Valuations then dropped to mildly compelling levels in 2002, which arguably set the stage for the multiyear rally that hit the wall last year. Even so, a number of value-oriented strategists warned that equities were still vulnerable, in part because they believed that the late-1990s excesses had only partially unwound in the 2000-2002 correction.
Fast forward to the present, in the wake of 2008's crushing losses, and the Q ratio now tells us that the market is fairly valued, and perhaps even trading at a discount. John Mihaljevic, a CFA and the editor of The Manual of Ideas (ManualofIdeas.com), a Web-based research outfit that publishes several investment newsletters, including Equities and Tobin's Q, estimates that U.S. equities generally have recently been trading at well under replacement cost, based on his reading of the Q ratio. In December, the ratio was at 0.5, which is lower than the historical average going back to 1900. "Longer term," he says. "Tobin's Q at 0.5 is bullish."
Perhaps, but it doesn't guarantee that buying stocks now is a shortcut to profits. Still, it's hard to ignore the apparent relationship between the fundamental measures of equities and investment returns.
Analyzing market fundamentals is a key part of the strategy at the Hussman Funds, a boutique shop that's beaten the odds with an impressive track record so far in the 21st century. The Hussman Strategic Total Return Fund defied the pull of bearish gravity last year by posting a 6.3% total return. Hussman Strategic Growth, on the other hand, took a small hit in 2008, retreating by 9%. Still, even that loss looks impressive in a year when the S&P 500 crumbled by 37%-its biggest calendar year loss since the Great Depression.
At the core of Hussman's investment philosophy is a focus on fundamental valuations. "The value of a security is nothing more than the present value of the stream of cash flows that it will deliver to investors over time," says John Hussman, president and portfolio manager of Hussman Investment Trust. He calls it "the iron law of finance." How does that inform his investment philosophy? "Basically, I look at the prospective return on stocks as a function of their valuation."
It's a principle that finds growing support in the empirical finance literature assessing equities. Consider dividend yields. As the chart shows, there's an apparent connection between the stock market's trailing-12-month yield and its subsequent ten-year return. In other words, higher yields generally foreshadow higher returns. And by that standard, dividend yields have been warning of lower equity returns for some time. It's not a perfect relationship, nor should we expect that yields alone dictate future performance. Nonetheless, it's a productive and arguably essential exercise that investors monitor yields, at least to put them in the context of other fundamental metrics.
Price-earnings ratios also harbor clues about the equity market's outlook, argues Robert Shiller in his book Irrational Exuberance. Surveying more than a century of stock market history, this Yale economics professor finds a robust connection between the market's P/E ratios at any one time and its returns over the following ten years.
Like the dividend yield, valuation levels have also offered clues about future returns, history suggests. That is, high P/E ratios may be followed by relatively unappealing performance and vice versa. "Our confidence in the relation derives partly from the fact that analogous relations appear to hold for other countries and for individual stocks," Shiller writes.
Besides that, the financial literature has identified other variables that hint at what a stock will do: short-term interest rates; the spreads between junk bonds and short-term interest rates; long-term and short-term interest-rate spreads; stock volatility; and book-to-market ratios.
Eugene Fama and Ken French, writing in a 1988 research paper in The Journal of Political Economy, observe that equity returns are "mean reverting" through time. "Our results add to mounting evidence that stock returns are predictable," they advise, albeit with limits. The predictable component of stock returns is, at best, 40% for small-company portfolios looking out by three to five years, the article says. For large-cap stocks, the predictability drops to roughly 25%.