A study assesses how well starting valuations have historically predicted future high-yield bond and stock returns and what current valuations could suggest for those returns.

Research by FTSE Russell confirmed that the negative correlation between high valuations and low total returns holds true in both the stock and high-yield bond markets. Monthly returns of the FTSE US High-Yield Market index and the Russell 1000 index from the past five years were examined. This suggests that high U.S. equity market valuations are strongly related to lower future long-run returns. The most popular measures to assess the relative market value of a firm are the price-earnings (P/E), price-to-book (P/B) and price-to-dividend (P/D) ratios. High price-earnings ratios may indicate an overly optimistic outlook for future aggregate earnings growth. Correlations between 10-year future returns and 12-month forward price-earnings ratio were shown to be especially strong, with high valuations based on the forward price-earnings ratio associated with low future returns.

Improved credit quality of U.S. high-yield bonds mitigates the inverse relationship of bond valuations and future bond returns, but implies downside risk for future returns where earnings growth is slowing. The researchers conclude that bond valuations may predict future returns. U.S. high-yield credit spreads have mostly forecasted future bond returns over the last 20 years, although stronger relationships exist over shorter time periods.

Source: “Valuation Matters: U.S. High Yield and U.S. Equities,” by Indrani De, Zhaoyi Yang and Alberto Allegrucci; FTSE Russell, May 2023.

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