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Tuesday, June 19, 2007

What to expect for long term equity returns

John Mauldin's latest Outside the Box newsletter contains an outstanding article by Dr. Prieur du Plessis.

In it, Dr. Plessis shows clearly how current market price to earnings ratios and dividend yields provide a good idea of future 10 year returns. Quite simply, the higher the current price to earnings ratio, the lower the market return going forward, and the lower the dividend yield, the lower the market return going forward.

As Jeremy Grantham at GMO has stressed repeatedly, "the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns."

In other words, valuation in the form of price to earnings ratios and dividend yields are terrible at predicting short term returns, but excellent at forecasting long term returns.

What is the current S&P 500 price to earnings ratio of 18.4 and dividend yield of 1.8% indicating? Returns of around 4-5% over the next 10 years.

If your retirement plan relies on higher returns while being broadly diversified or invested in the market, you may want to reconsider your investment choices.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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