Most investment advice is predicated on historic average returns. However, this has shown to be at odds with reality.
We often hear the media quote price earnings ratios (PE) to represent either prices relative to the next 12 months of earnings, or prices relative to the last 12 months of earnings.
Adam Butler, Mike Philbrick and Rodrigo Gordillo are wealth managers at Butler|Philbrick|Gordillo & Associates. Their research, titled “Valuation Based Equity Market Forecasts” is published with Dshort.com on Advisors Perspective, a website that focuses on investment strategies for advisors.
The authors found that, “The worst estimates are those derived from trailing 12-month PE ratios. Many analysts quote ‘Trailing 12-Months’ or TTM PE ratios for the market as a tool to assess whether markets are cheap or expensive. Quite often, analysts who quote the market’s PE ratio are generally referring to the trailing 12 month earnings. This number is often used to represent a ‘general consensus among market strategists to reassure the markets will do just fine over coming years.’”
Compared to using historical returns, the authors found that “always using the long-term average return as the future return estimate resulted in 350% more error than estimates from the multi-factor regression model over 15-year forecast horizons (1.6% annualized return error from our model vs. 5.55% using the long-term average).”
Alternatively, the authors looked at other valuation models that are used to explain up to 80% of the returns over a 5 to 20 year timeframe. The authors found that the Shiller PE, Q-Ratio, and total market price compared to GDP models along with deviations from long-term trends are significantly better at predicting returns over 5 to 20 years out. These valuation models are described below:
- Shiller PE (CAPE or PE10) compares the price of the investment currently to the earnings over the last 10 years. This valuation model also compares prices to the earnings statement.
- Q-Ratio compares current price to replacement value of companies. The Q-Ratio also compares prices to the balance sheet.
- Total market price compared to GDP (Gross Domestic Product) is the government’s value of final goods and services produced within a country. Market cap to GNP focuses on corporate value in proportion to the size of the economy.
- Price trends compare the historical price trend to current levels or deviations from the long-term price trends.
Lest we forget that financial planning is also about income, not just about investing. In their research, the authors sited author Michael Kitces from his 2008 work, titled “The Impact of Market Valuation on Safe Withdrawal Rates.” In his work, Kitces demonstrated that “the safe withdrawal rate for a 30-year retirement period has shown a 0.91 correlation to the annualized real return of the portfolio over the first 15 years of the time period.”
Even at the bottom of the market in 2009, the expected returns were only at 7% annually, which is slightly greater than the historical average. Currently, the analysis suggests that average annual returns will fall below 0% over the next 15 years.
The take-away for advisors is that using average returns or looking at price relative to trailing 12 months earnings is not a useful method because it does not effectively explain returns in the past. Having a clear understanding as to whether the stock market is cheap or expensive is detrimental for creating retirement income in the future for clients.