It makes sense that “buying when shares are cheap” improves the odds of good returns, while buying when prices are high does the opposite, says Fidelity’s Tom Stevenson in The Sunday Telegraph. The figures back this up.
Fidelity and Morgan Stanley have looked at the trailing price/earnings (p/e) ratio of the FTSE All-Share Index for every month since 1927, and compared the ratio with the market’s real average returns over the following one, three, five and ten years.
Buying cheaply has indeed been key to impressive returns. Whenever the p/e was below five, the real return over the next ten years was 15% a year. Buying the market when it cost over 26 times earnings leads to negative returns.
Today’s trailing p/e of around ten implies returns of 10% a year. However, we wouldn’t rush to invest. One worry, as Stevenson points out, is that profit margins have reached historically high levels and tend to revert to the long-term average. Falling margins and earnings implies higher p/e ratios and hence lower long-term returns.
The short-term outlook, moreover, is grim and suggests that prices could well be cheaper soon.