Surging equity markets since the lows of March 2009 have caught most investors by surprise, especially as new pieces of the economics puzzle are not always rosy and do not quite seem to support an overly bullish case.
Investors are increasingly struggling to make sense of the most likely direction of equity prices. Are we nearing the end of a cyclical bull phase in a structural bear market? Or will strong earnings growth ensure the longevity of the bull? Or is a “muddle-through” trading range in store? It seems to be a case of so many pundits, so many views.
It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with few people actually getting it right with any degree of consistency. Others believe the recipe for creating wealth is simply to follow the patient approach, saying “it’s time in the market, not timing the market” that counts. But “buy-and-hold” investors in the FTSE/JSE All Share Index are still 17,8% down from the previous all-time high of 33 233 on May 22 2008.
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?
To cast light on this issue, Plexus Asset Management compared the price-earnings (PE) ratios of the FTSE/JSE All Share Index (as a measure of valuations) and the forward real returns, considering total returns, i.e. capital movements plus dividends. The study covered the period from 1960 to May 2010. What the study did was combine PE ratios with five-year forward real returns.
In the analysis the PEs and corresponding five-year forward real returns were divided into eight groups (i.e. 12,5% intervals), ranging from the cheapest to the most expensive. The cheapest grouping, with an average PE of less than seven, shows an expected average five-year forward real return of 18,0% per annum. The most expensive grouping, with an average PE of more than 18, shows an expected average five-year forward real return of -0,9% per annum.
The analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made. The cheaper the markets at the time of the investment, the higher the future returns, the more expensive the market, the lower the future returns.
The study also shows the minimum and maximum average five-year forward real returns per grouping. Any investment at PEs of less than nine always had positive five-year real returns, while investments at PE ratios of nine and higher experienced negative real returns at some stage.
Although the above analysis is based on an earlier study by GMO’s Jeremy Grantham, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are very similar to those based on PEs.
Based on the above research findings, with the FTSE/JSE All Share Index’s current PE of 16,7 and dividend yield of 2,3%, the market is expensive by historical standards. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a “muddle-through” trading range for quite a number of years to come.
Although the research results offer no guidance as to calling market tops and bottoms, they indicate that it would not be consistent with the findings to bank on above-average returns based on the current valuation levels. As a matter of fact, there is a distinct possibility of some negative returns off current price levels..
Dr Prieur du Plessis is chairperson of Plexus Asset Management and author of the Investment Postcards blog
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