Most of our discussions these days start with some level of concern—odd with U.S. equity markets at or near record highs. Yet, because U.S. equities have done so well and the perceived risk within them has been so low, there is a feeling that this party simply cannot go on forever.
We Focus on What We Know
None of us knows exactly when a correction will come—we hear a lot of investors directly telling us that they have cash to deploy into the market when such a correction comes to pass. But certain statistics, like price-to-earnings (P/E) ratios, are much easier to find. Commonly, we’ll hear that the U.S. equity market has become or is becoming expensive, and for that reason, price levels will have to drop. Those with experience have learned—sometimes the hard way—that:
Valuation really isn’t a great predictor of how equity markets might behave in the short term, but for those interested in the longer term, we believe it can have major implications.
The Relationship between the Earnings Yield and the Potential Real Returns
In his book The Future for Investors, Professor Jeremy Siegel focused on equities as real assets and indicated that, over a variety of long time frames, the earnings yield on an equity market was very close to the long-term, after-inflation return that market generated over time. Simply put, this tells us the following:
