Being invested in equities so far this year has been far from smooth sailing, with the sharp decline in prices and elevated levels of volatility prompting many investors to reconsider the role of equities in their portfolios. While stocks have fallen, further easing by major central banks and worries about the outlook for corporate profits and the economy have depressed bond yields to levels last seen at the beginning of 2015. However, with prospective returns from government bonds clearly limited by the low level of rates, it is worth considering what the sell-off in equities implies for future returns. Historically, valuation has not been a great predictor of returns over the coming year, however, over a longer time horizon, forward P/E ratios and returns have tended to have a much stronger relationship. The recent sell-off has pushed both prices and valuations to levels that, looking over a 5-year time horizon, have historically been correlated with higher returns for equities than if stocks were purchased at higher valuations. Thus, while stocks could move lower before they move higher on the back of elevated volatility and legitimate concerns about energy and manufacturing, current valuations in the equity market may actually represent an opportunity for long-term investors.
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