The Stock Market's Complicated Evolving Relationship With Valuations

Stocks climbed last week with the S&P 500 rising 0.7% to close at 4,536.34. The index is now up 18.1% year to date, up 26.8% from its October 12 closing low of 3,577.03, and down 5.4% from its January 3, 2022 record closing high of 4,796.56.

In the stock market, do valuation metrics like price-to-earnings (P/E) multiples matter?

Of course they do!

However, they don’t appear to be very helpful when predicting short term moves in prices.

In a blog published on Tuesday, Nick Maggiulli of Ritholtz Wealth Management addressed “The Problem with Valuation.” Here’s a brief excerpt:

…there is nothing that says that these metrics have to return to their long-term averages. In fact, I believe the opposite. Valuation multiples are likely to stay above their historical norms for the foreseeable future. Why?

Because investing is much simpler today than it used to be. With the rise of cheap diversification over the last half century, investors today are willing to accept lower future returns (i.e. higher valuations) than their predecessors. This has fundamentally changed valuation metrics and made historical comparisons less useful than they once were.

I think Nick’s right. And I think we sometimes take for granted how much the frictions and costs have come down for those seeking to trade or invest in stocks.

Average valuations have been higher in recent decades. (Source: Nick Maggiullli)

On Thursday, I joined Jack Raines, Josh Brown, and Michael Batnick on The Compound And Friends podcast (listen to it here!). We spent a good amount of time wrestling with issues related to valuations.

Jack pointed out that trading fees have been coming down for decades, which certainly justify higher valuation premiums — if it costs less to trade, then the returns you require should probably be lower.

Another critical point to remember is that interest rates have been trending lower for the better part of the past four decades. Experts ranging from Robert Shiller to Warren Buffett to Jeremy Grantham have argued lower rates justify higher average valuations.

Perhaps the most disturbing observation about P/E ratios comes from Goldman Sachs. In a research note published a little over a year ago, Goldman analysts concluded (emphasis added):

While valuations feature importantly in our toolbox to estimate forward equity returns, we should dispel an oft-repeated myth that equity valuations are mean-reverting… We have not found any statistical evidence of mean reversion… Equity valuations are a bounded time series: there is some upper bound since valuations cannot reach infinity, and there is a lower bound since valuations cannot go below zero. However, having upper and lower bounds does not imply valuations are stationary and revert to the same long-term mean.

So just because you can calculate an average does not mean what you’re observing has a tendency to gravitate toward that average over time.

Maybe you’re not willing to accept what we’ve discussed here so far. Then, at least consider this: While there is some historical evidence that valuations may tell you something about long-term returns, that data also shows valuations tell you almost nothing about where stocks will go in the following 12 months.

P/E ratios don’t tell you much about the next year’s returns. (Source: JPMorgan Asset Management)

JPMorgan analysts ran the historical numbers. As the chart to the left shows, there is effectively no linear relationship between valuations and one-year returns. In other words, an expensive valuation doesn’t necessarily increase the likelihood that the following year’s returns will be weak. Similarly, a cheap valuation doesn’t necessarily increase the likelihood that the following year’s returns will be strong.

If this sounds familiar, it’s because it’s TKer Stock Market Truth No. 6: Valuations won’t tell you much about the next year.

To be fair, the chart on the right suggests there may be a relationship between valuations and longer term returns. Specifically, high valuations may mean lower average returns over rolling five year periods. But as Nick notes: “while future returns do seem lower, when we will experience them is anyone’s guess.“

The bottom line is that you should use valuation metrics like the P/E ratio with caution. Just because valuations are high at a given moment does not mean the next 12 months’ return will be weak.

A version of this post was originally published on Tker.co