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Dotty valuation – Buy US equities now and you could be locking into historically poor returns

19/05/2015

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

The US equity market is expensive. Here on The Value Perspective, we would imagine this is unlikely to come as news to you – not least because we have pointed this out many times ourselves in articles, such as CAPE of good hope. But then presumably you do not visit this site for news so much as different insights into value investing.                              

That brings us to the following chart from our friends at Minack Advisors, which shows the sort of real returns investors might expect over the next 10 years were they to buy into the US equity market on its current cyclically adjusted price/earnings ratio. Known for short as the ‘CAPE’, this metric comprises the average earnings generated by a business or market over the last 10 years, adjusted for inflation.

Source: Minack Advisors, 2015

The chart is striking on two levels – the first being that the line of best fit suggests, were you to buy into US equities at this valuation, you would be locking into a real return of about 1% a year for the next decade. Alternatively, because in reality it will almost certainly not be exactly 1% a year but something else, you could simply take a step back and look at the dots.

The chart uses data going back to 1900 and, compared with the middle area, there are very few dots  where the market has been at this level of valuation or higher. Returning to the numbers – and heading off the occasional emails from readers unhappy we do not always stress there is a range of possible outcomes (though we normally do, and did in spades in Mind the gap – how could you have done from this level?

Over the last century and more, the chart indicates the best real return you would have received from the current CAPE level is about 6% a year over the next 10 years while the worst is in the region of -1% to -2%. You will also note how rare it is to see a negative 10-year real return from US equities, from which you might draw your own conclusions as to just how attractive the asset class now looks in the context of history.

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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