I’ve posted Entry #323 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called It Is Not Reasonable to Expect a Perfect Correlation Between Valuations and Long-Term Returns.
Juicy Excerpt: There is never one wave of emotion passing through investors at a point in time. There are always multiple waves, some pushing prices up and some pushing prices down. The price that applies is the product of the interaction of the various waves of emotion. The P/E10 level from an earlier time can inform us as to the probabilities of each of the various waves of emotion being dominant at a point in time but they can never specify with certainty which wave will be dominant or to what extent it will be dominant. Hence,the correlation between the P/E10 level that applies at the time a prediction is attempted and the return that ends up applying in reality can never be perfect.
Stock returns are as predictable as we should expect them to be if Shiller is right that it is investor emotion that plays the dominant role in setting stock prices. We need to learn how to think about stock investing in the new world ushered in by Shiller’s 1981 research. Once we become comfortable with a new way of thinking, I believe that we will come to worry less about the statistical tools showing how strong the correlation is and focus more on how big an advance it is for us to be able to predict long-term returns to the extent that is now for the first time in investing history possible.