

The problem is that most (individual and particularly institutional) investors do not set an asset allocation and hold it for ten or more years; rather, they frequently adjust their portfolios in response to short?term conditions, among them changes in multiples, although these give no reliable signals about short?term returns. For this reason, it is conceivable that multiples could be at the same time useful tools to forecast long?term returns and poor tools to determine short?term asset allocations. That is, precisely, what the evidence in this article suggests. In fact, when multiples that provide reliable long?term strategic signals are (mis)used as short?term tactical tools, the resulting valuation?based portfolios do not outperform a simple 60?40 stock?bond portfolio.

The rest of the article is organized as follows. Section 2 discusses in more detail the issue at stake; section 3 discusses the evidence for the U.S. market and its relationship to previous findings; and section 4 provides an assessment.

2. The Issue

Multiples such as D/P and P/E have a long history as valuation tools; even CAPE, which has become increasingly popular only recently, can be traced back to Graham and Dodd’s (1934) Security Analysis. The usefulness of multiples to forecast long?term stock returns is on display in Exhibit 1, which relates the inverse of D/P (panel A) and P/E (panel B) to ten?year forward annualized returns over the Dec/1899?Dec/2014 period.1 Clearly, history shows that the more an investor paid per dollar of dividends per share or earnings per share, the lower were the returns he received in the subsequent ten years.

Asset Allocation

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