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What Influences Stock Returns?

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A look back in history reveals some telling trends

Today’s elevated valuations do hold a warning for investors. Although value is not the primary determinant of returns, at times horizons of a year or longer it does matter. Looking back over the past 60 years of annual price returns, i.e. not including dividends, the level of the P/E at the start of the year explained roughly 6% of the variation in the following year’s returns, according to Bloomberg data. That does not sound like much, but historically there has been a material difference in returns following periods when the P/E was above average (roughly 16.5) versus below. In years following above average valuations, the average price return was roughly 5%. In years when the S&P 500 started the year on the cheap side, the average return was over 11%.

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More interesting is what happened when valuations went from merely above average to truly expensive. In years when the trailing P/E ended the previous year above 20, returns were poor in the following year. The average annual price return was roughly 1%, with the S&P 500 advancing only 50% of the time. Downside risk was also accentuated; the bottom quartile of returns in those years was -11%, far worse than when stocks were cheaper.

Market Realist – Valuation multiple has a resounding effect on stock returns

As discussed in the first article, the US market (IWF) (IWD) is looking expensive based on historical valuation multiples and also relative to many other developed markets. Currently, the S&P 500 (SPY) (IVV) is trading at a forward PE (price-to-earnings) multiple of 18.5x, the highest since December 2009 and much higher than an average multiple of around 16.2x. Based on the past trend, this is a signal to investors of a lower return in the near term.

Valuation multiples and returns

Valuation multiples have a positive influence on markets’ (IJH) return expectations. This is amply clear from the above chart, which shows that when the PE (price-to-earnings) multiple is higher than average, the returns in subsequent years are normally lower. Conversely, when the PE multiple is lower, returns in subsequent years are generally higher. In 1991, when the index was trading at a forward multiple of 19.6x, the market was up by a mere 4.5% in 1992. Similarly, in 2001 the market was trading at 21.7x while recording a loss of 23.4% in 2002.

On the other hand, the market gained 34.1% in 1995 when the PE multiple was below average at 14.7x in the prior year. Similarly, in 2009, the market inched up 23.5% when the multiple was lower at 12.6x in 2008.

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