I’ve posted Entry #90 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called The Correlation Between P/E10 Values and Long-Term Returns Is Stronger Than Most Realize.
Juicy Excerpt: The stock price that applies on any given day is a COMBINATION of short-term and long-term effects. If the theory behind the VII model is correct, the short-term effects should always be pulling the data in the direction of showing no correlation and the long-term effects should always be pulling the data in the direction of showing a perfect correlation. The combined effect of the two contrary forces should be data showing a strong but imperfect correlation and one that grows as the time-period lengthens.
That is precisely what we see when we look at the 140 years of data.
If the VII model properly explains how stock investing works, we should not be expecting to see a perfect correlation when we compare the P/E10 value that applies on the day of a purchase and the long-term return produced in the years following that purchase. We should be expecting to see a strong but less than perfect correlation. That’s the correlation that appears on our computer screens when we generate graphics showing to us in pictures the story that the historical stock-return data has been trying to tell us for 140 years now.
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