Zen And The Art Of Risk Management

Zen, Zen and the Art of Risk Management

The correlation of ten-year forward returns and CAPE is statistically significant with an R-squared of .4803. In other words, valuation matters in the long run. Conversely, there is no correlation between quarterly returns and CAPE. The graph below further highlights valuations become a more critical measure of risk and reward over time. 

Zen, Zen and the Art of Risk Management

The use of valuations is often rebuked because they serve little purpose in daily trading. That is a fair statement. However, whether we are flipping stocks daily or holding for years, valuations provide an essential gauge of risk.

To be clear, just because we may evaluate a company using a long duration doesn’t mean we have to hold it for an extended period.  

Earnings Trends and Expectations

GDP and corporate earnings trend linearly over long periods. That said, short-term earnings fluctuate wildly. It is these vacillations from the trend that makes equity valuation harder than it needs to be.

Since earnings are what we are buying, comparing historical earnings trends to market-implied earnings is a shrewd way to value a company or index. This method allows us to assess if we are paying more or less than what we should expect to receive?

Such a comparison serves well for stable, mature companies. However, it becomes a difficult task for companies whose earnings grow or shrink in a non-linear fashion.

Fortunately, many broad market indexes, such as the S&P 500, have linear earnings growth trends over long periods. This happens because the index’s large sample size and industry diversification reflect broad economic trends.

 

Implied Earnings

The price to earnings (P/E) ratio of an index or stock coupled with an assumed holding period, is all we need to calculate the market-implied future earnings growth rate. For instance, if the P/E is 20 and we assume a 40 year holding period, we expect earnings growth of 7.78%. Earnings, compounding at a 7.78% rate, entails shareholders will receive enough earnings to pay back their initial investment in 40 years. If 7.78% is an acceptable 40-year return compared to other assets, the stock or index is fairly valued.

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