US stock market returns – what is in store?

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Stock market movements over the past few months have been characterized by increased volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly grappling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Are we still in a bull market, or perhaps experiencing a counter-trend rally in a bear market? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with very few investors actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns. The study covered the period from 1871 to November 2007 and used the S&P 500 (and its predecessors prior to 1957). In essence, a total real return index and coinciding ten-year forward real returns were calculated and used together with PEs based on rolling average ten-year earnings.

In the first analysis the PEs and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).


The cheapest quintile had an average PE of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average PE of 22,0 with an average ten-year forward real return of only 3,2% p.a.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3).



This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham’s GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.




Based on the above research findings, with the S&P 500 Index’s current ten-year normalized PE of 23.7 and ten-year normalized dividend yield of 1,6%, investors should be aware of the fact that the market is by historical standards not in cheap territory, arguing for luke-warm long-term returns. Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, there is a distinct possibility of some negative returns.

It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.

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10 comments to US stock market returns – what is in store?

  • Mr. Obvious

    I believe the idea of using 10 years of past earnings originated with Benj. Graham. I assume that using shorter periods produces wider variability in resultant returns, but the four-year business cycle seems like a good reason to look at PEs based on rolling four or eight years (2x the cycle) periods. Did your group look at other rolling earnings periods, Prieur?

  • Michael Mennell

    Thanks for excellent research. Very enlightening. Simple and clear. I certainly will heed this info when making decisions. Feel this bear market has a long life (4yrs?)left in it.

  • Allan

    Thanks for a very informative look at the S&P 500. I was discussing this very subject with a friend the other day and we ended off with the dilemma of timing and the discipline required to sit on the sidelines for what could be a considerable wait.

  • Sugam

    Wonderful article, clearly shows how many people forget what exactly value is… This clearly shows that recent sell-off in the markets are no way related to Value investing not working but on the other hand is a part of the process..

  • PdP: Once again, I like the research; although not a value guy, I do appreciate and understand the concept.

    You said: “It seems to be a case of so many pundits, so many views.” I am one of those pundits, and I couldn’t agree more. There is so much noise out there.

    You said: “It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with very few investors actually getting it right with any degree of consistency.” I agree that market timing is very, very hard to do but most investors (professionals and non-professionals alike) are inconistent in their returns because they lack consistency and discipline in their approach.

    You said: ” ‘it’s time in the market, not timing the market” that counts”. I agree with this to a point. I think most investors become traders when they get a winner and short circuit their investments to make them a trade. On the other hand, traders never want to have a trade turn into an investment. In any case, I think time in the market does reward those who choose to play but you have to know what those times are.

    In the end, an active approach (not buy and hold), with proper risk allocation and diversification across markets, should win out. There are some exquisitely simple strategies out there that beat buy and hold S&P500 with about 1/5th the risk; all you need is a monthly chart, a 10 period simple MA, and the ability to make 4 trades a year.

    In any case, that’s my two cents. The work you presented is definitely cool and clearly an antithesis to our “I want it now” world we live in.

  • Those who bet in “it’s time in the market” have to be very patient and healthy to get the expected profits if they get to buy crazy valuations like the ones in the mania: those guys who bought Cisco above the 70 area have a lot of time to wait for there profits.

    I think the problem with investors is the lack of patience in order to the market to give them what they expect, low or high valuations.

    I’m waiting for the low ones but I’m aware that the market can do one or two more up legs, no problem with that…

  • This is a comment by Don Bishop:

    “Warren Buffett has understood the theme of this article for at least 40 years. In 1969, 3 years after Shiller’s PE graph peaked, Buffett liquidated his investment partnership, and so had cash with which to buy cheap stocks during the 1973-74 bear market. In 2003, 3 years after the 2000 PE peak, Buffett started raising serious amounts of cash, which grew to $47 billion by last year. He understands that the best long term returns are produced by buying cheap stocks, and stocks are not yet cheap.”

  • ruth

    The S&P dividend yield competes against interest rates for capital. So, I’d like to see the dividend yield analysis repeated with attention paid to the interest rates of the same time period. Perhaps use the spreads (between short and long term rates) and then analyze 10-year returns. Would the 10-year returns be correlated with the spread? Or with interest rates directly? Should we be watching valuations or interest rates?

  • […] by historical standards not in cheap territory, arguing for luke-warm long-term returns,” he writes. “Although the research results offer no guidance as to calling market tops and bottoms, they […]

  • Stocker

    Back out Financials and I am not sure I agree with this, you can find plenty of stocks at 3-5 year valution lows.

    Grantham just lost the subadvisory relationship on three different funds at Vanguard, btw. Smart guy but his shop is not that great, according to what Brennan just did by firing him.

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