Observations: Borrowing Returns from the Future

Tuesday, February 15, 2011

Borrowing Returns from the Future

This post suggests that the price of extraordinary current stock market performance may be decreased future returns.

Starting P/E Ratio vs. 10-Year Stock Market Returns clearly suggested that high initial P/E ratios have a negative impact on subsequent 10-year returns. This post takes the analysis a step further in an attempt to see what we can learn from the "outliers" -- the historical results that are least consistent with the trend line.

Initial P/E Ratio vs. 10-Year Stock Market Performance Revisited

P/E ratio impact on future 10-year performance

Each marker in the chart above (click to expand) represents a year between 1901 and 2010. The placement of the marker indicates the Dow's normalized P/E ratio at the end of that year, and the annualized market return over the ensuing 10 years. The green trend line shows that, in general, every time the P/E ratio increased by 5, the annualized 10-year returns decreased by about 3% per year. (For a more complete explanation of the basic chart, see note at end of post and this post.)

In my experience, it is always helpful to look at the exceptions. So, in this version of the chart, I've added a band (the dotted red lines) around the trend line; about 95% of the results are encompassed within the band. The observations outside the dotted lines are the results that are least consistent with the trend line. What can we learn by looking at those "outliers"?

The Ending Points Matter Too

The red square below the 95% band represents the 10-year period beginning year-end 1922. Even though the initial P/E was well below the average (of 15), the 10-year performance was poor -- because it ended in 1932, in the midst of the Great Depression.

The four red squares above the 95% band represent 1987-1990 (1987 is partially obscured by 1988). Even though starting P/E ratios ranged from slightly above average to considerably above average, all four years produced stellar 10-year returns. Why? Because, those 10-year periods ended during one of the greatest bull markets in history. (Note: FYI, the two blue circles nearest to the four red squares represent 1986 and 1991.)

While starting P/E matters, it's not the only thing that matters. For one, extraordinary environments at the end of the 10-year period can overpower the impact of the P/E ratio at the beginning of the period.

Borrowing Returns from the Future

Interestingly, those stellar returns for the 10-year periods beginning 1987-1990 were, for the most part, transitory. They were achieved, in part, by a run-up to some of the highest price/earnings ratios in history. As a result, the ensuing 10-year periods began with high P/E ratios, and rather poor prospects. For the most part, they delivered as promised -- delivering some of the lowest returns on record; the four black squares represent the follow-on 10-year periods, beginning 1997-2000. (Note: the previous version of this chart stopped at 2008.)

Well above average 10-year performance was followed by 10-year performance that ranged from below the average (of 10%), to dismal. The way I think about it is, no matter how excited investors are about the market today, it has little or no impact on what earnings and dividends will be 10 years from now. Assuming average earnings and dividends growth, if the future investors do not assign the same, or higher, valuations, your returns are likely to be below average -- maybe way below average.

Pay Me Now or Pay Me Later

This is another incarnation of what I think of as the "pay me now, or pay me later" nature of the stock market. I think it's a good part of the reason for the long flat periods observed in "100 Years of Stock Market History." And, it's a good part of the reason why, if you look at my projected 10-year stock market returns, expected future returns decrease as current returns increase. The good news is it probably works in reverse as well -- I expect that well-below-trend performance saves returns for the future.

We'll take a look at the impact of initial P/E on 20-year returns in a future post.

Notes: The above scatter plot shows the historical relationship between the p/e ratio of the stock market at the time of purchase and the typical investor's return over the ensuing 10 years. By "stock market" I mean the DJIA (Dow Jones Industrial Average), though historical results for other broad-based indexes like the S&P 500 would be comparable. By P/E ratio, I mean the normalized price/earnings ratio as I calculate it (see About Normalized P/E Ratios). Finally, by typical investor's return I mean the total return of a hypothetical investor who bought the Dow Jones Index and held it for 10 years, reinvesting all dividends (with no taxes or commissions).

100 Years of Stock Market History: Periods of "irrational exuberance" seem to be followed by long flat periods.
The Composition of 10-Year Returns the relative contributions of earnings growth, dividends and changes in valuation.
A 10-Year Stock Market Projection: Using P/E ratio to estimate future 10-year returns.

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This work is licensed under a Creative Commons Attribution 3.0 unported license. Last modified: 2/16/2011