Total equity return has three components in general: corporate fundamentals dynamics such as earnings, change of valuations such as P/E and dividend yield.
Dividend yield is the most stable component and is currently around 2% at the broadest global equity index MSCI All Country World. Dynamics of corporate fundamentals such as revenues, earnings or cash flow is driven primarily by the current state of the economic cycle. As the economy grows, corporate fundamentals also have a strong tendency to grow. Conversely, when the economy is in recession, corporate fundamentals also have a strong tendency to decline.
The most volatile component of equity return is the change in equity valuations. The current level of equity valuations mainly reflects short-term market sentiment, respectively the current level of risk aversion among investors. Given that the current equity valuations are at all-time highs, there is a very high probability that valuations will normalize in the medium term of the next five years, i.e. a decline towards the long-term average, respectively equilibrium levels.
We refer to this process as the mean-reversion. The dynamics or change in equity valuations is therefore very likely to contribute negatively to total equity returns in the coming years, and therefore the expected equity returns in the coming years are also below average, at least as regards expected annual averages (p.a.).
We can also say that the dynamics of equity valuations is crucial for equity returns in the medium term. On the contrary, in the long run of more than ten years, its impact on total equity returns is negligible, as the growth of equity valuations over a few years is offset by their subsequent decline in the following years.
Investment Strategist at Conseq Investment Management, a.s.