In the Oct. 2, 2015, issue of Capitalist Times Premium, we analyzed the historical relationship between the S&P 500’s valuation and subsequent returns. (See Do Valuations Matter.) Our study showed that although expensively priced markets can rally and cheap markets can tumble further in the short term, valuation matters over longer holding periods of five to 10 years.
Today, the S&P 500 trades at 18.75 times trailing earnings. Market data from the past 40 years reveals that an investor who buys the S&P 500 when the index trades at 18 to 19 times earnings averages an annualized gain of about 7 percent over a decade-long holding period. Though positive, these total returns pale in comparison the S&P 500’s average annual gain of 11.3 percent over this 40-year period.
Price-to-earnings ratios in the US market could become even more expensive because corporate profits remain under pressure on a year-over-year basis, falling 5.14 percent in the third quarter of 2015 and 11.5 percent in the fourth quarter.
Corporate profits suffered a similar downturn in 2000 and 2007, presaging a US recession and accompanying bear-market correction in the S&P 500.
When corporate profits tumbled in 1998, the US didn’t suffer an economic contraction, in part because the Federal Reserve slashed interest rates by 75 basis points and orchestrated the bailout of Long-Term Capital Management, a highly leveraged hedge fund on the brink of default. Nevertheless, the S&P 500 still plummeted 22.5 percent from its July high to its October low that year.
Past issues of Capitalist Times Premium have highlighted the decline in the Institute for Supply Management’s Purchasing Managers Index (PMI) for US manufacturing industries as a sign of weakness in the economy.