Forecasting is hard, especially about the future, but with the right indicators we can make it at least a little less hard. In today's article I show how important valuations can be in shedding light on long term expected returns for emerging market equities. It's a unique angle on what is generally a well-understood principal in asset allocation.
The chart comes from a piece of research I did which looked across global equity markets at the relationship between the PE10 and expected returns. The chart shows the 10-year forward price change across time against the PE10 valuation metric.
On the detail, the PE10 valuation ratio takes price divided by trailing average earnings over the last 10 years. The 10-year forward price change is the rolling 10-year CAGR, but shifted back on the chart to line up with the timeframe (thus why the black line only goes to 2008 - i.e. those investing then will only be seeing a 10-year return this year). Notably, the 10-year forward return is shown inverted.
The link between the two series is fairly close. There's a simple economic logic behind this relationship: the higher the valuation you pay at the time of purchase, the harder it is to earn decent returns in the future. The reason is basically that you would need valuations to keep rising to do much of the heavy lifting for returns.
In that respect, when valuations are low - particularly at an extreme, it is much easier/plausible for valuations to rise and do the heavy lifting on raising future returns. In other words, valuation (or price paid) matters.
As for what the chart is telling us about expected returns, the current PE10 is pointing to a forward 10-year return of just over 10% (which is materially higher than that suggested for the US or Europe). There are of course uncertainties around such a projection, but as the chart shows its a decent rule of thumb.
It's worth noting that the pace of earnings growth is also critical (especially for emerging markets), but a lot of the time swings in valuations have a bigger impact. The other thing is that this chart only shows price or capital returns, and over the long run dividends tend to be a meaningful and relatively stable driver of total returns.
But for now, keep an eye on valuations, because they can tell you your future.
This article originally appeared as a submission at See It Market
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