Why Valuation Is a Limited Predictor of Asset Returns

Valuation can be a strong predictor of long-term asset returns, but we’ve found that its power as a performance indicator declines over shorter investment horizons. As shown below, you can see there’s a strong relationship between earnings yield, which is the inverse of price-to-earnings ratio, and long-term forward returns. In fact, almost 51% of the variability of 10-year forward equity returns can be explained by the starting earnings yield.

When earnings yields are relatively high, a portfolio gains two advantages that help it succeed over time. First, it’s exposed to a higher amount of corporate earnings per unit of cost. Second, equity prices tend to revert to the mean over time, giving the portfolio an additional benefit from price appreciation.

Why Valuation Is a Limited Predictor of Asset Returns - OppenheimerFunds

Source: Bloomberg, 8/31/15. Past performance does not guarantee future results.

On the other hand, valuations are an unreliable predictor of returns over shorter periods due to a number of factors, including the economic environment, the business cycle, investor risk appetite, and monetary policy. Each of these alone can drive valuations higher or lower. As you can see below, when the time horizon is shortened to one month, valuation provides barely any predictive power, attributing to almost 0% of the variability of forward returns.

Why Valuation Is a Limited Predictor of Asset Returns - OppenheimerFunds

Source: Bloomberg, 8/31/15. Past performance does not guarantee future results.

Instead of focusing solely on valuation, we believe a more effective strategy for asset allocation over shorter periods is to examine the business cycle through macroeconomic analysis. By assembling data from a variety of sources, our Global Multi-Asset Group (GMAG) is able to construct indicators that help show when the phases of the business cycle are changing and how to alter portfolios to capitalize on those changes.

By incorporating such analysis into the investment process, we aim to better manage risk and deliver a better investor experience in the short to medium term.

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