The obvious question is what is causing the cyclicality?
Stock Market 10-Year Rolling Returns vs. Price-to-Earnings (P/E) Ratio Graph
Above is a graph (click to expand) of the 10-year total return of the DJIA (Dow Jones Industrial Average) compared to the normalized P/E ratio. If there is a chart that I find even more fascinating than the 10-year rolling returns chart, it's this one. Each point on the rolling return graph represents the average annual return earned by an investor who bought the Dow at that year-end and sold 10 years later, reinvesting dividends in the interim. For example, the first point on the graph shows that an investor who bought at year-end 1901, reinvested dividends annually, and sold at year-end 1911 earned 7.9% per year.
The dotted line is the normalized price/earnings ratio (NPE) at the time of purchase. The NPE in 1901 was 15.6. This is calculated as the Dow price divided by the average earnings from 1896 through 1906. The earnings in the years prior to 1929 have been estimated. (Note: For a more detailed discussion of NPE, see About Normalized P/E Ratios.)
Normalized Price-to-Earnings Ratio and Returns for the Next 10 Years
It certainly appears that the 10-year return graph is very close to a mirror image of the normalized price-to-earnings graph. That is, when NPE goes up, returns tend to go down -- and vice versa. To the extent that is true, the message would be that the normalized P/E ratio (NPE) at time of purchase is the major determinant of 10-year returns. More specifically, Dow history shows high initial NPEs are associated with below average future returns; low initial NPEs are associated with above average future returns.
For example, the highest NPE (32.8) was in 1928, and so was the lowest 10-year return. That 10-year return, -1.3%, was the only negative 10-year return in our database -- so far. You might be interested to know that the third highest NPE (28.0) was in 1999. It doesn't show on the chart since the jury is still out; we won't know how buying in 1999 worked out until the end of 2009.
(Note: For a look at the impact of P/E independent of time, see Initial P/E vs 10-Year Returns. To see the impact in dollars, see the dollar impact of p/e ratios on 10-year market returns.)
Stock Market 20-Year Rolling Returns vs. P/E Ratio Graph
Above is the same chart as before (click to expand), but for rolling 20-year returns -- just to show that the first one isn't a fluke. I'm not including the 5 and 50-year charts. However, they convey the same basic message.
Using Valuation (P/E) to "Predict" Future Returns
This post provides visual evidence of the impact of valuation (specifically, price/earnings ratio) on future stock market performance. The Extraordinary Impact of P/E Ratios provides a different graphic representation of this same phenomenon, and also provides a method for quantifying the impact of multiple expansion/contraction.
Combined, the above posts provide compelling motivation to investigate ways to use valuation to forecast future stock market performance and results. The relationships displayed here are fundamental to the methodology I use to project stock market returns for the next 10 years.
Note: The above charts are based on DJIA (Dow Jones Industrial Average) data from my Stock Market Analysis Model. Results would be essentially the same if we used S&P 500 data.
Related PostsInitial P/E Ratio vs 10-Year Stock Market Returns, and Initial P/E Ratio vs 20-Year Stock Market Returns: for a different look at the historical relationship between P/E and future returns.
Projecting Stock Market Returns: Taking advantage of the relationship between P/E and future returns to project returns for the next 10 years.
How Much Will a $10,000 Stock Market Investment Grow to in 10 Years?: looks at the variability in the size of the ending portfolios resulting from the varying 10-year returns above.
What Will a $10,000 Stock Market Investment be Worth in 20 Years?: similar, but for 20 years.
Stock Market 10-Year Rolling Returns Analysis of the 10-year returns.
Stock Market 20-Year Rolling Returns Analysis of the 20-year returns.
For an index of all stock market posts, by subject area, see the sidebar to the left.
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Copyright © 2009. Last modified 11/3/2011