Why an incessant focus on valuation multiples guarantees subpar returns
I have lost count of the amount of times pundits have dismissed US markets, citing lofty valuations — they subsequently recommend allocations into cheaper markets such as Europe and Asia. I first heard this back in 2013, and had you followed their advice your returns would have been derisory.
From 01/01/2013 to today, you have forgone a return of about 140% by reallocating out of the US.
Another example is Mark Cuban, an American billionaire entrepreneur who said in March 2015 that the technology bubble is worse than the one 15 years ago. Following his advice meant foregoing a 200% return in the tech heavy Nasdaq-100.
We have become so conditioned to buy assets only at the right price that we continually dismiss tremendous opportunities because of a premium valuation. The next time you use price as an excuse not the invest, remember this: if you had purchased the S&P 500 during its lowest valuation in the 20th Century, which is 1917 at a 5.3 P/E ratio and sold it at its highest point, in 1999 at a 34 P/E patio — 80% of the growth came from appreciation in earnings per share (data from Fundsmith). The takeaway is that valuation is not the key driver of long-term performance.
Price-to-Earnings ratio (P/E) is a poor indicator of future returns
As I write the S&P 500 trades at a P/E ratio of 37 and the Nasdaq-100 at 38 times earnings, well over their historical average. However its worth remembering that P/E ratio’s were also at all time highs in 2008, when the S&P 500 touched 60!, selling out meant missing out on a 26% gain in the US market and a 30% surge in world stocks in 2009. The high multiples then and now are partly the result of a recession depressing earnings, pushing P/E’s to a very high level.
It’s very common to see high P/E’s during recessions, and they tend to reach record highs during market bottoms, just before stocks go on to rise substantially. A high P/E ratio doesn’t mean stocks will fall, more importantly it tells you nothing about forward earnings, the fundamental driver of stock returns.
On the other side, a low P/E ratio can lull investors into a false sense of security and indicate unsustainable high earnings. For example in October 1929, the US market traded at a P/E ratio of 17.8, not the sky high levels you’d expect before the Wall Street Crash on October 24. Selecting a market or stock because of low P/E is just as misguided as avoiding markets because of a high multiple, you have to dig deeper to understand why the P/E is high or low and where future earnings will be. This is no easy feat, outlier events such as World Wars and the current pandemic shape the economic landscape, triggering enormous innovations in the process. It was the pandemic which accelerated adoption of e-commerce and video conferencing etc, which in turn has helped drive growth in the Nasdaq-100; if you relied on backward looking valuation metrics, you would have likely missed out on this.
Cyclically adjusted price-to-earnings ratio (CAPE) is a poor indicator of forward returns
A widely used and over-hyped valuation metric is the CAPE ratio, popularized by Yale University professor Robert Shiller. It has averaged around 15 historically, however during the roaring twenties it peaked at 32.5, it subsequently reached another high of 23.7 in 1966 and hit 43.7 at the height of the dotcom bubble. Had you diversified out of US at these prices, you would have missed out on an annualized total return in the S&P 500 of 9.3%, 10% and 6.5% respectively (from September 1929, February 1966 and March 2000 to the end of November 2020).
Over the past 23 years, the CAPE ratio of the S&P 500 has been above its historically average about 97% of the time, over this period the US market went up by 480% on a total return basis. You would have missed out on most of this gain if you sold out when CAPE went above its historical average. Aswath Damodaran, the dean of valuation has looked at every possible market timing strategy using CAPE, and he couldn’t find a single approach where he could use CAPE to make money.
The stock market doesn’t care
Stock markets don’t care about CAPE, P/E ratio, P/B or any other multiple, what they do care about is future corporate earnings. Why is the US outperforming the rest of the world? Because US market possesses the right mix of biotech, software and consumer discretionary companies that are profiting from the new age economy. These firms came into their own post 2008 financial crisis, attaining monopolistic positions and enormous profit margins, pricing metrics would not have foretold this.
A quote that gets bandied about is “The four most dangerous words in investing are — this time it’s different” by John Templeton. This trite phrase is misleading because ‘every time is different’, no two recessions, economic cycles, government responses, monetary regimes etc are ever the same. Economies and stock markets keep evolving, and the key mistake people make is anchoring to previous outcomes, over-relying on investment history and outdated metrics as to guide to the future, it doesn’t work that way.
On a relative basis, markets are not overvalued
Investors too often fall into the trap of looking at valuation multiples in isolation, but in today’s unprecedented environment, the game has fundamentally changed. While stocks look expensive relative to their own history, they don’t look expensive relative to what your other choices are. Never in their history has 10-year Treasuries yielded less than 1%, and with alternative asset classes providing insignificant returns, equities are still by far the highest yielding asset.
The challenge investors face is having to reconcile two contradictory ideas, that equities have never been more attractive on a relative basis, while they have never been more overvalued compared to their own history. But one thing is clear, that valuations will tell you little about market returns in the future and basing your investment decisions on these metrics is a recipe for underperformance, because it leads you to buy and sell at inopportune times.
