April 24, 2010
By Laura du Preez
There is a strong long-term relationship between the real returns you can earn on an investment in the stock market and the price of the shares in which you invest relative to their earnings, Prieur du Plessis, the group chairman of Plexus, says.
In a recent online newsletter, Investment Postcards, Du Plessis says that Plexus Asset Management updated a previous comparison of price-to-earnings (PE) ratios of a major United States stock market index, the Standard & Poor's 500, to the subsequent real total returns earned from shares in the index. (Refer to this graph.)
The analysis strongly confirms that real returns decrease as PE ratios increase, Du Plessis says.
The study also shows, he says, that if you invested in the S&P 500 when its PE ratio was less than 12, you always enjoyed a positive 10-year return, whereas investments into the index at PE ratios of 12 or more had some negative real 10-year returns.
Thirdly, Du Plessis says, the study shows that investing at PE ratios of between 12 and 17 produced the biggest spread of minimum and maximum returns and were therefore less predictable.
Du Plessis says Plexus found the same relationship between PE ratios and subsequent returns over three, five and 20 years.
Plexus also tested the returns based on dividend yields, and the findings were that the higher the yield when you invested, the better your returns.
The S&P 500 index's current 10-year PE ratio is 20.3 and its 10-year dividend yield is 2.1 percent, which means that by historical standards, the market is expensive, Du Plessis says.
Plexus's finding that investing at high PE ratios tends to produce lower returns means that we can expect "unexciting, long-term returns, possibly a 'muddle-through' trading range for quite a number of years to come", Du Plessis says. There is also a distinct possibility that some returns may be negative off these price levels, he says.
Du Plessis says that any signs of earnings disappointments or a renewed slowdown in economic growth could trigger a pull-back in equity prices.
A major risk to global equity markets is a double-dip recession in Western countries due to China's efforts to cool its economy and the emergence of the debt crisis in the euro zone, he says.
  
 
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