## Sunday, March 25, 2012

### Initial P/E Ratio vs. 1-Year Stock Market Returns

This is the last in a series on the relationship between the P/E ratio at the time of purchase and the stock market returns that follow.

Previous posts have analyzed returns for the ensuing 20 years, 10 years, and 5 years. This post concludes the series by looking at returns for one year.

### Scatter Diagram: Initial P/E Ratio vs. 1-Year Stock Market Performance

 Starting P/E Ratio vs. 1-Year Returns

The above scatter plot (click on image to expand) shows the historical relationship between the price/earnings ratio of the stock market at the time of purchase and
the market's return for the following year. In the chart, each dot represents a hypothetical purchase at the end of a year between 1901 and 2010.

The dot's position on the horizontal axis shows the stock market's normalized P/E at the end of a year; the dot's position on the vertical axis shows the total return of a hypothetical investor during the following year. For example, the rightmost dot represents a year when the normalized P/E was 32.8; the next year's return was -12.9%.

### Continuing the Trend

The trend lines for the previous posts in this series all went from the upper left quadrant of the graph to the lower right quadrant -- i.e., from low starting P/E with high subsequent returns, to high starting P/E with low subsequent returns. In those posts, we saw that as we reduced our planning horizon from 20 years to 10 years to 5 years in the future, the impact of a unit increase in the P/E ratio went from -0.4%/year to -0.6%/year to -1.1%/year. That is, there was a negative impact that got larger as the time period got shorter.

So, you might have expected that the one year graph would have an even more negative slope -- maybe -1.5 - 2%/year... and you'd be right; it's -1.6%. That is, for every unit increase in the P/E ratio -- say, from 15 to 16 -- the market return for the following year was reduced by 1.6%.

### Compared to the Series on the Composition of Stock Market Returns

For a somewhat different perspective on the impact of the price/earnings ratio on returns see the earlier series that analyzes the composition of stock market returns over time. There, we broke out the contribution that dividends, earnings growth and changes in valuation make to 1-year, 10-year, and 50-year returns.

In the composition of market returns series, the three charts look completely different, so it is very helpful to look at the three charts in that series at the same time. In the one-year view, the variation in returns is dominated not by earnings or dividends, but by valuation (by expansion and compression of the earnings multiple). However, the critical contributors to 50-year returns are earnings and dividends. Ten-year returns display a revealing mix of the two extremes.

### 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 market's return over the ensuing year. 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, the total return is that of a hypothetical investor who bought the Dow Jones Index and held it for a year, reinvesting all dividends (and ignoring the impact of expenses such as taxes or commissions). Note that earnings and dividends prior to 1929 have been estimated based upon another stock index.

### Related Materials

See the other posts in this series:
Initial P/E Ratio and 20-Year Stock Market Returns
Initial P/E Ratio and 10-Year Stock Market Returns
Initial P/E Ratio and 5-Year Stock Market Returns
Related series: The composition of stock market returns
The Extraordinary Impact of Price/Earnings Ratios: The relative contributions of dividends, earnings growth and change in valuation to 1-year stock market returns.
The Composition of 10-year Stock Market Returns: same, but for 10 years.
Earnings & Dividends Determine Long-Term Market Returns: same, but for 50 years.
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