Many of us follow the Market Index. However, few of us realise its relationship to Market P/E.
The chart above helps us to relate Market Index to Market P/E.
“It’s time in the market, not timing the market” that counts."
This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?
In an attempt to cast light on this issue, an interesting multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns was done by my colleagues at Plexus Asset Management. The study covered the period from 1871 to 2006 and used the S&P 500 Composite Index (and its predecessors). In essence, a total real return index and coinciding ten-year forward real returns were calculated, and used together with PEs based on rolling ten-year earnings.
This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21).
The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.
A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.
It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.
http://investmentpostcards.wordpress.com/2007/06/05/us-equity-returns-what-to-expect/
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