Thursday, October 20, 2005

Impact of P/E ratios on Long-term Returns

“A 40% increase in P/E ratio over a 40-year period increases returns by less than 1% annually. Similarly, a 40% plunge in the P/E ratio over that holding period reduces returns by just over 1% annually.”
- John P. Hussman (The 40 year forecast for the S&P 500 Index)

This makes sense to me.

The broad market’s P/E ratio is about 20 today. Is market overvalued? Undervalued?

Let’s suppose someone is in his/hers middle 20’s and buys into S&P 500 at today’s prices. This person wants to retire at the age of 65 and intends to sell the S&P 500 holding at that time.

If the terminal P/E at the sell-time is at 12, 40% below the P/E of today; the total impact on the overall return will be just about 1% annually.

Also, if the terminal P/E at the age of 65 is at 28, 40% above the P/E of today; the total impact on the overall return will be just about 1% annually.

The time is key here. The time dampens the effect of the swings in the market and smoothes out the averages. The big swings in the market valuations like the 40% rise or fall in P/E ratio has very negligible effect on the outcome of the long-time buy-and-hold portfolios.

Is market overvalued? If the time is on your side, paying 40% higher P/E will reduce your returns over the 40 years by only 1%.

Is market undervalued? You tell me.

4 comments:

Jonathan said...

Hmm... I've never heard of it discussed in that way. Very interesting. Although of course 1% annually over time can be a big difference.

rarely right said...

I would like to see the effects of market p/e over shorter periods. The minimization of the importance of p/e valuation is due to the extremely long period used in the study. 40 years is much longer than the average holding period for investors. It's notable that Hussman goes on to say that he does not thing this is a good time to invest based on valuation. Granted, his piece was written earlier this year.

Suresh said...

rarely right,

Dr. Hussman's perspective that equities are overvalued hasn't changed much since he wrote that article. See, e.g., his "The Durable Sense of Doom" article at http://www.hussman.net/wmc/wmc051212.htm. Concerning that later article, what I thought was interesting was that Dr. Hussman advises passive indexers to stay the course, "[i]f your current investments are relatively small compared with the future savings that you plan to invest."

Anonymous said...

Following the link Hussman says that now is not a good time to put loads of wealth into stocks and if you have a large percentage of your wealth is in stocks think about lightening the amount.

So overvalued based on source.