Models of Future Stock Market Returns

Finance professionals focus on what they call “valuation ratios” because ratios take out the change in components over time. For example, the S&P 500’s earnings yield ratio is a ratio of the operating corporate earnings to the market value of all stocks in the S&P 500. Academics change the name from the more commonly known “price-to-earnings ratio” or “p/e” to “e/p” or “earnings yield” by inverting the ratio. This makes sense because the resulting ratio is the yield or investment return on the S&P market value assets. If stocks are valued at $10 trillion, hypothetically, and their aggregate earnings are $1 trillion, stocks are yielding 10 percent ($1 trillion/$10 trillion). Over time, the components of the ratio, earnings and market value, change and grow as the economy expands. However, the ratio itself varies much less than its components because it measures the relationship between the two components, not the details of each. Ratios, therefore, are useful in assessing relationships rather than specific data. Sometimes these relationships have predictive value.