Let’s start with a debatable, but widely held fundamental concept of investing: the best predictor of future returns for stocks is the current valuation. This is generally true of a single stock, a sector, or an entire country’s stock market. Academics and practitioners debate whether important factors like gross profitability, price momentum, earnings momentum, yield, size, or reinvestment are useful to forecast future returns but you will be hard pressed to find anyone who discredits the importance of valuation. There is just too much overwhelming and robust empirical evidence to argue against it.
We still have to caveat the claim of valuation being the best predictor of future returns. It is arguably the best predictor of future long-term returns. It is decidedly not so useful as a predictive tool in the short-run. Let us explain.
It’s not what you buy. It’s what you pay.
There is no single agreed-upon perfect measure of value to evaluate stocks. At RPG, we have tested countless measures and rely on three value metrics to forecast stock returns. Of those three, our favorite measure (albeit, still an imperfect one) is the Cyclically Adjusted Price to Earnings ratio or CAPE and so we will use it here as our measure of value. At the end of the day, it generally tells the same story as the other two metrics.
Readily-available CAPE data for the S&P 500 goes back to January 1926. For the charts that follow, we break up this monthly valuation data to find the cheapest 10% of months (1st decile), the 2nd cheapest 10% of months (2nd decile), and so on. These deciles can then be used to evaluate how the US stock market performed from different valuation starting points. The chart below shows those deciles and the range of 1-year returns for each one. For example, when the S&P 500 Index was at its cheapest starting points (far left), the range of returns over the next 12 months was -25.9% to 162.9%.
There are few well-evidenced conclusions one can draw from this data. What should become clear is that 1-year returns are not closely foretold by the starting valuation. Consider, for example, the investor who decides that she is not going to invest in US stocks when valuations are in the two most expensive deciles. This investor would have missed out on a 1-year gain of 48% starting in April 1997 or a 58% climb starting in September 1928. Alternatively, she would have experienced devastating 12-month losses had she only elected to own stocks when valuations were in the cheapest 50% of historical levels.
The chart below portrays the data differently. The dark-shaded blue area shows the valuation of the S&P 500 over the past 91 years. The Carolina blue line then illustrates the 12-month forward return of the S&P 500 from each starting point (and yes, there needed to be at least one subtle reference to the 2017 college basketball national champions). What should again become quickly clear is that one-year returns are all over the board and not clearly correlated with the market cheapness or richness.
However, when the time horizon is extended, there is far greater explanatory power of market valuation on future returns. The chart below uses all the same data but instead of the light blue line representing 1-year forward returns, it now represents 10-year forward returns. It should be more evident here that when valuations reach elevated valuations (late 1920’s, late 1990’s), future returns over the next decade are generally depressed. Alternatively, when valuations reach extreme lows (early 1930’s, 1940’s, late 1970’s), future returns over the next decade are generally high.
To demonstrate this connection more clearly, the chart below plots each month dating back to 1926 using the horizontal axis as the starting valuation (stocks rich on the right side, cheap on the left side) and the vertical axis as future returns. Again, there is minimal linkage between valuations and 1-year returns in the first chart but an obvious connection in the 2nd chart using 10-year returns. For our statistically-inclined readers, the valuation model only explains 7% of the variability of 1-year returns but explains 54% of the variability of 10-year returns.
If you’re not yet tired of charts, here’s the final one which also may be the simplest. Below you see data from the same 91-year period with the cheapest markets on the left to the most expensive on the right. The trend here should be obvious to the naked eye: median 10-year returns are highest when stocks are cheap and gradually decline in almost perfect formation as stocks become more expensive. Notably, the chart looks almost identical for averages but we spare one more chart.
So, what does all this mean?
We’re done with charts and almost done with data. What are the takeaways?
We can predict the future…but it may take 10 years. Stock returns over long stretches are fairly predictable as evidenced from the data above. We realize that investing using long-term forecasts as our guide (and the patience they require) may not be ideal but we’re committed to investing based on what we can reasonably well-predict rather than speculating on what we cannot.
Current equity valuations in the US are rich and returns over the next decade should be low. As of March 31, 2017, the CAPE stood at 29.2 which puts it cleanly in the most expensive decile of valuations. Per the table below, that does not inherently mean that future returns over the next decade will be negative or that there will be a massive correction. It simply implies that we should expect lower than normal returns from US stocks over the next 10 years.
Low expected returns for US stocks do not mean investors should take more risk or seek higher yielding assets. We wrote here about the implications and the three ways that investors can respond to such an environment.
There is a world beyond US borders. US stocks are expensive. Stocks outside of the US are not. We explained this dichotomy in last quarter’s investment commentary. The purpose of today’s commentary was to demonstrate the strong long-term relationship between valuation and future returns. We use US data to demonstrate this connection because there is a longer history – not merely to highlight how rich US stocks are (although that’s clearly a take-away).
We hope that we have not overwhelmed you with wonky charts and numbers. As always, we invite you to contact us if you have any questions about global investment markets, your finances, or if you wish to review the health of your financial plan.
With warm regards,
Resource Planning Group