US Equity Returns: What To Expect
John Mauldin's Outside the Box

Blog Subscription Form

  • Email Notifications
    Go

Archives

Introduction

This week's letter is by good friend Dr. Prieur du Plessis, who is managing director of Plexus Asset Management based in Cape Town, South Africa. What kind of returns can we expect from US equities over the next ten years? It turns out that while you can get an average number, the range of actual historical returns is actually larger than you might think. Thus, past performance is not indicative of future returns, but past performance and current valuations can give us some hints.

This is one of a series of postings that Prieur does at a blog site called Investment Postcards from Cape Town, which is starting to get the international notice that it deserves, as I see references popping up in more and more places. You can see his work at http://investmentpostcards.wordpress.com/. (The last two posts are about gold and gold stocks, which I also find very interesting.)

Plexus Asset Management is the "Morningstar of South Africa." They track all the various funds in South Africa, host annual awards and do a lot of very sophisticated research. (I should note that I am a partner with Plexus in some businesses in South Africa.) I trust you find today's material truly Outside the Box.

John Mauldin

ADVERTISEMENT
Our "Undervalued Stock of the Month" Is Now Trading at a 26% Discount
If you're looking for a great bargain on one of the world's fastest-growing companies, then you need to learn more about our "Undervalued Stock of the Month" for June 2007. Due to market volatility, the shares have pulled back -76% from their all-time highs. As a result, bargain hunters now have a rare opportunity to pick up one of the world's most dominant companies at a 26% discount below our estimated fair value.

Click here to learn more about our "Undervalued Stock of the Month"

 

US Equity Returns: What To Expect

By Dr. Prieur du Plessis

"Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." - the gospel according to Warren Buffett. Although this sounds quite simple, there are two schools of thought on how to go about accomplishing it.

Firstly, the market timers believe the answer is to "buy low and sell high". However, a second group (including many prominent academics) maintain this is easier said than done, with very few investors actually getting it right with any degree of consistency. They expound that the recipe for creating wealth is simply to follow the patient approach, saying that "it's time in the market, not timing the market" that counts.

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?

In an attempt to cast light on this issue, an interesting multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns was done by my colleagues at Plexus Asset Management. The study covered the period from 1871 to 2006 and used the S&P 500 Composite Index (and its predecessors). In essence, a total real return index and coinciding ten-year forward real returns were calculated, and used together with PEs based on rolling ten-year earnings.

ADVERTISEMENT
You're a savvy investor. And interested in opportunities for capital appreciation.
Especially those where you can transact between major foreign currencies--and globally diversify your portfolio. And the EverBank® WorldCurrency Access Deposit Account offers you just that--and so much more.

Like FDIC protection against bank insolvency3, access to your funds and the potential for capital appreciation--if the selected foreign currency increases against the U.S. dollar. Attractive to many--given the fall of the dollar--loss of principal can occur if the selected currency loses value versus the dollar.

EverBank WorldCurrency Access Deposit Accounts. A simple, liquid and original approach to foreign currency investing. Learn more today.

EHL/FDIC
07EWMGNET007



In the first analysis the PEs and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1). The cheapest quintile had an average PE of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average PE of 21,6 with an average ten-year forward real return of only 3,2% p.a.

Diagram A.1


This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided in smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3). This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

Diagram A.2

 

Diagram A.3


A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham's GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Diagram B.1

 

Diagram B.2

 

Diagram B.3


Based on the above research findings, with the S&P 500 Index's current PE of 18,4 and dividend yield of 1,8%, investors should be aware of the fact that the market is by historical standards not in cheap territory, arguing for luke-warm returns. Although the research results offer no guidance as to when and at what level the current bull market will run out of steam, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, investors should expect higher volatility and even the possibility of some negative returns.

ADVERTISEMENT
Zacks Logo
The $2,062,387 Stock Secret
One proven stock-picking system turned $10,000 into $2,062,387 since 1988. Beating the S&P 500's profits by 2,577%. That's no typo. Discover now how you can get free stock picks from this market-beating system every trading day.

Learn more now.


It is easy to understand why Grantham came to the conclusion that "the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns".

Conclusion

Your always finding value in South Africa analyst,


John F. Mauldin
johnmauldin@investorsinsight.com


Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

Communications from InvestorsInsight are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors and other contributors do not necessarily reflect the opinions of InvestorsInsight, and should not be construed as an endorsement by InvestorsInsight, either expressed or implied. InvestorsInsight is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not indicative of future results.




Posted 06-18-2007 1:15 PM by John Mauldin