Earnings Yield as a Predictor of Future Returns

The chart below is an attempt to measure the extent to which current earnings yield is a predictor of future returns.  The blue bars are the earnings yield of the S&P 500 at the recorded date (according to the Shiller P/E, which admittedly may not be the best measure).  The red bars are the realized annualized forward returns on the S&P 500 from that date until January 1, 2012.  For instance, in 1972 the earnings yield of the S&P 500 was 5.79% and the annualized return between 1972 and 2012 was 6.48%.

There are a couple interesting conclusions from the chart:

1) forward returns do track value to some extent, bulging for those who bought in the 70s and 80s and falling along with earnings yield in the 90s.

2) Past 1990 the two metrics diverge.  This is mostly because the time frame over which value is realized is compressed.  In other words, whereas a purchase made in the 1960s has had 50 years to smooth returns, a purchase in 2000 has only had 10. It's not surprising therefore that forward returns haven't exactly tracked valuation.  However the divergence is extremely informative about what we may expect from the market over the years to come.  The fact that the market has performed significantly worse than the "predicted" earnings yield in 2000 implies that the market has risen too slowly since 2000 and is undervalued relative to that date.  The fact that it has risen more than the predicted earnings yield in 2008 implies that it has risen too fast relative to that date.

The discrepancy during the 80s shows that the two metrics aren't prefect predictors of each other, but it is food for thought.  Also, it should be noted that this analysis did not include returns on the S&P from dividends.