Climb Every Mountain

economisthighvaluations

The implication of high valuations is that future returns are likely to be subdued. This is most obvious in the case of bonds: a yield of 2% means the nominal return if you hold the bond to maturity will be 2%. The real return may even be negative if inflation rises.

When it comes to equities, returns can continue to grow only if profits rise rapidly, or if valuations get even higher. Since profits at American firms are already close to a record high relative to GDP, rapid growth is unlikely. And hoping for higher valuations is betting against the odds.

Worse still, there is always the chance that profits or valuations will return to their historical norms. If that happens, Deutsche reckons the average real return from equities over the next ten years will be negative. The same is true for Treasury bonds, European corporate bonds and American residential property.

This is sobering news for investors, who face a different kind of “money illusion” when valuations have been rising. The period of moving from a low valuation to a high one is pleasant; it is just not so nice when you get there. If equities move from trading on a dividend yield of 4% to a yield of 2%, then share prices will double (assuming dividends do not change). But to repeat the trick, the yield will have to fall to 1%. At some point, the lucrative revaluation must stop.

From the Economist.

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