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by David Stanowski 05 September 2007 A previous article, Are Stocks Cheap?, argued that by using the time-tested methods of P/E ratios, and Dividend Yields, it was very clear that stocks are currently very expensive! Professor Robert Schiller, and others, have taken these indicators a step further by using them to predict stock market returns at various points in the future. They have been able to answer the question, "Does the P/E ratio and Dividend Yield, at the time of stock purchases, make a significant difference in the subsequent investment returns?" Contrary to the Dollar-Cost-Averaging approach, the Random-Walk model, the Buy-And-Hold philosophy, and the You-Can't-Time-The Market school of thought; these studies show that P/E ratios, and Dividend Yields can "predict" future returns! The theory is very simple: If you buy stocks when they are cheap, you will have better returns than if you buy them when they are expensive. This would seem to just be common sense, but common sense is usually very uncommon when it comes to buying and selling stocks! This study used U.S. stock prices from 1871 to 2006 to calculate a year-end P/E ratio. Each P/E ratio was plotted against the average ANNUAL REAL (i.e. adjusted for inflation) return ten years later. Investors who bought stocks at P/E ratios of less than 6, had average ANNUAL REAL returns of 16.1%, versus investors who bought stocks at P/E ratios of greater than 21, who had average ANNUAL REAL returns of 1.8%!! Buying at the extremes of the P/E ratio range produced results with a 10-to-1 variation! The same correlation held with P/E ratios between 21 and 6. Buying stocks, at any time when P/E ratios were less than 12, found no negative results (losses), after a 10-year holding period. Buying stocks, at any time when P/E ratios were greater than 12, had some negative results, after a 10-year holding period, including a few major bear markets. Surprisingly, the correlation between the P/E ratio, at market entry, and real returns one year later was much weaker! However, after 3, 5 and 10 year holding periods, P/E ratios showed a high degree of predictability of the later returns. This same data series was used to run a study of Dividend Yields, at the time of market entry, versus real returns, ten years down the road; and it produced similar results! Investors who bought stocks when DY's were greater than 9%, had average ANNUAL REAL returns of 15.7%, versus investors who bought stocks when DY's were less than 3%, who had average ANNUAL REAL returns of 4.5%!! Buying at the extremes of the DY range produced results with a 3-to-1 variation! The same correlation held with DY's between 9% and 3%. Buying stocks, at any time when DY's were greater than 5% found no negative results (losses), after a 10-year holding period. Buying stocks, at any time when DY's were less than 5% had some negative results, after a 10-year holding period, including a few major bear markets. As a previous article noted, the current P/E ratio is around 20-21. 135 years worth of data says that this P/E ratio will probably produce an average ANNUAL REAL return of 1.8%-3.3%. Hardly a lot of potential reward for riding out a period with the risk of a major bear market, and large NEGATIVE returns!! Likewise, the current DY of 2.5% shows an expected average ANNUAL REAL return of about 4.5%, with the same likelihood of a major bear market. To read the full article about this study: The decline from the all-time bearish extremes in the P/E ratio (44.2), and Dividend Yield (1.2%), at the 2000 top, will more than likely take about 20 years, before these indicators can work off their extreme levels, and move to bullish extremes, which will allow the stock market to hit a final bottom. The DJIA probably needs to drop to at least 3,500-4,000 before its P/E ratio and DY reach the levels of previous bear market bottoms! The stock market rally from 2002 to 2007 has made the market patterns, since the 2000 top, very confusing, unless you factor out the extreme inflation that occurred during this period, as was done in Stock Market Divergences. In this article, the charts of the "Deflated" versions of the three major stock indexes strongly suggest that all the action, since the 2000 top, has been the start of a very long bear market! There is no evidence that we are in a period that will be friendly to stock market investors, unless it is from the short side. Expected returns are very low at a time when downside risks, from a major bear market, are very high!
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