Should Investors Care That Stocks Are Expensive?

Coincident to the latest string of market records, another milestone was recently hit. The S&P 500 has recently been trading for more than 20x trailing price-to-earnings (P/E), according to Bloomberg data. The last time the market traded at these levels was 2009, when earnings were still depressed by the financial crisis and recession.

Before analyzing what it does mean, it is worth pointing out what it does not. There is no magical significance to crossing this particular threshold. Furthermore, as most investors realize, valuation is a poor short-term timing mechanism.

Don’t overemphasize stocks’ relative value to bonds

Bulls will also correctly point to the fact that stocks are cheap relative to bonds. While true, as I have argued in the past, in this case relative value may not support future returns. A large part of the reason bonds are expensive is because of extraordinary monetary policy, both here and abroad. To the extent policy reflects a dour outlook for both real and nominal global growth, corporate earnings are likely to remain in a rut, suggesting a lower not higher multiple. Additionally, while stocks look cheap relative to bonds, historically valuation multiples, rather than the equity risk premium, have been the better predictor of future stock returns.

A look back in history reveals some telling trends

Today’s elevated valuations do hold a warning for investors. Although value is not the primary determinant of returns, at times horizons of a year or longer it does matter. Looking back over the past 60 years of annual price returns, i.e. not including dividends, the level of the P/E at the start of the year explained roughly 6% of the variation in the following year’s returns, according to Bloomberg data. That does not sound like much, but historically there has been a material difference in returns following periods when the P/E was above average (roughly 16.5) versus below. In years following above average valuations, the average price return was roughly 5%. In years when the S&P 500 started the year on the cheap side, the average return was over 11%.

More interesting is what happened when valuations went from merely above average to truly expensive. In years when the trailing P/E ended the previous year above 20, returns were poor in the following year. The average annual price return was roughly 1%, with the S&P 500 advancing only 50% of the time. Downside risk was also accentuated; the bottom quartile of returns in those years was -11%, far worse than when stocks were cheaper.

No alarm bells will sound simply because multiples crossed the 20 threshold. Today the market is only marginally more overvalued than it has been for most of the past 18 months. Stocks have traded to far loftier levels, notably in 1987 and the late 1990s, before investors finally capitulated. Of course, in the late 1990s the market was benefiting from robust growth, soaring productivity, falling inflation and declining interest rates. Today, investors are primarily relying on one argument: bonds look worse.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

© BlackRock

© BlackRock

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