Sunday Spectacle CLXVII

Rolling 10-Year Stock Market Return

vs

Starting P/E Ratio

(source: "Gazing at the future: why stocks are underperforming," Crestmont Research. Downloaded March 25, 2012)

I think I posted similar, if not the same, charts, a few years ago and I thought it was a good time to revisit.

The above chart plots the rolling 10-year S&P 500 return (annualized), along with the starting P/E ratio at the beginning of the 10-year period. The starting P/E ratio—you can think of the P/E ratio as a proxy for valuation—plays a huge role in determining future returns. After all, if you buy something at a high price, your returns are likely to be lower than if you buy the same thing at a lower price. Typically, a high P/E ratio will compress and you'll post weaker returns.

The long-term stock market return is 10% per year and the average P/E ratio is around 15 (Crestmont has it pegged at 15.5). In the chart above, you'll notice that the 10 year return tends to be low when the P/E ratio is well above the long-term average, and vice versa.

The chart below clearly illustrates how bull markets tend to involve expanding P/E ratios (rising from a low value to high) and bear markets involve P/E compression (from a high value to a smaller one).

Secular Stock Market Cycles & the P/E Ratio

(source: "Secular Stock Markets Explained," Crestmont Research. Downloaded March 25, 2012)

Everyone has their own definition of secular bull and bear markets but Crestmont Research uses the P/E ratio to mark them.

The last decade has been a rough one for US stock market investors largely due to P/E compression. The P/E ratio of the S&P 500 has been falling from a peak set back in 2000, and this has had a strong negative impact on total return.