April 21, 2009
A strong relationship is apparent. Investors in January 1929, when normalized P/E ratios peaked at over 30, would have been well-advised to avoid the equity markets, as subsequent 40-year performance reached its lowest level over the time period shown. Several years later, in the depths of the Depression, P/E ratios reached their lowest point – nearly 5 – at subsequent 40-year performance peaked at nearly 14%.
Investing when P/E ratios are below 15 – ideally below 10 – yields 40-year performance of 12% or more. That is modestly good news for today’s investors. According to Shiller’s web site, the normalized P/E ratio as of March 2009 was 13.1.
The equity risk premium
Equity investors expect to be compensated for the additional risk they bear over periods as long as 40 years, thus earning what is called the “equity risk premium.” Arnott claims – and we agree – that the “correct” risk premium is about 2.5%, despite his claim that many believe it is as high as 5%.
Interestingly, Arnott’s data shows the average premium was 6.27%, using his trailing 40-year monthly returns. An entirely different picture emerges, however, when the data are examined over shorter time intervals:
Time Interval |
Equity Risk Premium |
40 years |
6.27% |
30 years |
6.05% |
20 years |
5.12% |
10 years |
3.67% |
1 year |
2.57% |
Drilling down to 1-year returns gives almost exactly the 2.5% premium Arnott cites.
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