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In the 1992 U.S. Presidential election, Bill Clinton’s campaign strategist James Carville coined the catchphrase “It’s the economy, stupid”. In a highly complex political narrative the quote was meant to emphasize that the economy dominates election outcomes and tend to dwarf most other political issues.

Medium- to long-term equity market trends are, in a similar vein, also dominated by one single factor, and it is not necessarily “the economy”. Investors and Asset Managers love to speculate about the economic cycle, inflation, interest rates, monetary policy regimes and trends, geopolitics etc. in their endless efforts to predict equity markets. In this blog, I will argue that the valuation level is the critical gauge for long-term real returns on public equity markets and that perfect foresight of long-term earnings growth for listed companies is much less important.

Valuation matter (a lot)…

In a discounted cash-flow model framework, the stock-market valuation level (P/E) can be written as

where Pd = the dividend ratio, rf = risk free interest rate, erp = equity risk premium and geps = the growth rate of earnings (per share). From the denominator it follows that the valuation level is determined by a discount factor (1 + rf+ erp), i.e. what returns investors (ex ante) expect to get to invest in the stock market, and earnings growth (geps). A higher/lower discount factor warrants a lower/higher valuation ratio. Higher/lower (expected) earnings growth justifies lower/higher valuations.

Real return and valuation

(S&P500, 13 non-overlapping ten-year periods and current)

Valuations and real returns on equities are highly time varying. In the chart to the left, cyclically adjusted valuation levels (based on Shiller’s data) and real returns on the S&P500 portfolio are plotted. The stats suggest that there is a significant statistical relationship between valuation levels, at the beginning of a ten-year period, and the subsequent realized 10-year real equity returns. A high/low valuation level is followed by low/high real returns. Close to 30 % of the variation in real returns can be explained by variations in valuation levels. For instance, at the beginning of the 1950’s, the P/E ratio was very low (around 11) and subsequent annual real return very high (13 % plus). The P/E-ratio was, on the other hand, extremely high at the beginning of the 2000’s (above 36) and real return during the subsequent decade was even negative. As expected, the average 130-year valuation level corresponds well with realized real returns. The average earnings yield (inverted P/E-ratio) has been 6,1 and the average real return has been 6,4 %.

… more than “clairvoyant” earnings…

From the chart below, we can see the same relation between real returns and real EPS growth. EPS is a companies-based proxy for broad macroeconomic trends. Even though other factors also play in, there should be a link between the macro-economy and average corporate earnings.

Real return and EPS-growth

(S&P500, 13 non-overlapping ten-year periods)

Decade by decade, there seems to be no relation between real earnings growth and real stock market returns. Earnings growth varies just as valuation levels does, but being “clairvoyant” and knowing the coming decades earnings growth doesn’t seem to be important in forecasting long-term market trends. That doesn’t necessarily mean that EPS-trends are unimportant but could potentially be the result of perfect foresight by market participants and thus correctly priced into the market. An important difference compared to the valuation metrics above is also that valuations are readily available at every time while earnings growth need to be forecasted.

… which doesn’t even add explanation when valuation fail.

There is of course variation in real returns that could not be fully explained by variation in valuation. There is at least a handful of decades that are outliers in the valuation-narrative.

Real return, valuation and EPS-growth

(S&P500, 13 non-overlapping ten-year periods)

In the 1950’s, low valuations “warranted” even higher returns than was realized, but that didn’t correspond with high earnings growth, quite the opposite. The 1990’s also saw higher returns than implied by valuation, but again, real earnings were sub-par to the long-term average. In the 1930’s, low valuations suggested much higher returns than what was realized even though real earning grew strongly. In the 1970’s, as well, returns were much lower than “predicted” by valuations with reasonably strong real earnings growth. As a matter of fact, real earnings growth was spectacularly strong in the 2000’s but extreme valuation levels took its toll nevertheless. Only in the 1910’s, negative real returns and very low valuation levels are associated with extreme negative earnings growth. Unexpected and dramatic changes in the level of inflation seems to be at play in some of the outlier decades.

Implications for long-term investors

Taking the statistical results at face value, the coming decade will likely be quite subdued as far as a large cap growth tilted portfolio of US listed stocks are concerned. A cyclically adjusted P/E-ratio at 32+ doesn’t bode well for real returns. Based on the average of 130 years of data, current valuation would imply real returns of some 3 percent a year. Plugging the current valuation yield into the regression equation above would imply zero real return on average during the coming decade. Considering that 10-year US TIPs yields around ½ %, forward-looking equity risk premiums are currently minus ½ % to 2 ½ %, way below historical excess returns.

Even though market participants, for now, seem willing to take on risk and stick to a rather benign market outlook, there are financial, economic and geopolitical adversities that could take their tribute in coming years. In the 20th century the world experienced a lot of such economic, financial and geopolitical turbulence, clearly revealed in dramatically changing patterns in earnings growth from one decade to another. However, it didn’t correlate to changes in real equity returns over the same periods. The flip side is of course that, even if things develop in accordance with a reasonably optimistic macroeconomic scenario in coming years, real return prospects are nevertheless very bleak. Valuation is the key driver and valuations (at least where the US is concerned) are historically high.