Savita Subramanian, quantitative equity strategist at Bank of America Securities, has provided convincing evidence that price-to-earnings valuations are the most important driver of U.S. equity performance over longer time periods.
U.S. investors, then, have reason to be concerned about the current high P/E ratio of more than 21 times.
The same model applied to domestic equities, however, produces much more mixed results.
Simply stated, buying U.S. stocks when they’re cheap works, according to Ms. Subramanian. Her comprehensive analysis of more than 30 years of market data was recently presented in her annual Everything You Wanted to Know About Quant report, which this year reached 276 pages. She writes that once P/E ratios are adjusted for the market cycle, “market valuation explains about 80 per cent of the variability in equity market returns over the next 10 years.”
The first accompanying scatter chart is a simplified version of the strategist’s work – the P/E ratios are not smoothed out to compensate for the rise and fall of earnings caused by the profit cycle – but it clearly underscores the trend.
Each dot represents the S&P 500 P/E ratio (X-axis) for every month from June, 1994, to May, 2010, and the subsequent 10-year average annual return (Y-axis). The dot furthest left, for instance (it’s from Feb. 27, 2009, but dates are not plotted on this type of chart), shows an instance when the P/E ratio was 12.1 times, and the average annual return for the next decade was 14.2 per cent.
The downward sloping trend line indicates that forward returns on U.S. equities decline as P/E ratios rise. The data points are generally tightly bunched around the trend line indicating a strong relationship between P/Es and subsequent 10-year market performance. The current trailing P/E ratio of 21 times suggests average annual returns of about 5 per cent for the next decade (before dividends).
The second chart represents the same data for the S&P/TSX Composite Index. As with U.S. equities, the trend line moves downward and rightward indicating lower returns as P/E rise. However, the dots are not closely packed around the trend line, indicating a much weaker connection between valuations and Canadian equities (this is verified by correlation calculations done separately).
The second chart provides weak guidance for Canadian investors. If we find the current S&P/TSX Composite P/E ratio of 19 times on the X-axis and look then to the Y-axis, we can see dots in a huge range from 0.7 per cent to 7.7 per cent for forward 10-year returns. This wide variance does little to help with investment planning for the next decade.
Ms. Subramanian’s research is highly relevant to U.S. investors who can now expect long-term equity returns in the acceptable-to-mediocre range over the next decade. The calculations can’t, however, be applied meaningfully to domestic stocks. We can speculate that the TSX’s large weighting in materials stocks – which have wildly fluctuating P/E ratios dependent on global, rather than local factors – is behind the lack of correlation.
This doesn’t mean Canadians don’t have to worry, only that P/E ratios provide little to no guidance on what to plan for over the next decade.
Scott Barlow is the Globe and Mail’s in-house market strategist.