What Does Stock Market Valuation Tell Us About Future Returns?

Many different measurements can be used to value the stock market. Of the most thirteen popular measurements listed below, eight are in the highest valuation category (Very expensive), four are in the second highest category (Expensive), and only one is in the middle category (Fairly valued):  

This data strongly suggests that the stock market is currently expensive compared to historical standards. While one might expect this to lead to a downturn, high valuation measurements have not consistently predicted stock market downturns. There have been times when the stock market has continued to show positive returns despite high valuations. 

However, the market has been at these current valuations many times in the past. We can use this historical data to gain an understanding of the pattern of returns that have followed. To do this, we will select the most common valuation measurement which is the forward price-to-earnings ratio (forward P/E). This ratio is currently priced at 20.5x, and the historical average over the last thirty years has been 16.7x.

Since 1999, the five-year annualized returns that have occurred after market valuations of 20.5x have averaged in the mid-single digits. In contrast, five-year annualized returns that have occurred after the average market P/E of 16.7x are in the high single-digit to low double-digit returns. The green vertical lines in the chart below on the x-axis and the corresponding horizontal green lines show the average annual returns on the y-axis: 

Furthermore, the historical range of returns is much narrower at the current 20.5x P/E ratio. Low double-digit returns down to low single-digit losses are all that have occurred at these valuations (see red rectangle in the chart below). However, the range of returns is much wider at the average P/E ratio of 16.7, with a greater frequency of double-digit returns reaching as high as 20% (see red rectangle in the chart below):

In Summary:

Stock market valuation tools do not provide reliable guidance for the timing of stock market downturns. However, we have experienced many instances of historical market performance after reaching current market valuations. This data tells us that average five-year annualized returns are lower at current valuations than after reaching average market valuations. Therefore, it may be prudent to lower stock market return expectations over the next five years compared to the returns from the last five years! 

Have questions or want to speak with our team directly? Contact us.

Robert Amato, CFP®, CIMA®

Principal

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Compass Wealth Management is a Registered Investment Advisor. Advisory services are only offered to clients or prospective clients where Compass Wealth Management and its representatives are properly licensed or exempt from licensure. This article is solely for informational purposes and is not intended to be relied on as a forecast, research, or investment advice, and is not a recommendation, offer, or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Compass Wealth Management to be reliable, are not necessarily all-inclusive, and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investments involve risks.