Valuation Metrics and Spreads Can Inform Future Returns

Research has found that valuation metrics and spreads can provide useful information with regard to future returns, according to an article in by BAM Alliance research director Larry Swedroe.

Metrics such as earnings yield or CAPE, the article says, “have information in terms of future returns—the higher the earnings yield, the higher the expected return; and the larger the spread in valuations between growth and value stocks, the larger the future value premium is likely to be.” The relationship, the article reports, holds across asset classes as well as across stocks.

The October 2018 study findings are as follows:

  • There are common variables that forecast all factor premiums (except profitability) and provide evidence that the individual stock premiums also vary in coordination with the market price of risk;
  • Increases in the cross-sectional book-to-market spreads significantly forecast increase in one-month-ahead premiums for all except the profitability factor;
  • Increases in the investment (profitability) spreads marginally forecast increases in the investment (profitability) premiums.

The article concludes that the findings bode well for value investors, as the “relatively poor performance of value stocks in the U.S. over the past decade has led to a widening of the book-to-market spread between value and growth stocks, restoring it to about the same level it was when Eugene Fama and Kenneth French published their famous study, ‘The Cross-Section of Expected Stock Returns’ in 1992 (they had found a large value premium).”