In a recent white paper by Fidelity Investments the authors show that valuation in and of itself is a poor predictor of future short term market returns. The report evaluates a number of valuation indicators, including the Shiller CAPE, and points to some shortcomings with the CAPE calculation. In addition to Fidelity, Jeremy Siegel has highlighted issues with the CAPE calculation. Nonetheless, valuation is certainly important for investors to pay attention to as they allocate investment dollars to equity. The Fidelity report does show that valuations are a much better predictor of longer term market returns.
As we noted in yesterday's post, Equity Market Continues To Track Like the 1990s, one characteristic over the past two years similar to the mid 1990s is the fact multiple expansion has enhanced recent equity market returns. Like Fidelity, at HORAN Capital Advisors, we to believe multiple expansion is likely to continue to enhance returns over the near term. The below chart shows the role multiple expansion had in the mid 1990s compared to the returns in 2012 and 2013.
|From The Blog of HORAN Capital Advisors|
Source: Fidelity Investments
The Fidelity report includes commentary on valuation measures beyond CAPE and trailing and forward PEs. We have written about the importance of looking at alternative measures of valuation like P/NIPA (price to national income and product account corporate profits) and P/CF (price to cash flow.) Both of these measures have benefits and disadvantages; however, they do make an effort to look at a more comprehensive economic earnings picture or evaluate earnings excluding one time write-offs.
No one measure is a panacea in determining the "right" valuation for the market. However, there is enough data provided by these alternative measures that gives some confirmation that multiple expansion can continue to have a positive impact on large cap equity market reurns in the near term.
U.S. Equity Valuations Not an Obstacle in 2014
by: Jordan Alexiev, CFA, Senior Analyst; Austin Litvak, Senior Analyst