P/E ratio and the future of stock market return

The price to earnings ratio  (P/E ratio)  is a very common metric used to assess the relative value of a security or index.  Now of course it doesn’t tell the whole story so when doing valuations one still needs to take into account several other important ratio’s and metrics as well, but it’s a straightforward measure that does have a reasonably high level of predictive power, especially in the long-run.

• If the P/E ratio of the stock market is high it means valuations in general are expensive and stocks are statistically more likely to underperform going forward.

• If the P/E ratio is low, average valuations are cheap and stocks are statistically more likely to perform better going forward.

So let’s check in on where we are with S&P 500 valuations as of September 28th, 2016

This is the P/E 10, also called CAPE which is better than traditional P/E because it takes into account trailing earnings

As you can see it’s not the highest we’ve ever been, but it’s safe to say we are in the upper end of the range when viewed over the last 125 years.  Actually we’re currently sitting in the 96th percentile, so the markets rarely get this expensive.  Now a high P/E ratio on it’s own doesn’t mean you should go out today and sell all your stocks, or short everything you can.  It’s possible that market valuations get stretched even further than they already are.  One of Warren Buffett’s many famous quotes is:

“Markets can stay irrational longer than you can stay solvent.”

It’s a great quote that essentially means don’t try to time the markets in the short-run. Having said that, the historically high P/E ratio should at the very least serve as a warning sign that the stock market is currently quite expensive.

I’m not trying to be a doomsday guy and tell everybody the sky is falling, but let’s look at a chart that shows how far we have deviated from the long-term average:

We’re currently 75% above the long term average.  Only 3 times in history did markets get this stretched.  1929, 1999, 2007.  And what shortly followed were:  Great depression, dotcom bust, financial crisis…

Below is a chart of how well the P/E ratio predicted future stock market returns:

In the short to medium term it’s less than 50% predictive so the P/E ratio should only be one of several metrics used to assess value for those time frames. However when viewed at 10 years and longer it’s been an excellent predictor of future returns. Since I’m a long-term investor, this is the time frame that matters most to me which is why I feel the stock market is so overpriced right now.

The bottom line is, nobody knows what’s going to happen over the next few years. We might see the next recession begin next month, or it might not be for another 3-4 years yet.  However statistically speaking it’s perfectly reasonable to assume that stock market returns over the next 10 years will be significantly lower than the long-term average.  And the last several decades already saw lower than average returns already so this doesn’t bode well for buy and hold investors going forward.

A P/E 10 of over 26 in 2016 doesn’t leave much room for growth in the coming years which means investors today should be looking for investments that aren’t dependent on the stock market for future gains.

I invite you to learn more about the VTS Tactical Volatility strategy which has very low correlation to the S&P 500.

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