Skip to main content

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.

Story continues below advertisement

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.

Story continues below advertisement

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.

Report an error Editorial code of conduct
Due to technical reasons, we have temporarily removed commenting from our articles. We hope to have this fixed soon. Thank you for your patience. If you are looking to give feedback on our new site, please send it along to feedback@globeandmail.com. If you want to write a letter to the editor, please forward to letters@globeandmail.com.

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff.

We aim to create a safe and valuable space for discussion and debate. That means:

  • Treat others as you wish to be treated
  • Criticize ideas, not people
  • Stay on topic
  • Avoid the use of toxic and offensive language
  • Flag bad behaviour

Comments that violate our community guidelines will be removed.

Read our community guidelines here

Discussion loading ...

To view this site properly, enable cookies in your browser. Read our privacy policy to learn more.
How to enable cookies