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How Does One Predict Equity Market Returns?
Malaysia Perspective | 25 June 2013

By The Research Team 

In our assessment of stock market attractiveness, we focus on two key parameters, namely earnings and valuations. The bulk of fundamental stock market analysis revolves around macro-economic factors and the careful study of corporate fundamentals, but ultimately, these parameters involved in stock market analysis relate back to a simple question: What do economic and corporate sector considerations suggest about the trend in earnings and the stock market valuation going forward?

Key Components Of Equity Market Returns
Our emphasis on earnings and valuations stems from the simple reasoning that equity market returns can be distilled into three components, namely

1)    Earnings growth,

2)    An expansion of the valuation multiple

3)    Dividend yield.

Of the three components, the dividend yield is generally a positive contributor; since companies in the stock market pay dividends on aggregate (the S&P 500 has averaged a 3.9% annual dividend yield since 1927). Thus, an investor seeking to predict equity market returns should focus on the other two parameters, namely earnings growth and the valuation multiple.

Chart 1: Economic Growth Drives Earnings

Economic growth drives corporate earnings over time, hence the importance of incorporating macro-economic factors into an analysis of the stock market. As highlighted in Chart 1, US nominal (not adjusted for inflation) GDP expanded by a compounded 6.7% per annum between 1946 and 2010, while US corporate earnings grew at an annualised rate of 7.1% over the same period. However, the growth trend in corporate earnings is far more volatile compared to nominal GDP, due in part to the exacerbated declines in corporate profitability in recessions, and the rapid recovery in earnings as the economy picks up once again. Over a single calendar year (1946-2010), US corporate earnings have declined by as much as 28% (in 2008) or grown as much as 52% (in 1946). This is in marked contrast to the 15.1% year-on-year increase in US nominal GDP in 1951, or the 1.7% contraction in 2009.

Chart 2: Earnings Drive The Stock Market

Similar to the relationship between economic growth and earnings, stock market performance has been driven by earnings of the underlying companies (as shown in Chart 2), with the S&P 500 gaining an annualised 7.3% (excluding dividends) from 1946 to 2012, while the earnings of the underlying stocks have grown by a slightly faster compounded annualised rate of 7.4% over the same period. Driven by the underlying profitability of companies, the S&P 500 has also fluctuated to a large extent over a single calendar-year period, chalking up losses of as much as 38.5% (in 2008), or gains of 45% (in 1954). Nevertheless, the long-term trend indicates that earnings have grown at a relatively stable rate, aiding the equity market in posting similar returns over the long term.

Valuation Considerations

Chart 3: Stock Market Valuations

In addition to earnings growth, valuations play a huge role in determining equity market investment returns. As shown in Chart 3, long-term average price earnings ratio (PE ratio) of the US stock market (since 1954) is 16.4X, but the measure has fluctuated significantly, rising to as much as 30X in the late 1990s, or falling to as low as 7X in the early 1980s. Based on the market’s price earnings ratio (PE ratio), an investor gets a sense of how expensive or cheap the market is on a historical basis, and all other things equal, an investor should be looking to invest in the equity market when valuations are lower rather than higher.

Investing in a cheap market thus provides an additional component of return in terms of a potential increase in the valuation multiple, but similarly, investing in a market with high PE ratios could entail downside risks if the valuation multiple contracts. To exemplify this risk, investors only need to look back to the past performance of US equities from end 2012 to end 2012. Despite US earnings growing by annualised rate of 8.2% over a decade, the S&P 500 delivered a much softer positive return of 4.9% (annualised, excluding dividends) over this ten-year period. This poor performance is primarily attributed to the compression of the valuation multiple over the period, from 19.1X at the end of 2000, down to 14.1X at end 2010, a 26.1% decline over the period.

Putting Them Together: Predicting Equity Market Returns
Knowing the three components of equity market returns, one merely has to add (to be mathematically correct, the rates of return are geometrically linked) the return for each component together to derive a prediction for the overall equity market return. For example, assuming that earnings will continue to grow at 7.4% per annum and that the dividend yield remains at the current 2.1% (2013 estimated yield, as of 31 May 2013), investors may approximate the long-term US equity market return at 9.5% per annum, assuming no changes in the market’s PE ratio.

Current Forecasts For The US Equity Market
Of course, the 7.4% rate of earnings growth is the long-term historical rate, and earnings may rise quicker following a sharp recession, like in the case of the 2008-2009 downturn. Current consensus estimates are for earnings growth rates of 7.5%, 11.2% and 10.2% for 2013, 2014 and 2015 respectively, while at current levels (as of 31 May 2013), the US equity market trades at just 14.8X current year earnings, a discount to both the long-term historical average of 16.4X, as well as our own 15X estimate of fair value for the US market. Based on these forecasts and the assumption of a 2.8% annual dividend yield for 2013, we can derive potential upside of 33.1% for US equities by the end of 2015, which translates to a 12.1% annualised rate of return, significantly higher than the generic long-term expected rate of return.

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