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. Has the market started bottoming out, or are bourses still in the grip of the bear? 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 not many people 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 October 2008 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding 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% per annum, whereas the most expensive quintile had an average PE of 22.6 with an average ten-year forward real return of only 3.1% per annum.

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. Interestingly, given that the current 10-year normalized PE of 14.9 falls in the middle of this range, the exceptional volatility being experienced at the moment is consistent with historical patterns.

As a further refinement, holding periods of one, three, five and 20 years were also analyzed. 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 14.9 and ten-year normalized dividend yield of 3.1%, investors should be aware of the fact that the market is by historical standards still only in “average value” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a “muddle-through” trading range for a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current ten-year normalized valuation levels. As a matter of fact, there is a distinct possibility of some negative returns.


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

  • Articles such as this are very helpful to form some opinion as to where the market is likely to provide a solid entry point.
    Many investors, such as myelf, are currently hesitant to commit although valuations and yields are tempting by past standards.

  • Frank Wordick

    1) In matters financial, things are rarely perfectly clear. If they were, everyone would be a multimillionaire. As more than one person has said, “Life wasn’t meant to be easy”. Or as a very good financial advisor once said to me, “I’ve got a Master’s degree in Finance and I can’t figure the market out”. However, considering that the earnings outlook seems rather grizzly and analysts are predicting GDP growth in the negative 4% to 5% range over the next two quarters, it is difficult to see a rosy future just over the horizon. Also, we have some rather cluey people like Albert Edwards and Bennet Sedacca predicting a cyclical bottom of 500 or less on the S&P500. This stock market measure is currently well above 800.
    2) As to trading corrections, I wouldn’t consider it, but then I’m no good at that sort of thing. I have extremely long time horizons like James Montier. Now Sedacca got in just before the cranberry sauce rally. Whether he got out or not before its collapse is another thing.
    3) “Does one’s entry level into the market … make a significant difference to subsequent investment returns?” Of course it does! Common sense tells you that. A study of previous markets bottoms and run-ups teaches one that the Price low comes well before the Price/Earnings low. In the previous bull market, the Price low occurred in 1975, when the P/E ratio was still high. The P/E ratio bottom did not take place until 1982 after earnings bloomed. After the market bottomed in ’75, it took off like a rabbit, which is normally what happens and continued to rise smoothly into 1982 and beyond, altho earnings rose faster than prices. Those investors, who were too clever by half and waited for the P/E low, had less money to invest in the market at the P/E low. Why would one want to pass up the Price low and wait years for the P/E ratio low? Would the money market have been paying higher rates thru the full seven year period preceding the P/E ratio low? I don’t think so! A lot of reknowned (I know I spelled it wrong) analysts focus on P/E ratios. John Mauldin, for instance, does. Richard Russell counts the previous bull market as having begun in 1982 at the P/E ratio low, ignoring all the price appreciation from 1975. Does this make any sense to you?

  • Denzil FEINBERG

    Your analyses took a LOT of number- & company-crunching, many thanks. I shall forward the article to a few Canadian portfolio managers I’ve got to know in my 34 years as a financial planner.

    They are enjoying buying the low P/E high dividend companies your analysis shows SHOULD grow rewardingly over the next 5 or so years.

    Sectors like financials fit into the chosen few likely profitable areas, while fears still abound, for sure.

    Denzil FEINBERG CFP R.F.P. (Ottawa, Canada)

  • Ben

    According to Barron’s Market Lab, S&P 500 P/E is 19. Looking back at past recessions, low double-digit to single-digit P/E’s are not uncommon, and I suspect we’ll get there too. Glad to see that someone is focusing on the basics

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