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By Christine Benz | 10-18-2012 02:00 PM

A Strong Economy Doesn't Equal Strong Returns

There is effectively zero correlation over long periods of time between a country's GDP growth and stock market returns, according to Vanguard chief economist Joe Davis.

Christine Benz: Hi, I'm Christine Benz from Morningstar. Investors often believe that strong economic growth will fuel strong stock market growth. But some recent research casts doubt on that idea. I sat down with Vanguard's chief economist Joe Davis to discuss some recent findings on this topic.

Joe, thank you so much for being here.

Joe Davis: Thank you, my pleasure.

Benz: You looked at a lot of different metrics in an effort to determine which of those are most predictive of what the stock market might return in the future and which are least predictive. Let's start with those that have the most predictive ability, and you didn’t find anything with terrific predictive ability, but generally speaking valuation tends to be the best predictor.

Davis: Clearly and we looked at more than a dozen. [There is] very little predictability at all across any of those measures in the short run, a one- or two- or three-year period. But if we look out five and importantly in this study 10-year period, which is area of focus for strategic asset allocation, valuations clearly rise to the fore. We looked at a number of valuation metrics, particularly those that smooth earnings by various formulas. Popular one in the industry is the so called cyclically adjusted P/E or the…

Benz: Schiller P/E.

Davis: The Schiller P/E, the P/E 10, and surprisingly, it may even be surprising to some that, that predictability for the so-called Schiller P/E is similar to just using earnings of one year, one year ago. And that’s important today because those two measures are suggesting a different outlook for equities, because a gap [as grown between those two measures].

I think importantly what [Vanguard does] is look at a basket of valuations, and when you put that altogether they are more normal than abnormal for the current state. But clearly valuations give you about 40% probability of ascertaining what the return will be over a five- or 10-year basis.

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