By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management

Developing capital market expectations is a crucial component of Stringer Asset Management’s investment philosophy. While we use several different inputs in developing these forward-looking expectations, we think that valuations can be an accurate and intuitive way to forecast future stock market performance.

Simply put, the less we pay for an asset, the more we expect to get out of it relative to history. However, it is important to remember that valuations are only applicable to gauging the stock market environment when coupled with long time horizons. Basically, expensive stocks can remain expensive for multiple years, while cheap stocks can remain cheap for many years. Therefore, when considering forecasts based on equity market valuations, we prefer to look out at least three years.

The earnings yield is one of the more impactful valuation data points that we use in developing our expectations. The basic form of the earnings yield is defined as the earnings per share divided by the current stock price. It is also the inverse of the price-to-earnings ratio. We can compare the earnings yield of a broad index, such as the S&P 500 Index, to other yields and its own history, to get a sense of how we stack up today through relative valuations.

By plotting the earnings yield and the subsequent performance of the S&P 500 Index, we can see a relationship between the variables. Conceptually, we are gauging how the earnings yield relates to market returns over various timeframes. As you can see from the chart below, the relationship becomes more pronounced as the timeframe increases. Valuations are not a strong indicator of expected equity market performance over a short timeframe, but valuations can be a significant indicator over the long-term. Therefore, analyzing the market by this manner must be done with a long-term outlook.

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As you would imagine, the higher the earnings yield, the greater the probability the market will achieve higher returns over the next several years. For example, the earnings yield in April 1980 was 14.37% and the S&P 500 Index returned 16.89% annualized for the next decade. At the current earnings yield range of 4-5%, the average forward ten-year annualized return of the S&P 500 Index has been around 7.83%.

Note that there has been a wide range around the long-term total return average at the current earnings yield level. This range spans 1% at the low end to 15% at the high end. The 1% low end occurred from January 2001 to December 2010, and covered the tech bubble burst and the global financial crisis. The high end of the current earnings yield range occurred from September 1987 to August 1997, from Black Monday until well into the information technology revolution.

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Market forecasting should not be the cornerstone of an investment management process because the investor’s individual circumstances take priority. However, by looking at the historical data, one may derive information on the current valuations relative to long-term averages. This method of gauging the financial markets is not one-hundred percent accurate, but Stringer Asset Management believes valuations are a good measure to consider when developing long-term expected returns. Investors should not blindly put capital to work based on valuations but it is better to have tailwinds than headwinds.

This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.

DISCLOSURES

Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.

Data is provided by various sources and prepared by Stringer Asset Management LLC and has not been verified or audited by an independent accountant.

The S&P 500 Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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