Swedroe: Valuations And Asset Allocation

October 20, 2014

Pay Attention To Prices

When forecasting investment returns, many individuals make the mistake of simply extrapolating recent returns into the future. Bull markets lead investors to expect higher future returns, and bear markets lead them to expected lower future returns. But the price you pay for an asset also has a great impact on future returns. Consider the following evidence:

The average historical P/E ratio for the market has been around 15. A study covering the period from 1926 through the second quarter of 1999 found that an investor buying stocks when the market traded at P/E ratios of between 14 and 16 earned a median return of 11.8 percent over the next 10 years. This was remarkably close to the long-term return of the market. The S&P 500 returned 11.0 percent per year for the 74-year period 1926-2000.

On the other hand, investors purchasing stocks when the market traded at P/E ratios of greater than 22 earned a median return of just 5 percent per year over the next 10 years. And investors who purchased stocks when the market traded at P/E ratios below 10 earned a median return of 16.9 percent per year over the next 10 years.

CAPE Ratio A Useful Indicator

We also have evidence of how the 10-year Shiller CAPE (cyclically adjusted price-to-earnings) ratio should impact expected returns. When the CAPE ratio was below 9.6, 10-year, forward real returns averaged 10.3 percent. In relative terms, that is more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation).

The best 10-year real return was 17.5 percent. The worst 10-year real return was still a pretty good 4.8 percent, just 2 percentage points below the average, and 29 percent below it in relative terms. The dispersion between the best and worst outcomes was a 12.7 percentage point difference in real returns.

  • When the CAPE ratio was between 15.7 and 17.3 (or generally in the area of its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward real returns were 15.1 percent and 2.3 percent, respectively. The dispersion between the best and worst outcomes was a 12.8 percentage point difference in real returns.
  • When the CAPE ratio was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was 8.3 percent, still above the historical average of 6.8. However, the worst 10-year forward real return was -4.4 percent. The dispersion between the best and worst outcomes was a difference of 12.7 percentage points in real terms.
  • When the CAPE ratio was even higher, above 25.1, the real return over the following 10 years averaged just 0.5 percent —virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year forward real return was 6.3 percent, just 0.5 percentage points below the historical average. But the worst 10-year forward real return was now -6.1 percent. The dispersion between the best and worst outcomes was a difference of 12.4 percentage points in real terms.

 

 

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