Equity Valuation and Portfolio Management

CHAPTER 5

Valuation over the Cycle and the Distribution of Returns^*

Anders Ersbak Bang Nielsen, Ph.D.

Portfolio Strategist Goldman Sachs International

Peter C. Oppenheimer

Chief Global Equity Strategist Goldman Sachs International

There is substantial empirical evidence that valuation is a good predictor of returns over the long run.¹ Put simply, as intuition would suggest, buying an equity market when the valuation multiples are low, and the dividend yield and required equity risk premium are high, typically generates much better future returns than if buying an equity market when the opposite holds. However, while valuation today provides a great deal of information about future expected returns, it tells us nothing about how these returns should be distributed over time. Are they evenly distributed over several years, or are the returns bunched into short periods of time? What, if anything, determines the way that these returns are generated?

Historical observation suggests that the answer to this questions can be found in the relationship between valuation, earnings, and the economic cycle. For example, during periods when investors are expecting the onset of recession and falling profits, returns to shareholders deteriorate as a result both of declining expectations about the near term prospects for profits as well as a result of lower valuations attached to future expected cash flows. The opposite tends to occur at the peak of the cycle when investors are more confident. ...