“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – the gospel according to Warren Buffett. Although this sounds quite simple, there are two schools of thought on how to go about accomplishing it. 

Firstly, the market timers believe the answer is to “buy low and sell high”. However, a second group (including many prominent academics) maintain this is easier said than done, with very few investors actually getting it right with any degree of consistency. They expound that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.  

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns? 

In an attempt to cast light on this issue, an interesting multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns was done by my colleagues at Plexus Asset Management. The study covered the period from 1871 to 2006 and used the S&P 500 Composite Index (and its predecessors). In essence, a total real return index and coinciding ten-year forward real returns were calculated, and used together with PEs based on rolling ten-year earnings.  

In the first analysis the PEs and the ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).


The cheapest quintile had an average PE of 8,5 with an average ten-year forward real return of 11,0% p.a., whereas the most expensive quintile had an average PE of 21,6 with an average ten-year forward real return of only 3,2% p.a. 

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.  

The study was then repeated with the PEs divided in smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3).



This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage. 

A third observation from this analysis is, interestingly, that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable. 

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.   

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham’s GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.     




Based on the above research findings, with the S&P 500 Index’s current PE of 18,4 and dividend yield of 1,8%, investors should be aware of the fact that the market is by historical standards not in cheap territory, arguing for luke-warm returns. Although the research results offer no guidance as to when and at what level the current bull market will run out of steam, they do indicate that it would be irrational to bank on above-average returns from these valuation levels. As a matter of fact, investors should expect higher volatility and even the possibility of some negative returns. 

It is easy to understand why Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.