How Market Valuations Impact Future Market Returns
Your total return you can expect as an investor comes from a combination of a stock's expected return & its unexpected return.
A stock's expected return depends on what the company owns versus what it owes (this is known as the book value of equity) as well as a discount rate demanded in aggregate by market participants who hold shares of the company.
A stock’s unexpected return is the excess cash flow generated over and above the applied discount rate. This makes the company more attractive to investors and prices rise as investors incorporate this information into current prices.
This applied discount rate forms a price which represents the aggregate of investors expectations of a company’s current and expected future profits.
The unexpected return isn’t calculated in discount rates because it’s just that – unexpected.
Prices by themselves mean nothing.
You need to apply prices to some fundamental underlying metric of a company to get an idea of what the company is worth.
A common way to value companies is relative to their earnings – this is known as the price to earnings ratio (PE ratio).
As an investor, this tells you what you’re paying for the rights to a company’s cash flows.
Expectations of future returns can be tied back to fundamentals of how cheap or expensive a company's cash flows are.
If you go to the store and see prices marked up by 10 or 20% relative to what prices were last week, you would venture to say this is a bad deal because the current price relative to what you paid last week is higher.
In the same way:
If you go to the store and see prices marked down by 10 or 20% relative to what prices were last week, you would venture to say this is a good deal because the current price relative to what you paid last week is lower.
Markets are no different.
If you’re paying $1.20 for $1 of a company’s profits versus .80 cents for $1 of a company’s profit, all else equal, you’d rather buy stocks that offer a discount from their fair value.
Why would this occur in the first place?
Because market participants are applying a higher discount rate applied to that company’s cash flows, making it cheaper.
A company price could be cheap for a variety of reasons (& many of those are likely valid reasons) such as lost revenue, higher cost of goods sold resulting in lower profit, new management, etc.
The uncertainty of this company's current and projected future cash flow is greater so market participants are not willing to pay the same price for $1 of that company’s earnings - they want to pay less.
More uncertainty = more risk
More risk = higher return (or discount rate) demand by investors
When we look at the historical data, we can see that underlying metrics that quantify the value of a company such as its price relative to its earnings, reveal trends that give insight into future market returns.
Consider Nobel Prize winning economist Robert Shiller who evaluated next decade real US equity returns sorted by Shiller E/P ratio from over 114 years of market data:
What we see is that stocks that had expensive prices over the next decade averaged 3% in real return.
Compared to:
Cheap stocks which averaged 13% in real return over the next decade.
Translated in real terms of markets today, cheap stocks are value securities and expensive stocks are growth securities.
But this isn’t the full picture.
To look at how cheap a company is relative to its fundamentals is not enough.
This would be the equivalent of going to a gas station and looking for sushi.
Yes, you can get a great price but at the risk of food poisoning (or insert other risk) ... it’s not worth it.
Just because you can take more risk doesn’t guarantee you more return.
When looking to capture the returns of the markets there’s a few things you can do to reduce your risk and increase your expected future return:
Pool risk together through owning funds that hold thousands of stocks.
To own individual stocks is like playing with fire & when it comes to your wealth, you don’t want to get burned.
Own index funds or Dimensional funds to receive market returns at low cost.
Owning actively managed expensive mutual funds or ETFs reduce your total return. Opt to be the market instead of trying to beat the market.
Diversify your portfolio on the following levels:
Owning U.S. and international markets by market capitalization
Holding companies of different sizes (small cap, mid cap, & large cap)
Not overweighting growth stocks (holding a blend or a tilt to value)
Systematically rebalancing
This is the only free lunch in investing - keeping your portfolio risk in alignment.
Above all:
Remember markets are resilient.
Market volatility is the price you pay for higher returns.
With changing economic policy, new legislation, geopolitical turmoil, etc. It makes perfect sense why market prices are changing as they try to incorporate all this new information in current prices.
If your goal is long term wealth generation:
Remember to zoom out and think in decades over days.