Investor’s Insights: Market Valuations And Stock Returns – Part 1 by Steven De Klerck

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In a first step, I would like to discuss the most important table from the paper “The Market P/E Ratio, Earnings Trends, and Stock Return Forecasts“. Over a long period – 1881-1994 – the study examines the relationship between the valuation of the US stock market and real stock returns over the next ten years. Here, the researchers apply the cyclically-adjusted price-to-earnings ratio (PE10) of the US stock market.

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All of the aforementioned period’s months are split up in five groups. In the first group, we have all months with a PE10 ratio smaller than 10.5; in the fifth group, the researchers group all months with a PE10 ratio larger than 20. Subsequently, they compute for each group the average real US stock return over the next ten years. The researchers document a significant negative relationship between valuations upon the ten-year periods’ start and real stock returns over the next ten years. The first group results in a real annual return of 11.7 percent; for the fifth group, Weigand and Irons document a negative real annual return of -0.15 percent. Conclusion: the lower the initial valuation, the higher your average future stock return. Otherwise said, this means that current valuations contain important information about future returns.

At present (December 7, 2014), the S&P500 has a cyclically-adjusted price-to-earnings ratio of 27. Starting from this historically high market valuation, it should be no surprise that both Research Affiliates and GMO predict low real stock returns for the US stock market over the next ten years, both for small and large caps.

Investors often combine this quantitative and historically significant information with economic insights and forecasts, insights and forecasts which in many circumstances largely appear to be a reflection of the current economic situation. Here, the question arises in which way a quantitative assessment can be achieved ex ante about the incremental added value of these economic insights and forecasts. In absence of a clear answer on this matter, the conclusion seems to be that in the best case scenario this added value happens to be zero.

Expectations of one year ahead growth in GDP and expectations of nominal price growth are not significantly associated with country level returns.

Ellahie et al., 2014

Investor's Insights: Market Valuations And Stock Returns [Part 1]