Valuation is good predictor of market returns

By DAVID MOON, Moon Capital Management, LLC
August 28, 2011

You already know not to panic. You’ve heard the mantra a million times: just wait; the market will come back. The past three weeks certainly haven’t been pleasant, but you lived through 2000 and even remember a little about 1987.

If you didn’t believe it before, you’re a firm believer that you can’t predict the daily swings in the stock market. If anything, you would have guessed that the market would have been spooked during the debt ceiling debate, not after its solution.

Even if you fit this description perfectly, you might still struggle trying to determine what to do now.

You don’t want to buy bonds. The government’s chief money guy has already declared his intent to keep interest rates at zero for almost two more years.

You bought into the Internet sector at the high point – and are afraid that buying gold right now might be the same thing.

Stocks scare you, but the Dow is trading about the same place it did in 2000.

Forget that the Dow has been flat for 11 years. Some people will use that as a scare tactic to persuade you to avoid stocks. Others claim that it suggests a massive long-term increase is on the horizon.

Neither group has history or data on its side.

The single best predictor of the returns of the overall stock market over a ten-year period is the valuation – as measured by the P/E ratio – at the beginning of the period.

Want to give yourself a chance at earning an average real (after inflation) return of 1.4 percent over a ten-year period? Buy stocks when they are trading at more than 21 times earnings.

Want a shot at earning a 16.5 percent average real return? Buy stocks below six times earnings.

The S&P 500 currently trades around 15 times earnings. The historic real 10-year return following purchase dates at this valuation level is 6.3 percent. The lowest 10-year return following a P/E ratio of 15 was a loss of five percent. The highest return was 16 percent.

The conclusion? It is extremely difficult to make money in stocks – even over periods as long as a decade - when buying a broad basket (like the S&P 500) at valuations as frothy as 21 or more times earnings.

That describes exactly where we were in 2000.

It’s also difficult not to make money when buying at single digit P/Es.

When the Dow Jones Industrial Average increased from 1,000 to 11,000 – like it did from 1982 to 2000 – it’s pretty easy to make money in stocks. You simply have to be in the game. The P/E ratio on the overall market was a whopping seven in 1982, virtually begging investors to buy stocks.

The ones who did were handsomely rewarded.

At today’s valuations, the data isn’t so clear cut. Whether investors make or lose money from a moderate valuation level depends less on simply being in the game and more on variables like the specific securities in which you invest.

And like the valuation of the overall market, the valuations of those individual securities matter, as well.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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