June 5, 2008 - 5:24pm

In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment.

Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

Valuations and Long-Term Returns

The idea behind the study is fairly simple. We took 100 years' worth of monthly data on the S&P 500 stock market index. For each month, we calculated two figures: the market's average valuation during the month, and the 10 year total returns on the market dating from that month.

Here is a little more detail on the calculations, for those interested. (If you are not interested, feel free to skip the next two paragraphs).

The market valuation is a modified price-to-earnings ratio based not on the past year's earnings, as are typically used, but on the past 10 years' worth of earnings. This technique is recommended by Yale professor Robert Shiller (who also provided most of the data for this study) in order to smooth out the shorter-term ups and downs in market earnings that result from the booms and busts of the business cycle. Earnings are also adjusted for inflation to provide an even comparison between periods with different levels of inflation. We think that this method of valuation makes a lot of sense for long term investors because it smooths out earnings spikes and troughs and provides an indication of how expensive stocks are compared to a sustainable level of earnings.

The 10-year future return for each month includes both stock price appreciation and dividends. Returns are also adjusted for inflation.

Once we had each month's valuation and return, we separated all the months out into five quintiles based on valuation (i.e., cheapest through most expensive) and determined the average annualized 10-year return for each quintile. The chart below shows the results.

Clearly, starting valuation has been quite predictive of average long-term returns. People who bought in the cheapest 20% of months enjoyed an amazing average 10-year return of 15.7% per year after inflation. Their counterparts who bought during the most expensive 20% of months averaged just 3.4% per year. And at every quintile in between, higher valuations led to lower average returns.

As one might expect given the above results, people who bought at high valuations were also a lot more likely to lose money even after 10 years. A full 33.3% of the time periods in the highest valuation quintile led to real 10-year returns that were negative, while the lowest valution quintile didn't contain a single period of negative real returns. As a matter of fact, the very worst annualized return for the lowest valuation quintile was 4.9%. It is typical to believe that higher rewards go hand in hand with taking more risk, but this study indicates that investors who heed the message of valuations can enjoy higher returns with lower risk.

Incidentally, valuations predict average returns on shorter timeframes than 10 years. For instance, the 7-year return results looked very similar to the above with a 17.3% return for the cheapest quintile and a 3.9% return for the most expensive quintile. Averages are similar even for shorter timeframes. The problem is that the variation among the numbers comprising those averages gets higher and higher as the timeframe gets shorter, rendering the predictions less and less useful. This makes sense -- a market that's overvalued or undervalued may stay that way for years, but as time goes on the market is more and more likely to have reverted to a more normal valuation (with a commensurate impact on returns).

In case anyone thinks that 100 years ago is ancient and irrelevant history, we also ran the study for the past 50 years and achieved very similar results, with the cheapest quintile sporting an average real return of 15.0 percent versus just 3.1 percent for the most expensive quintile.

Where Are We Now, and What To Do

With the S&P 500 at 1,377.20 as of this writing, we fall comfortably within the most expensive 20% of time periods as measured by the price to 10-year real earnings ratio. As a matter of fact, we fall comfortably within the most expensive 10% of time periods. This means that we are in a situation that has, on average, led to very poor long-term returns for buyers of the S&P 500.

So what does one do?

We'll start by talking about what not to do.

Conventional wisdom has it that the stock market returns 10% per year over the long term, so at any given time you should just close your eyes, go all in to a stock market index fund, and forget about it. Hopefully the above study sheds some light on why this is a poor approach. As the chart shows, that 10%-per-year figure includes lengthy periods of widely disparate returns. And starting valuations provide a pretty good idea of the kinds of risks and returns that can be expected in the future.

All in all, the strategy of buying the entire market regardless of prevailing valuation just doesn't make sense to us.

Granted, people who go all in to the U.S. stock market right now may end up getting decent long-term returns. It has happened, even at these valuation levels, and even over 10-year time frames. But it's been fairly rare, and unless "this time is different," history suggests that the stock market is likely to provide poor long-term returns and a higher risk of loss from this level of valuation.

At the same time, staying out of the market entirely entails its own risks. With short-term interest rates below the rate of inflation, cash is a sure loser for all but the shortest time periods. For this reason, as we warned in our inaugural article appearing on this website, cash is anything but a safe haven. Bonds are even worse, generally speaking, because we feel that they are seriously underpricing long-term inflation risk.

The solution, we think, is to stay invested, but to carefully choose your investments rather than indiscriminately buying the entire stock market. The above study treats the entire stock market as a single unit -- this is useful to get an idea of overall valuation, but it's certainly not a limitation that we suffer as investors. The ability to invest in individual sectors, in other countries, and in alternative asset classes is important to investors trying to navigate high-risk, high-valuation markets like this one.

We firmly believe that there are great profit opportunities in any market, and this one is no different. But when markets are broadly overvalued, it is that much more important to choose your investments carefully. It is crucial to stay cautious, skeptical, and patient; to diligently seek out good values and avoid the risks that are being underestimated by others; and to analyze the economic and monetary trends and understand their likely effects on the markets and the world.

Such analysis is exactly what we do here at Pacific Capital Associates. Feel free to visit our commentary archive if you're interested in our thoughts on the risks and rewards to be found in today's markets.

• Read more investment articles at pcasd.com.
• Learn about how we can help investors benefit from the ideas presented in our articles.
• View our answers to frequently asked questions about what we do.
• Subscribe to our RSS feed.