Overvalued Markets and Average Ten Year Forward Real Returns

So a reader asks about my comment about staying out of overvalued markets. How does one DO that? The answer is that there are several measures that I personally use to gauge value but I am going to show you a simple analysis as to how this might be done. Remember that I will be talking about AVERAGE RETURNS. This is an important point. We are trying to control for risk. Sometimes our risk control measures will be well rewarded. Sometimes not. And sometimes the stock market presents you with a hand to be played that ON AVERAGE you should just toss back. Here goes.

In this analysis we are going to assume that the broader stock market represented by the S&P 500 Index is the proper benchmark for comparing stock market returns. And we are also going to assume that, on average, that what investors are concerned about is returns ten years out. I know, that 's a lifetime for some and if investor behavior during the recent crash is any indication, many have hair trigger fingers.

In the first analysis the price to earnings or PE ratios and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals).



The cheapest quintile had an average PE of 8.5 (you paid 8 and 1/2 times earnings for the shares)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.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham's GMO, (an investment advisory having billions of dollars under management and having splendid risk-adjusted returns over its lifetime) it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams below and, as can be expected, are very similar to those based on PEs.



So where does the market sit based on these measures? The fourth most expensive quintile based upon PEs and the most expensive quintile based upon current dividend yields. Does that mean the market is about to fall tomorrow? No, research shows that in the short term market performance bears little relationship if any to these valuation measures. But for an investor who needs the money in 2019 for a child's education and also needs a 10% return in order to fully fund it, these analyses should give reason for pause. COULD expectations be met with an investment here? Sure, outliers exist in life and what we are presenting here is a RANGE of performances. But, as we began his analysis, ON AVERAGE, investments here are not well rewarded.