728x90 AdSpace

Latest News
July 26, 2016

Should Investors Care If Stocks Seem Over-Valued?

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.
About the Author: Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The BlackRock Blog.
Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Investing involves risks, including possible loss of principal. This material is not intended to be relied upon 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 are as of July 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking" information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 BlackRock, Inc. 
All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners. USR-9884

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

© EconMatters All Rights Reserved | Facebook | Twitter | YouTube | Email Digest | Kindle

  • Blogger Comments
  • Facebook Comments
Item Reviewed: Should Investors Care If Stocks Seem Over-Valued? Rating: 5 Reviewed By: EconMatters