The Impact of Current Valuation on Future Returns
October 01, 2017
By Patrick V. Masso, CFA
Valuation is the subjective determination of how much something is worth. Before trading in your old car for a new one, you may check the internet to see how much the dealership should offer you for that old clunker. An appraiser estimates the value of your home before you sell it.
The stock market is nothing more than a giant valuation machine. Market participants use a myriad of data to subjectively determine what the current price should be. Some rely on bigger picture macroeconomic information, such as the unemployment rate or applications for mortgage loans. Others focus on company level data points like how many iPhones Apple sold last quarter. The culmination of examining these data and estimating their expected trajectories leads to transactional decision making – “Based on the current price, analyses of historical data, and anticipated trajectory of further data, should the asset be bought or sold?”
Lurking in the shadows of these countless calculations and analytical frameworks is an even grander question: “Does valuation even matter?” History shows the answer is “yes”, but the degree to which it matters depends largely on your investment time horizon. Pop quiz! How much do you think today’s valuation of the S&P 500 matters to the next five years’ worth of stock market returns? Can today’s valuation predict 90% of the next five years’ returns? Will it explain 75%? Historically speaking, and as shown on the following page, today’s valuation only explains a little over 30% of the next five years returns! The longer the time horizon, the more important valuation becomes. Returns over the shorter term are driven more by sentiment, the path of growth and inflation, corporate sales and earnings growth, geopolitical shocks, interest rates, and currency movements, for instance.
One often cited valuation metric is the price-to-earnings (P/E) ratio of the S&P 500 stock index. This number is created by taking the current price of the S&P 500 and dividing it by the next twelve months estimated earnings per share. Right now, the S&P 500 is trading at approximately 2,550 and the next twelve months earnings per share for the companies within the index is $142.56. This results in a P/E ratio of about 18. The P/E ratio was less than 9 during the depths of the great recession. Both the P/E ratio (blue) and next 12 months estimated earnings (green) are plotted in the second chart on the following page.
Notice the P/E ratio has not been this high since 2004. However, also observe the estimated earnings for the S&P 500 are at all-time highs after a two-year period of going sideways when the negative impact of lower oil prices reverberated through the manufacturing segment of the economy.
Can the stock market continue the grind higher? Yes, but at this point in the business cycle we would expect it to be driven more by the trajectory of earnings growth (the green line increasing) than by P/E expansion (the blue line increasing). Keep in mind that investing is a “relative” discipline and the bond market, with its all-time low interest rates, is not currently offering stock investors a more attractive alternative. Focus on the factors affecting the green line going forward. They will be of increasing importance to stock market returns over the coming months and quarters.
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