Charts like these (including my own) that attempt to correlate valuation metrics with future returns start off at a significant unfair advantage relative to other types of correlation efforts. Note that a valuation metric is just the current price divided by some variable (earnings, book value, sales, etc.). Neglecting dividends, the long-term future return is just the difference between the current price and some price far out in the future. Notice that “current price” shows up in both of these terms. Is it such a surprise, then, that valuation metrics and future returns seem to correlate well?
Roughly:
(1) Valuation Metric = Current Price / Variable
(2) Future Return = Future Price – Current Price
If future prices are inclined to rise at some rate over the long-term, then any time current price falls (and the same fall isn’t exactly mimicked way out in the future), (1) will go down, and (2) will go up. The valuation metric will fall, and the return–the distance between the future price and the current price–will rise. Hence the (inverse) correlation.
Now, if you choose a denominator for the valuation metric that is highly noisy, its noise may get in the way. But if you choose a denominator that is smooth over time, the pattern will hold. Notably, the plot of the valuation metric versus future return will end up producing a series of coinciding squiggles and jumps that create the visual illusion of non-trivial correlative strength, when there is none.
Charts like these (including my own) that attempt to correlate valuation metrics with future returns start off at a significant unfair advantage relative to other types of correlation efforts. Note that a valuation metric is just the current price divided by some variable (earnings, book value, sales, etc.). Neglecting dividends, the long-term future return is just the difference between the current price and some price far out in the future. Notice that “current price” shows up in both of these terms. Is it such a surprise, then, that valuation metrics and future returns seem to correlate well?
Roughly:
(1) Valuation Metric = Current Price / Variable
(2) Future Return = Future Price – Current Price
If future prices are inclined to rise at some rate over the long-term, then any time current price falls (and the same fall isn’t exactly mimicked way out in the future), (1) will go down, and (2) will go up. The valuation metric will fall, and the return–the distance between the future price and the current price–will rise. Hence the (inverse) correlation.
Now, if you choose a denominator for the valuation metric that is highly noisy, its noise may get in the way. But if you choose a denominator that is smooth over time, the pattern will hold. Notably, the plot of the valuation metric versus future return will end up producing a series of coinciding squiggles and jumps that create the visual illusion of non-trivial correlative strength, when there is none.