Why Stock Market Valuations Matter

Why Stock Market Valuations Matter


As the stock market has risen to near record highs in recent months, some investors have been asking whether it’s still a good time to get into stocks. The answer lies in the concept of investor participation vs. investor perfection. History shows that even investors who had bad timing when buying into stocks, but who stayed in the market for five or more years, ended up making more money than if they had just sat on their cash.

That said, when you enter the market can have a significant impact on your returns, especially in the short run.

Imagine jumping into the stock market in July 1990. Six months later, the S&P 500 was off 15 percent. How about getting started in March 2000? Over the following year, the S&P 500 fell 25 percent.

Starting in October 2007? Twelve months later, the S&P 500 was down 42 percent.

These Great Moments in Bad Timing have much in common. They were followed by recessions and stock market corrections. But perhaps more importantly, they were all preceded by periods of excessive valuation. In 1996, Alan Greenspan referred to this as “irrational exuberance,” a phrase that hearkens back to investors paying too much for what really matters in investing — earnings/profits.

Valuation is the process of determining what a company or a group of companies is currently worth. Essentially figuring out an enterprise’s intrinsic value — based on profits.

Let’s explore what happens to markets during different periods of valuation. In order to do so, we need to shift our focus from the market’s odometer (the market level) toward what we’re paying for that odometer reading (valuations), be it above, below or right on the “sticker price.”

Let’s walk through why valuation, expressed as a stock’s Price Earnings Ratio (P/E), matters — and then plug that into our bigger worldview.

In its basic form, P/E is simply an investment’s price tag — the price we pay divided by what we expect to earn each year from that investment. When looking at stock market-related investments, we’re typically talking about an index or group of stocks like the S&P 500 or an individual stock divided by a dollar number. For example, say the S&P 500 level is roughly 2,400 and expected earnings are $135 for the next year. Divide 2,400 by $135, and we get 17.75. Let’s round it and call it 18 as the current market’s P/E level.

Now let’s pop these numbers into our odometer analogy. The 2,400 number is the odometer’s level. The number 18 is what we’re paying for the odometer, and herein lies the real key. Our P/E is what we’re paying for each $1 of earnings. That’s paramount for us as investors.

Historically, we’re better off getting into stocks when valuations are low. Why? Because that means stocks are cheaper relative to what they’re earning.

Here’s a quick example of how valuations work using an investment property for the sake of simplicity. Patricia can buy rental home A for $100,000 and receive $20,000 in annual rent. She could essentially pay five times the rental income should she purchase this investment. House B, on the other hand, costs $100,000 and pays $10,000 in rental income. In this case, Patricia would be paying 10 times the rent should she purchase this investment. Assuming the homes are equal, it’s a much better deal to buy house A. It’s a similar concept when looking at the stock market.

With assistance from the Ned Davis Research Group, I went back and analyzed stock market returns when investing at different valuations (or market price tag levels) from 1928 until 2016. What was I looking for? How markets fare on average over the next year when the P/E ratio is high versus midrange versus low range.

When Stock Market (S&P 500) P/E levels are:

1. Below “sticker price” (9.5 and lower) — In this P/E range, stocks would be considered “on sale.” Historically, of the three categories, this has produced the highest market returns over the following year. On average, 20 percent a year. That’s right, per year.

2. At “sticker price” (9.5-16.5) — In this range, stocks are considered fully or appropriately valued. Historically, returns over the next year have come in around 5 percent per year.

3. Above “sticker price” (16.5 and higher) — In this range, stocks begin to enter the “expensive” territory. Historically, returns are relatively flat over the next year.

What do these numbers illustrate at their essence? That yes, valuations matter.

Commit this next point to memory: It’s not about the market’s odometer level; it’s about what we are paying for the current odometer level.

Today, we are hovering at 18 times earnings. Back to our analogy, we’re paying just north of “sticker price” for the market’s current odometer reading. To put our current level into further context, before the bear market of 2000-2001, the S&P 500 was trading at a whopping 36.5 times earnings, or twice as expensive as where we are today.

An important point to note here is that we don’t stay in any of the sticker price ranges forever. Instead, we flow in and out of the categories listed above as the market changes and shifts.

Add these two words to your list of investment truisms — valuations matter. Now, as a hopefully more informed investor, you can incorporate this truism into your larger, overarching investment strategy.

Wes Moss has been the host of “Money Matters” on Ne


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