Here's Why You Should Lower Your Equity Return Expectations

When I was a young pup (in the era when we used to program computers with punched cards), the three most commonly used valuation ratios for stocks were the P/E ratio, the P/B ratio and dividend yield. Now all three of these metrics are pointing to a long-term low return environment for equity prices.

In a recent post, I showed that the trailing P/E ratio for the S&P 500 was elevated relative to its own history, even adjusted for the current low level of interest rates (see Should you sell in May? ). Let's do some simple math and assume that 10 year return expectations are 5.0% (an arbitrary assumption, but roughly in the right ballpark).

Supposing that instead of correcting, stocks were to rise 25% in a single year, but 10 year returns stay at 5%. Simple math tells us that the return for the remaining 9 years comes to 3%, which would make equity prices highly stretched as they would be unattractive relative to U.S. 10-Year Treasury yields.

On the other hand, a 15% pullback in a year would raise 9 year expected returns to 7.5%, which is a level that is far more interesting for investors. You can play around with some of the assumptions, but the bottom line is that equities do not have room for the kinds of rallies that we saw in the 1980's and 1990's.

The moral of this story: Lower your return expectations.

Disclosure: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd.  (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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Written By: Cam Hui