Wednesday, December 3, 2008

US stock market returns – what is in store?

Prieur duPlessis writes an interesting piece at The Big Picture. To his analysis I would add the standard disclaimer "Past results are no guarantee of future performance" not for the CYA value but because of the fact that U.S. market history is the only dataset we are working with.

For much of the early data, 1871 to 1896 and the introduction of the the DJIA or 1926 for the intro of the S&P, we are dependent on the work of the Cowles Commission which reported monthly results for their indexes.

If you think of the changes over the last 137 years you see that we are trying to pin down a moving target. Cowles decided not to go back past 1871 in the construction of their index because

a) prices and corporate events (earnings, dividends, stock splits, etc.) were much harder to track/verify, and

b) the universe of equity issues was pretty much comprised of railroads, with oddities such as one of my favorites, the New York Guano company, making up the publicly traded industrial concerns.

There are other, non-index, factors that make comparisons inexact: the rise of the American industrial colossus from it's agrarian roots; the change from net debtor to net creditor and back to (world's largest, ever) net debtor; differences in dividend payout ratios and on and on.

So with caveats planted firmly in the back of the mind, here's the Big Picture:

US stock market returns – what is in store?

Stock market movements over the past few months have been characterized by increased volatility as uncertainty became paramount. And as new pieces of the economics puzzle are added every day, investors are increasingly grappling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Has the market started bottoming out, or are bourses still in the grip of the bear? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns. The study covered the period from 1871 to October 2008 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).


The cheapest quintile had an average PE of 8.5 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....MUCH MORE

The "based on data from Prof. Robert Shiller..." is a ref to his work organizing/interpreting the original Cowles Commission data. Here's his homepage with a link to the data.