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By Ron Surz Ron@PPCA-Inc.com, Originator of Age Sage
- Returns on stocks and stock markets are the result of just 3 factors, 2 of which are easy to predict.
- The hard factor to predict is Price/Earnings ratio because it is driven by investor psychology.
- All you need is a P/E forecast and you’ve got a forecast of market return. It’s that easy.
The following formula is always correct because it is a tautology. To predict the future, simply estimate earnings growth and P/E expansion or contraction, which is driven by investor behavior.
Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1
The following table shows where we are now and highlights where we will be if P/Es revert to normal.
As you can see, the 2018 market return will be 8% if P/Es are unchanged, but the market will lose 28% if P/Es return to their historic mean of 20. And a P/E decline to 25 produces a 10% loss. As you can also see, if earnings do not grow at the anticipated 6% rate, market returns will adjust, but not as dramatically as the response to P/E expansion/contraction.
What is your outlook for earnings growth in the stock market over the next 12 months? Where do you see P/Es a year from now? You can look up your cell (forecast) in the table above.
Be aware that we are talking about market timing here. Risk management is a related but different topic that I’ll cover in a future article.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.