Sunday, May 22, 2011

The Impact of Starting P/E Ratio on 20-Year Stock Market Returns

One of the most dependable predictors of long-term stock market performance is the initial normalized price/earnings (P/E) ratio. This post uses a scatter plot to demonstrate the relationship that has existed historically between P/E and returns over the next 20 years.

Note: if you find the graph below difficult to understand, see Initial P/E and 20-Year Rolling Returns first.

Scatter Diagram: Starting P/E Ratio vs. 20-Year Stock Market Returns

The above scatter plot (click on image to expand) 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 next 20 years. It is exactly analogous to the previously posted Starting P/E Ratio vs. 10-Year Stock Market Returns. And, both are conceptually related to Rolling Returns vs Initial P/E Ratios, which looked at the relationship of initial P/E and subsequent returns over time -- that is, with time as the horizontal axis.

Similar to the 10-year chart, each dot represents a hypothetical
purchase at the end of a year between 1901 and 1990 (the last year for which we can calculate 20-year returns). The dot's position on the horizontal axis shows the stock market's normalized P/E at the end of that year; the dot's position on the vertical axis shows the annualized total return of a hypothetical investor over the next 20 years. (See note at end of post) For example, the rightmost dot represents a year when the normalized P/E was 32.8; the annualized return over the next 20 years was 2.5%. (FYI, that year was 1928.)

As The Starting/Initial P/E Increases Future Returns Decrease

As before, as a general rule, the dots move from the upper left quadrant of the graph (low P/E, high return) to lower right quadrant (high P/E, low return). The green line is the statistically calculated trend line that best fits the data. It shows that, on average, if the P/E increases by 10, the expected future returns decrease by about 4% per year for the next 20 years.

For comparison, for that same change in P/E in the 10-year post, future returns decreased by about 6% per year. Conceptually, the steeper 10-year curve makes sense to me since, in essence, you have fewer years to regress back to the average price/earnings ratio. These results also suggest that the impact of the initial P/E diminishes with time.

Normalized P/E Ratios Over 20 Are Rare -- Well, They Used to be Anyway.

The returns above are for 20-year periods beginning from 1900 to 1990. Only six of the 90 readings represent years with P/E ratios greater than 20; in the past, such elevated readings were extremely rare. However, since 1990 there have been 11 additional years with P/Es above 20! In other words, two thirds of the readings above 20 that have ever occurred have occurred in the last 20 years. Since, in general, higher P/E ratios tend to be associated with lower returns, these elevated readings are a key reason why my projected returns have been so low recently.

In the previous post, 10-year returns beginning at price/earnings ratios greater than 20 were uniformly, consistently below average; this time, that is not the case. Interestingly, there seem to be almost as many "exceptions" as there are years following the trend line. There are two 20-year periods with initial P/E ratios above 20 that produced 20-year returns greater than the 10%/year average -- the periods beginning in 1935 and in 1936.

High Price/Earnings Ratios Do Not Invariably Result in Poor Returns

The reason high p/e ratios typically generate below average 20-year returns is, obviously, because these markets are expensive. Unless P/E ratios at the end of the period are at least as high as they were at the beginning, the change in valuation will act as a drag on returns. In fact, that was the case for these two 20-year periods as well; the P/E dropped from above 20 to around 16 in both cases. However, total return is a function of not only the change in valuation, but also dividends and earnings growth. (see, e.g., The Composition of 10-Year Returns.)

The reason I normalize earnings over an 11 year period is to get a good estimate of what I think of as the on-going, sustainable earning power of the Dow. Typically eleven years is long enough to smooth out earnings which are temporarily exceptionally high or low. During the Great Depression, earnings were extraordinarily depressed for an extended period of time. As a result, the 1935 and 1935 estimate for sustainable earnings for the Dow index was less than \$7 -- which, in hindsight, was too low.

The Negative Impact of High Starting Market Valuations Persists Even Over Periods As Long As 20 Years (but can be offset by exceptional dividend & earnings growth)

The bottom line is that between 1935/36 and 1955/56, both normalized earnings and dividends grew at about 8%/year -- well above the normal rate of about 5.7%/year. Thus, the negative impact of the decrease in the p/e ratio over the 20-year period was more than offset by the increase in earnings and dividends.

Needless to say, 8%/year growth in earnings and dividends for 20 years is not something I would plan on....

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 20 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 20 years, reinvesting all dividends (with no taxes,commissions or other expenses).

Related Posts

Other posts in this series

Starting P/E Ratio vs. 5-Year Stock Market Returns
Starting P/E Ratio vs. 1-Year Stock Market Returns
Other related posts
Initial P/E Ratio vs Rolling Returns: Similar concept, but with "years" on the horizontal axis.
Borrowing Returns from the Future evidence that the price of significantly above average returns now tends to be below average returns later.
P/E Ratio Impact On Future Returns: Returns of purchases made when p/e is high compared to returns of low p/e purchases. Impact in \$\$\$.
Range of Stock Market Returns in Dollars: 10-100 Years (bar chart)
The Variability of 20-Year Stock Market Returns, in Dollars: a closer look at the 20-year bar in the link above.
Dow P/E History since 1929: An overview of P/E ratios over time.
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