JP Morgan’s latest quarterly Guide to the Markets provides some excellent charts highlighting where the stock market stands across several different valuation measures.
The table in the chart below summarizes several of these measures and the conclusion is clear, the market is historically expensive. Interestingly, the only metric that concludes the opposite is the earnings yield spread, which is the forward earnings yield (consensus analyst estimates of Earnings-per-Share over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Baa ratings are the last tranche of investment grade bonds, just above high yield bonds (aka junk bonds). Perhaps more than anything else this underscores how low yields are in the bond market, be they investment grade, high yield or Treasury bonds. Rates are so low that even a historically expensive stock market can look comparatively attractive.
Perhaps surprisingly, the market’s valuation has come down this year because earnings have been so strong. As shown in the chart below (right side), the market’s return has been driven by growth in earnings while multiple expansion has declined. This means the “E” in the Price-to-Earnings ratio has grown faster than the “P”, hence the overall price one pays for those earnings has declined.
What to make of this information? Well, it’s important to note that not any single valuation measure has an excellent track record of predicting future market returns. If it were that easy, we would all buy when the measures indicated the market was cheap, and sell when they indicated the market was expensive. But wouldn’t all that buying drive the market to be expensive when it’s cheap? And how about all that selling when the market is expensive? Hmm…the ole’ chicken and the egg conundrum. If it were that easy, we’d all be zillionaires, but then nobody would be rich by definition…bah humbug!
The chart below does a good job highlighting how weak these measures are as forecasting tools. Using the forward P/E as a measure to forecast future returns, its ability to explain subsequent 1-year returns has an R² of only 6%. R² is a statistical measure that represents the proportion of the variance for a dependent variable that is explained by an independent variable or variables in a regression model. Whereas correlation explains the strength of the relationship between an independent and dependent variable, R² explains to what extent the variance of one variable explains the variance of the second variable. For example, if the R² of a model is 50%, then approximately half of the observed variation can be explained by the model’s inputs. In plain English, the forward P/E does a terrible job of forecasting short-term returns. All of the valuation measures do.
Now, if we expand the forecast horizon beyond one year, the forward P/E and all valuation measures improve in their ability to predict subsequent market returns. Below, we see the 5-year forward forecast has an R² of 42% which is much better than the 6% for the 1-year forward forecast, but still no crystal ball. Additionally, it tells us nothing of what the return sequence will be. The market could be up four years straight and then collapse the fifth, or it could go sideways for the five years, no one can know for sure.
So what good are these valuation measures? Well, far from being pinpoint accurate we can think of them as useful for setting longer-term expectations. And this makes intuitive sense, the more expensive the market is, the less we should expect in return. This does not mean the return will be negative, it may just be less positive.
In conclusion, valuation is just one input into a larger framework of investing. How the economy is performing overall, whether it is trending higher, slowing down, or declining plays an extremely important role in determining whether the consequences of high valuations will matter. The S&P 500 represents only one area of the market (the largest companies), it does not say anything for example, about mid or small sized companies, value or growth oriented stocks, or international stocks.
Perhaps most important is to remember base line rates in investing. These are the historical tendencies (statistically measured) of the market. These provide the base-line expectations we can anticipate of the market.
- Since 1947, for all 1-year rolling periods the S&P 500 market is up 75% of time. As can be seen in the table below, the longer the time horizon, the better the odds for a positive return. These stats capture both historically expensive markets, cheap markets, and everything in-between. Taken all together, the odds for investing over the long term in stocks are pretty compelling.
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