Are U.S. Equities Going To Disappoint Investors?

As the bull market approaches its seventh anniversary next March, many investors are increasingly nervous.

Partly, this anxiety stems from a deterioration in fundamentals, given the decelerating global economy. But years of unconventional monetary policy have also pushed valuations to heightened levels.

With U.S. stocks trading at a premium to other markets, as well as their historical norm, investors are reasonably wondering: Has the U.S. bull market run its course?

Key Stock Valuation Metrics That Predict Future Returns

In answering this question, as my co-author Terry Simpson and I write in the new Market Perspectives paper, “Assessing the Value of Valuations,” it’s helpful to look at what today’s valuations can tell us about the possible distribution of future U.S. stock market returns.

One popular valuation metric, the Equity Risk Premium (ERP), can be useful in assessing both relative returns and the right mix of stocks versus bonds. However, according to my team’s analysis of S&P 500 returns and valuations from 1924 to 2014, using data accessible via Bloomberg and Robert Shiller’s Web site, the ERP doesn’t provide much information as to the future return of U.S. stocks.

However, a simple price-to-earnings (P/E) ratio, whether based on a snapshot in time or a smoothed measure of earnings, can be more useful, providing some indication of the possible distribution of future returns, our analysis shows.

Whether you’re looking at a basic P/E measure or a cyclically adjusted price-to-earnings (CAPE) ratio, over a one-year horizon, higher current U.S. stock market valuations are generally associated with lower future returns, and returns have generally been higher when the starting valuation is lower. Put differently, as intuition would suggest, below median P/E multiples typically lead to higher average returns, while above median multiples have historically been associated with periods of below-average returns.