There are many popular and obscure valuation ratios and models (e.g. P/E, CAPE, Fed) that investors, analysts and strategists employ when forecasting the stock market.
And according to a recent report from Vanguard’s Joseph David, Roger Aliaga-Diaz, and Charles Thomas, they’re all pretty terrible.
The three tested a bunch of popular metrics against stock returns since 1926 to test whether they explained actual returns (as measured by R2). Here’s summary of their conclusions:
- “First, stock returns are essentially unpredictable at short horizons. As evident in the R2s, the estimated historical correlations of most metrics with the 1-year-ahead return were close to zero”
- “Second, many commonly cited signals have had very weak and erratic correlations with realised future returns even at long investment horizons. Poor predictors of the 10-year return included trailing values for dividend yields and economic growth, corporate profit margins, and past stock returns.”
- “Our third primary finding is that valuation indicators—P/E ratios, in particular—have shown some modest historical ability to forecast long- run returns.”
In other words, if you have to use one of these measures, use them for long-term investing. And use them as a guide, not gospel.
Here’s a chart from the report:
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