Do valuations predict long-term returns? Examining US Equities through various size and style indices

The inverse relationship between equity market valuations and subsequent long-term returns is well-documented in empirical research. High starting valuations, particularly forward P/E ratios, tend to foreshadow lower long-term returns, while low valuations often signal higher returns. This relationship underscores the importance of valuation as a guide for portfolio construction and risk management.

Our findings in this research paper align with this principle, and we find:

• Across the Russell 1000, higher forward P/E ratios are strongly associated with lower subsequent annualized 10-year total returns. The R-squared value of approximately 0.39 in our analysis suggests that forward P/E explains a significant portion of the variability in long-term returns.
• A similar trend is observed in the Russell 1000 Growth index, where the relationship appears even stronger, with an R-squared value of 0.48. This highlights the heightened sensitivity of growth stocks to valuation levels. This would be expected given that growth stocks, by definition, are valued based of expectations of much higher growth in future and so are their returns would be more sensitive to their valuations.
• For the Russell 1000 Value index, the correlation is much weaker (R-squared of 0.23), reflecting the less valuation-sensitive nature of value stocks, which often derive returns from income and resilience rather than multiple expansion.
•  Interestingly, the relationship is almost non-existent for the Russell 2000 (small caps), where the R-squared value is near zero. This suggests that other factors, such as earnings volatility and their higher sensitivity to economic cycles, may play a larger role in predicting small-cap returns.

In our research, we acknowledge the statistical consideration that the use of overlapping returns introduces serial autocorrelation, which can inflate R-squared values of our analysis. Nevertheless, we need overlapping 10-year annualized returns in the interest of having enough observations in a roughly two-decade sample period. Also the same analysis across different size and capitalization indices provides an apple-apple comparison of the predictive strength of starting valuations. These findings reinforce the importance of considering starting valuations when making long-term investment decisions, particularly in large-cap equities and growth-oriented strategies.

• Russell 1000: Valuation matters for Large cap and Broad Equity Markets 

The Russell 1000 represents the US large-cap equity market, and being 95% of the total US market capitalization as of December 31, 2024 is also a broad and comprehensive representation of the overall US equity market. As seen in the top-left chart, there is a clear negative relationship (R-squared of 0.39) between forward P/E ratios and subsequent annualized 10-year returns. High valuation periods, have historically been followed by subdued returns, validating the role of valuations as a forward-looking measure.

• Russell 1000 Growth: Valuation Sensitivity in Focus

The growth-oriented subset of the Russell 1000 demonstrates the strongest valuation-return relationship (R-squared of 0.48) . This is unsurprising, given that growth stocks typically derive a larger portion of their value from future earnings, making them more vulnerable to valuation re-ratings. 

• Russell 1000 Value: Stability Amid Cycles

The value subset of the Russell 1000 exhibits a weaker but still meaningful negative correlation between valuations and returns (R-squared of 0.23) . Value stocks, often characterized by higher dividend yields and less aggressive growth assumptions, tend to be less affected by valuation multiples. However, even here, elevated starting P/E ratios have been associated with diminished 10-year returns.

• Russell 2000: Small caps are the Outlier

The Russell 2000, representing small-cap equities, deviates from the broader trend. The negligible R-squared (0.02) value suggests that forward P/E ratios have limited predictive power for small-cap returns. This could reflect the greater influence of macroeconomic factors, market cycles, and earnings volatility on smaller companies.

• FTSE USA: Valuation matters more than Russell 1000

The FTSE USA Index belongs to FTSE Global Equity Index Series (GEIS) and reflects the performance of the broad US equity market. The scatterplot for the FTSE USA, which has a smaller of stocks (544 stocks as of December 2024) compared to Russell 1000, also shows a clear inverse relationship between valuations and 10-year returns, with an R-squared of 0.51—slightly surpassing the Russell 1000 in explanatory power.

• Comparison of explanatory power of 12M FWD P/E in 10Y returns

The additional charts deepen the analysis of the predictive power of 12-month forward P/E ratios across different equity segments. The bar charts offer a comparative view, illustrating how valuations influence various market segments. Large-cap equities, represented by the Russell 1000, exhibit a far stronger relationship between starting valuations and future returns than their small-cap counterparts in the Russell 2000, where macroeconomic and cyclical forces likely dominate. Meanwhile, growth stocks emerge as particularly valuation-sensitive, with their long-term performance closely tied to starting multiples. Value stocks, in contrast, show a weaker but still significant relationship, underscoring their defensive nature.

Understanding the valuation-return relationship can inform both strategic and tactical asset allocation decisions:

• Strategic Asset Allocation: Investors with a long-term horizon should consider current valuation levels when setting expectations for future returns. Periods of high valuations, by indicating possible lower future long-term returns, may warrant a more conservative approach to equity allocations, while lower valuations could present opportunities to take on additional risk.
• Tactical Adjustments: For growth-focused investors, the strong valuation sensitivity of growth stocks suggests the need for greater caution during periods of elevated P/E ratios. Conversely, value-oriented strategies may offer resilience in such environments.
• Small-Cap Considerations: The lack of a clear valuation-return relationship for small caps underscores the importance of other factors, such as earnings growth, sector composition, and macroeconomic trends, in driving returns. 

As of today, US equity markets are trading at historically elevated forward P/E ratios, particularly within the growth segment. This raises questions about the sustainability of recent returns and the potential headwinds for future performance.  The simple univariate relationships between valuation and future returns are indicating approximately 1.5%, 0.6%, and -2.7% annualized returns for the Russell 1000, FTSE USA and Russell 1000 Growth respectively for the next decade. In contrast, value stocks appear relatively lower priced, where the simple univariate relationship between valuation and future returns are indicating approximately 4.9% annualized return, offering a possible refuge for investors seeking stability.

The Russell 2000, with its minimal valuation sensitivity, may warrant a closer look for those willing to navigate its higher volatility in pursuit of idiosyncratic opportunities. However, small-cap investors should remain vigilant about economic conditions and credit market dynamics, which tend to have an outsized impact on this segment.

Starting valuations play a pivotal role in shaping long-term returns for equity markets, particularly for large-cap and growth-oriented strategies. While other factors such as economic and policy dynamics remain crucial, valuations provide a reliable lens for setting expectations and managing risk.

For investors, the message is clear: pay attention to where you start. In the current environment of elevated valuations, maintaining a disciplined, valuation-aware approach could be the key to navigating an uncertain future.