Valuation ratios such as P/E are not very useful in making one year predictions, although they do a fair job of predicting longer-term returns of at least 5-10 years.
Considering this, we will not perform a market forecast for 2013 or any other single year, unless we can support it with a high standard of evidence. Instead, let's use those valuation ratios to evaluate the markets today and estimate how that affects returns over the next 10 years. It’s not as exciting, but it’s far more responsible and reliable.
The following table shows valuation ratios for global stocks and US real estate as of 12/14/2012, with all P/E ratios using 10 years of earnings. Estimates for future returns assume that valuations revert to fair levels 10 years from now and that asset classes otherwise perform in line with their historical averages.
|Asset Class||Valuation Ratio||Market Valuation||
Future 10y Returns
vs Historical Average
|US Stocks||Q||40% overvalued||3-4% per year lower|
|US Stocks||P/E||27% overvalued||2-3% per year lower|
|Foreign Stocks||P/E||16% undervalued||1-2% per year higher|
|Emerging Market Stocks||P/E||10% undervalued||1% per year higher|
|US Real Estate (REITs)||P/E||64% overvalued||5% per year lower|
The two valuation ratios for US equities (Q and P/E) are calculated using separate sets of data yet produce similar results, indicating that our methods are consistent.
US stocks and especially US real estate are overvalued by a significant amount, so we can expect lower than historical average returns for both assets classes over the next 10 years. Valuations for stocks outside the US look far more attractive, making higher than average returns more likely.
Since predicting returns even in the 10 year range exhibits a high margin of error, tactical bets should be measured and sized appropriately based on investment goals and risk preferences.