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January 11, 2014

Valuation today and expected future returns

After the outstanding equity market performance of the last few years, investors are wondering if shares are still attractively priced today. The most important rule in investing remains that the future performance of every investment is a function of its present valuation. The higher the price you pay, the lower the return will be.

One of the best ways in our opinion to evaluate the attractiveness of equity market pricing is the Shiller P/E. It is named after Robert Shiller, the Yale professor who can claim credit for calling both the dotcom and housing bubbles in his book Irrational Exuberance and who won the Nobel price for Economics in 2013.

The Shiller P/E tries to eliminate the effect of the economic cycle on valuations; without it, stock markets look expensive when earnings collapse in recessions and look cheap when earnings are high in booms. So it averages earnings over 10 years, and adjusts them for inflation; at the moment, the p/e is 25.5x, well above the historical mean of 15.9x.

Shiller Graph

What were future equity returns when the Shiller P/E was at current levels? The average 10 year real return was just 0.5%. Indeed, if you rank years by Shiller P/E, then you get an almost perfect relationship between valuations and future returns.

Shiller Table

What are the conclusions for today? Caveat emptor. The time to buy an index and expect double-digit returns are over. Investors have to be far more selective than in previous years. The table above for the US market also implies that investors should rotate some money out of the US market and increase their European exposure since European equities are trading at a lower multiple and offer the potential for better long-term returns.

For further questions, please contact us at info@ipanema-capital.com

Source: AQR, Cliff Asness, Nov 2012

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