It’s well-established in the literature that valuation metrics—such as the dividend yield (D/P) and the earnings yield (E/P), as well as its cousin, the Shiller CAPE 10—provide important information in terms of future expected returns. In fact, these metrics are the best that investors have for predicting long-term equity results. For instance, the Shiller CAPE 10, a cyclically adjusted price-to-earnings ratio, has been found to explain about 40 percent of returns for the next 10 years.
The negative relationship between current valuations and future returns can tempt many investors into pursuing what are often referred to as tactical asset allocation (TAA) strategies. Such investors increase their equity allocation when valuations are low relative to their historical mean, and lower it when valuations are relatively high.
Which, of course, raises the question: Does the historical evidence support market-timing strategies based on valuations? Javier Estrada sought to answer that question in his new paper, “Multiples, Forecasting, and Asset Allocation,” which was published in the Summer 2015 issue of the Journal of Applied Corporate Finance.
A Long-Term Trend
Estrada begins by showing how tempting historical results can be. For example, for the period December 1899 through December 2014, when the current price-to-earnings (P/E) ratio was less than 10, the 10-year forward return to stocks averaged 14.8 percent. In contrast, when the P/E was above 18.8, the 10-year forward return to stocks averaged just 6.3 percent. And the relationship was monotonic. As the P/E levels rose, forward returns fell. The more you paid for a dollar of earnings, the lower the 10-year return.
However, when Estrada examined one-year forward returns, the monotonic relationship broke down. For example, when the current P/E was between 10.4 and 13.3, the one-year forward return was 7.3 percent. When it was higher, between 16.4 and 18.9, the one-year forward return averaged 11.7 percent. And when the current P/E was above 19, the one-year forward return averaged 10.0 percent.
Using the dividend yield instead of the earnings yield produced similar results. Thus, while valuation metrics do provide valuable information regarding long-term returns, the evidence is much weaker when looking at the short term.
Estrada found that the correlation of the dividend yield and the 10-year forward return was -0.43. Using the earnings yield produced an even stronger negative correlation of -0.52. While the correlations of the dividend yield and the earnings yield with the one-year forward return were also negative, they were much weaker, at -0.18 and -0.10, respectively.