VALUATION TOOLS Dividend Yield is the Best Tool to Forecast Trends

From the perspective of investing, it is easier to ascertain what is in the valuations rather than to forecast cash flows in the coming quarters or years. The key question is which valuation metrics does a better job in forecasting returns. Out of the 11 different metrics (absolute, relative and interest rates related) evaluated by Morgan Stanley, the metric with the best R-squared (best explanatory power) on one-year forward returns since 2004 has been dividend yield. The next two best are value assigned to future growth and modified earnings yield gap. For each of the past five years, yield or related metrics have been the best at predicting one-year forward returns. The world has been short on yields since 2008, and this probably explains yields' superior predictive power. In effect, the market has cared less for earnings and book values, i.e., P/E and P/B. Ten years ago, these 11 metrics on average predicted an annual CAGR in returns that fell just 30 bps short of what the market delivered in the subsequent decade (17% vs. 17.3%).