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.


Comments

  1. Jeremy Grantham of GMO has the exact same analysis in all of his quarterly reports. Think he uses seven year time frame though?

    ReplyDelete
  2. Yep, Grantham uses the starting P/E ratio to illustrate his points but his actual analysis is based on GMO's own estimates. Grantham seems somewhat bullish on stocks whereas the P/E ratio implies a more bearish stance.

    John Hussman also has similar results using his own proprietary method.

    ReplyDelete

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