When forecasting investment returns, many individuals make the mistake of simply extrapolating recent returns into the future. Bull markets lead investors to expect higher future returns, and bear markets lead them to expected lower future returns. But the price you pay for an asset also has a great impact on future returns. Consider the following evidence:
The average historical P/E ratio for the market has been around 15. A study covering the period from 1926 through the second quarter of 1999 found that an investor buying stocks when the market traded at P/E ratios of between 14 and 16 earned a median return of 11.8 percent over the next 10 years. This was remarkably close to the long-term return of the market. The S&P 500 returned 11.0 percent per year for the 74-year period 1926-2000.
On the other hand, investors purchasing stocks when the market traded at P/E ratios of greater than 22 earned a median return of just 5 percent per year over the next 10 years. And investors who purchased stocks when the market traded at P/E ratios below 10 earned a median return of 16.9 percent per year over the next 10 years.
Yesterday I linked to Larry Swedroe’s excellent piece on asset allocations and valuation at ETF.com. I wanted to pull out the most salient point here because I think it’s so crucial for investors to understand. The debates about CAPE and valuation that rage constantly in the media usually center around a “should you buy or sell” question. In truth, there is no buy signal from PE ratios, but there is a very real possibility of higher or lower long-term returns depending on when the bulk of your money is invested in stocks.
Fortunately, we don’t currently sell at an extreme PE multiple in US stocks, although it is elevated. Meanwhile, many foreign stock markets are becoming scary-cheap.