4 Pillars of Equity Returns

Ed Keon of Pru has a nice report out today about the 4 pillars of equity returns that have shown predictive power in the past and do not require a forecast. They are: valuation, relative valuation, modest inflation and a strong profit environment.

Currently, all of them are pointing to a good year.

1) Valuation – Stocks are trading at an average P/E ratio versus history, which has generally indicated ~10% returns, but transaction costs and capital gains/dividend taxes are lower than history so multiples could expand by 1 or 2 points.

2) Relative Valuation – Stocks are clearly cheap versus bonds and real estate. For the last 60 years this has always led to out-performance of stocks until equilibrium is re-established. This is creating massive economic incentive for companies and private equity firms to increase leverage (issue overvalued debt to buy undervalued equity). At the same time, novice U.S. investors are selling equities ($12.4 billion of large cap funds in 2006) and putting it into money market, foreign stock funds and taxable bond funds ($400 billion).

3) Inflation will likely be in the 1 – 3% percent range that has historically been the sweet spot for stocks, ~13% returns.

4) Profits are strong and companies are performing better than one might expect based on the slowing macro data.