Outcomes on the horizon
Most people expect P/E to measure current valuation and to show historical patterns. But more features are available from some versions of P/E. The methodology behind the Crestmont P/E enables investors to anticipate the future. It may not precisely predict the market ten years away, but it frames within a relatively tight range the likely outcome. One component from determining the Crestmont P/E is a means to assess the future trend line for EPS using estimates of future economic growth (GDP).
GDP growth over this decade, albeit somewhat uncertain, is highly likely to average within a fairly narrow range between 2% and 4% annually. The higher value of 4% reflects growth reverting to its long-term average. The lower value of 2% indicates significant drags on the economy. With population growth near 1%, even just a little productivity drives economic growth to 2%. Most pessimists predict between 2% and 2.5%. Most optimists hope for 3.5% or slightly higher. If you poll your favorite economists, the high odds-on range for average economic growth will almost certainly be 2% to 4%.
The other major factor for estimating stock market returns is a reasonable estimate for P/E in the future. From earlier principles, the primary driver for P/E is the inflation rate. Although the range of outlooks for inflation can be quite broad, there are three primary categories of outlooks. The first is higher inflation, the second is price stability (i.e., low inflation), and the third is deflation. For each category, there is an estimated P/E using The Y Curve and historical data.
For ease of reference, Chart 6 repeats the earlier Chart 3 (which presents the range of EPS based upon various scenarios for GDP growth). Therefore, with three scenarios for economic growth and three scenarios for the inflation rate, there are nine composite scenarios for stock market outcomes. When the scenarios for P/E (from Chart 5) are applied to the scenarios for EPS (in Chart 6), and dividend yields are added to the results, the result is the Probable Outcomes Matrix in Chart 7!
Chart 7. Probable Outcomes Matrix: Real & Nominal Returns
This identifies the two major factors that drive stock market returns over the long-term. Certainly there are numerous other factors that impact these two, but the ultimate value of the stock market (i.e., the value of its cash flows), is determined by the growth in cash flows and the discount rate applied to those cash flows. The cash flows of companies emanate from earnings, which for the stock market overall is driven by economic growth. The discount rate, as reflected in P/E, is driven by the inflation rate.
These scenarios are useful in several ways. First, they frame the range of probable outcomes. That helps investors to structure their portfolios and financial plans. Although the scenarios reflect what is likely, they also tell us what isn't likely. For example, an average or better stock market return (i.e., the famous 10%) is highly unlikely for this decade (without another bubble of course). As investors consider various investments for diversification, alternatives with solid 6%, 7%, 8%, etc. return profiles can be quite attractive.
Some investors are afraid to miss the next secular bull market (longing for the 1980s and '90s again) and thus often shun such investments. They see them as anchors that compromise stock market portfolios. Yet in secular bear market periods, like today, those "anchors" may turn out to be engines!
With the right tools and reasonable assumptions, the future of stock market returns is on the horizon and visible to investors. There's no reason that anyone should look back in 2019 and say "who knew?" as savings underperform or dwindle. Institutional investors, especially, risk great burden if they rely upon unrealistic assumptions for returns. Early recognition, whether individuals or institutions, can enable smaller solutions in advance rather than major reactions in crisis.
Copyright 2011, Crestmont Research (www.CrestmontResearch.com)
Ed Easterling is the author of recently-released Probable Outcomes: Secular Stock Market Insights and award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. Further, he is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU's Cox School of Business where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets at www.CrestmontResearch.com.