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Investment Strategy

The Value of Valuation

By Elliott H. Gue, on Oct. 5, 2015

Is the stock market cheap, or is it expensive? Does it matter? Most investors have probably asked themselves these questions on numerous occasions over the past few years. Valuation concerns have become all the more pressing now that the market has climbed steadily for almost seven years.

First, let’s explore whether valuations matter by comparing the S&P 500’s rolling 1-year returns to the index’s price-to-earnings ratio for the trailing 12 months.

Logic would suggest that buying the S&P 500 at a lower price-to-earnings ratio should result in stronger returns over the ensuing year, while entering this position at a higher multiple would result in lower returns. Let’s check out what the data shows us.

(Click graph to enlarge.)SPX 1 YR Scatter

The trend-line in our scatter diagram demonstrates that from 1960 to the present, buying the S&P 500 when the index’s price-to-earnings ratio was relatively high produced inferior returns over a one-year holding period.

At the same time, the graph includes plenty of instances where buying the broader market at elevated valuations produced impressive gains. For example, the S&P 500 traded at a nosebleed valuation of 26.8 times earnings at the end of November 1998, but still climbed 20.9 percent over the next 12 months—almost two times the average rolling annual gain of 11.3 percent.

R-squared is a statistical metric that quantifies how well the trend-line fits the data; an R-squared value of 0.0841 suggests a weak relationship between price-to-earnings ratios and the index’s performance over a one-year holding period.

When we extend the holding period to 10 years, the relationship between the S&P 500’s price-to-earnings ratio and the index’s annualized returns is much tighter, with the trend-line exhibiting an R-squared value of 0.55.

(Click graph to enlarge.)SPX 10-Yr Scatter

What does this exercise tell us? Valuations affect the S&P 500’s returns, but this impact manifests itself more clearly over the long haul. In other words, price-to-earnings ratios are a poor metric for timing the market, but a useful tool for investors looking to hold positions over a longer time frame.

The S&P 500 trades at 16.74 times its trailing earnings. Over the past 40 years, this benchmark index has exhibited a monthly price-to-earnings ratio between 16 and 18 on 65 occasions. For these months, the annualized return over the ensuing decade averaged 6.81 percent, compared with 11.3 percent for the entire data sample.

What does that mean for investors? The stock market looks expensive right now; historically, buying the S&P 500 at these levels would result in positive, but subpar, returns over the next 10 years

History also tells us that investors with a longer time horizon usually have a good buying opportunity when the S&P 500 trades at less than 15 times earnings. And when the index’s price-to-earning ratio drops to less than 14, investors who back up the proverbial truck usually do well over the next 10 years.

Valuation and LT Returns

If the S&P 500 were to retrench to 15 times trailing earnings, the index would slip to about 1,700. A pullback to 14 times earnings would take the S&P 500 back to 1,585. Bear markets in US equities have averaged a 25 percent decline since 1960, a move that would take the S&P 500 from its 2015 high to about 14 times earnings.

Our outlook calls for the S&P 500 to enjoy a year-end relief rally that will approach its 2015 high. This last-gasp upsurge will resemble the rallies in US equities that took place in fall 2007 and March through September 2000; we expect a bear market to start by early 2016.

We have a three-part plan for dealing with the coming bear market:

  • Step No. 1: Exit our most vulnerable positions on the stock market’s next rally;
  • Step No. 2: Take advantage of a rally in the broader market to add hedge positions that will profit in a selloff; and
  • Step No. 3: Build a shopping list of stocks to buy if the US stock market suffers a significant correction.

Evergreen 2015

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