There has been some interesting growth in the research out there of what really predicts long-term returns. And as you know, ironically--notwithstanding all the headlines about it -- it turns out that things like GDP growth in the last quarter has almost no actual predictive value for markets over any useful time period. Certainly, in the aggregate over a multidecade time period, how much the economy growth matters, but it has nothing in the way of actual predictive value.
Valuation is kind of an interesting one, though. What we're finding
more and more from valuation is that it's actually still not very good
at telling you what's going to happen with the markets in the next six
or 12 months and where they are going in the near term. But it's perhaps
better than we give it credit for in how much it actually predicts
long-term market returns. I suppose in some way the recent research on
this really just goes back to Benjamin Graham almost a hundred years
ago, who noted that, in the short term, markets act like a voting
machine; in the long term, they act like a weighing machine. In the long
term, valuation eventually comes to bear and either lifts up returns if
things are cheap or drags down returns when they are more expensive.
Benz: So, when you look at various time periods over
which valuation tends to be most or least predictive, you said in the
short term it's not so predictive, while over longer time periods it is.
But very long time periods, again, maybe not so effective.
Kitces: It starts to break down. So, we've looked at
lots of different valuation measures of this question of what works.
Ironically, some of the ones that are most popular that we talk about
most often really don't work very well. Things like forward-looking P/E
ratios tend to be very poor at predicting market returns over really
much of any time horizon because, unfortunately, we just tend not to get
forward earnings correct. Particularly in market returns, we usually
don't see the recession coming until it's too late, and then we tend to
overestimate the declines and underestimate the turns when they come.
So, we find that forward P/E ratios don't work very well. Things like
earnings over the past year are a little bit too short term.
The measures we find that work the best are those like the Shiller
P/E ratio. It's often called cyclically adjusted P/E ratios, or CAPE,
where we actually take 10 years' worth of trailing earnings, adjust them
for inflation, and average them out over that whole time period. So, we
get something that's kind of smoothed out for all the volatile market
cycles, and that turns out to actually have some very powerful
predictability of future market returns; but as you said, it's only over
longer time periods.
When you look over a time horizon like a year, it turns out that
Shiller CAPE is only slightly more predictive than monkeys throwing
darts at stocks. It's almost random. It's ever so slightly better, but
it's almost random. As the time horizon stretches out, though, it
becomes much, much better, and there is actually an incredibly high
correlation between Shiller market valuation and returns over the next
eight years or so. It's actually quite good, and it explains almost half
the variation in eight-year returns. So, it doesn't necessarily tell
you how you're going to get there over eight years--it just says that
from high valuation points, the market returns tend to be worse over
eight years and then from low valuation points, they tend to be better.
Then, when we stretch the time period out even further, it actually
starts to break down again. So, we've seen a lot of people say things
like, "I'm just going to drag all my retirement spending way down
because it looks like the 30-year return on the market has to be bad if
valuations are so high." But we actually find that the predictability of
valuation for 30-year returns is hardly any better than it is for
one-year returns. So, one year is too short--markets happen because they
are a voting machine; 30 years is actually too long because whole
economies can restructure themselves over 30 years. We really find it's
that eight to 15-year time period where it's really powerful, which
matters a lot for, say, retirees thinking about sequence-of-return risk
and accumulators who might be in their 40s or 50s and could be 10 or 15
years away from retirement and are trying to figure out whether the
market is likely to cooperate with their portfolio growth and getting
them to the finish line. But you have to be careful not to either focus
too short or too long.