There is a famous quote by legendary investor Benjamin Graham that contains important wisdom:


In the short run, the market is a voting machine but in the long run, it is a weighing machine.


This means that in the “short run,” which can last days, months and even years, overall financial prices are driven by bullish and bearish investor psychology... with these mood swings amplified by central and commercial banks creating money out of thin air. The primary way to manage investments in the short-term is to focus on various technical and sentiment indicators, as well as leading economic indicators.


However, in the “long run,” which can be a decade or more, overall financial prices and long-term returns are driven by valuation levels. This means stock prices (or the prices of other financial assets) in relation to key fundamentals... such as free cash flows, revenues, earnings, dividends, GDP, etc. For example, when stock prices are:


  • high on a historical basis in relation to corporate revenues or profits, they typically have low returns over the next decade or so.
  • low on a historical basis in relation to corporate revenues or profits, they typically have high returns over the next decade or so.

The below chart from Professor Robert Shiller shows S&P 500 stock prices in relation to inflation-adjusted S&P 500 earnings per share over the past ten years...



    This helps smooth out earnings cycles, which is why Shiller calls this the “CAPE Ratio” for Cyclically Adjusted Price-To-Earnings Ratio. When this P/E ratio is:


    • high- as it was in 1929 and 2000- then stock returns over the next decade are usually low.
    • low- as it was in the early 1920s and early 1980s- then stock returns over the next decade are usually high.


    For a detailed explanation of how we estimate long-term asset returns, including a formula we use that provides reasonably accurate long-term estimates, please see our free Special Report titled “How To Invest For Bull And Bear Profits.”




    Education
    We started this website to combat all the myths we see the financial press and Wall Street peddle, including...