Valuations Are Irrelevant to Stock Returns Over One-Year Time Frames

Larry Swedroe unpacks a new paper that looks at tactical strategies based on price-earnings ratios. The conclusion will not shock regular readers of this sort of research: Over longer holding periods, the valuation you start with matters for forward returns.

But one-year future returns have no link with current valuations at all.

Here’s Swedroe, writing at ETF.com (emphasis mine):

For example, for the period December 1899 through December 2014, when the current price-to-earnings (P/E) ratio was less than 10, the 10-year forward return to stocks averaged 14.8 percent. In contrast, when the P/E was above 18.8, the 10-year forward return to stocks averaged just 6.3 percent. And the relationship was monotonic. As the P/E levels rose, forward returns fell. The more you paid for a dollar of earnings, the lower the 10-year return.

However, when Estrada examined one-year forward returns, the monotonic relationship broke down. For example, when the current P/E was between 10.4 and 13.3, the one-year forward return was 7.3 percent. When it was higher, between 16.4 and 18.9, the one-year forward return averaged 11.7 percent. And when the current P/E was above 19, the one-year forward return averaged 10.0 percent.

In other words, whenever you hear someone make a forecast about the year that we’re in, and use valuation as the reason for either good or poor returns, you should know that you’re listening to charlatanism at worst or, at best, an uninformed person who has not looked critically at the historical data.

Valuation matters. It just doesn’t matter all that much tomorrow or the next day.

Source: Joshua M. Brown from "The Reformed Broker" online blog. Click here to view site.