Drivers of Stock Market Returns
Drivers of Stock Market Returns
When making a decision for investment in a specific equity market it is important to consider what will be the drivers of subsequent returns.
This concept is outlined in detail by a number of well-respected sources; the following is details how Financial Planning Wales uses this information in our investment process -
The boom and the bust were normal — just two more swings in stock returns over the past century. Reversion to the mean is the iron rule of the financial markets. –
John Bogle Founder of Vanguard
Our equation for stock returns is based on how the Price Earnings (PE) ratio and Profit Margins could revert to their mean over the coming years – will there be expansion or contraction – and also adding in the income from dividends. We can then put this information into a simple equation to create a forecast of future potential returns over a chosen period – in this case 10 years.
|
Potential Future Returns |
= |
PE reversion to mean |
+ |
Profit Margin Reversion to Mean |
+ |
Dividend Yield |
The graph to the right shows all three components with the results in the bottom right hand side; and whilst there are is some variation - stock prices deviated significantly from these fundamentals in the run up to the Tech Bubble and Financial Crisis – it provides a more than reasonable forecast of potential returns.
Currently we see that the US is priced for returns of -3.06% p.a. for the next ten years with PE ratios and profit margins contracting and only modest dividend growth; sentiment may continue to be supportive of equities but the odds are not in investors favour.
