Valuation Matters

It's common sense that equity returns depend on the starting valuation. In other words, mean returns from an asset class mean little for an asset where returns are mostly dependent on capital gains. When capital gains are a significant proportion of total returns, starting valuation should be more important than historical performance. It seems simple and obvious, but most investors who are allocating a long-term portfolio still don't pay enough attention on valuation.

Using Robert Shiller's data on equity returns from 1884 through 2009 (available on his website: www.irrationalexuberance.com), the median 3-year (annualized) return of the stock market is 9.5% and the average is 10.63%. The best 3-year return out of that period was 194.5% annually and the worst 3-year return was -80% annually.

But if one incorporates valuation, measured by the Shiller PE (analysis from Keith Goddard, CFA):

Clearly, valuation is a key determinant of equity returns.

The current Shiller PE is around 20.


According to the analysis on valuation-adjusted returns from Keith Goddard, this is not a great time to buy stocks. That's probably true, but historical trends also indicate there is some upside that can be realized in equity markets over the short-term. As you can see on the chart above, equity valuations are higher when interest rates are low. As we can safely assume rates will stay low for an extended period, we can expect valuations to return to the average of the "great moderation" (referring to the low rates and inflation of the last 2 decades). The average Shiller PE during this time was about 25, so equity market returns over the next few years might not be as low as indicated by Goddard's data. An investor can earn a pretty return in equities over the next few years as the Shiller PE grows from 20 to 25.