Why? The reason is that they revert to lower yields, which results in a boost from the rerating component of returns. The link between the entry yield and subsequent returns is one of the strongest relationships in stock (and bond) markets, providing a golden longer-term rule and a Great Investment Picture.

The graph below shows entry yields and returns from 1960 for the All Share Index (ALSI). Returns are calculated over five years. The strongest relationship is over a five-year horizon -- it becomes weaker over shorter periods.

Note that an absolute change in yield of two percentage points results in a 100% change if it is from, say, 2% to 4% but only a 20% change if it is from 10% to 12% so a log scale is appropriate for the yield.

 

 

The message is quite clear and simple. Buying equities on high yields results in high returns, and vice versa. The strength of the relationship is impressive.

We can use the graph to estimate future returns. For example, the market’s current earnings yield is 5.9% (equivalent to a PE of 17x). We can see that historically this has resulted in returns over the next five years that averaged around 9% p.a., with the lowest being 3% p.a. and the highest 15% p.a.

The market is therefore not particularly cheap at present and we should expect returns well below the levels of the past. (From the picture we can see this average was around 20% p.a.)

 

However, the picture also provides some comfort – over no 5-year period has the return from the market ever fallen below zero.

For other Great Investment Pictures see The Effective Investor by Franco Busetti, Pan Macmillan, 2009, available at Exclusive Books branches or online  Effective Investor at Exclusives as well as Kalahari The Effective Investor at Kalahari.net