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Tackle Today: The Time Frame Where Valuation Does Matter!

April 15, 2021

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High P/E = Lower Return


Today’s message complements yesterday’s Tackle Today, highlighting the S&P 500’s high P/E ratio. Here’s how I think about valuation. It matters little, if at all, in the short-run (say, 1 year). But it does matter some in the intermediate-term (5 years).

Let me elaborate.

Study the chart of the day for a moment. It plots the S&P 500 P/E ratio on the horizontal axis. More expensive markets are on the right, cheaper ones are on the left. The vertical axis plots market returns over the next year (left chart) and five years (right chart). The red arrow illustrates where we are Today with an S&P 500 P/E of 21.9.

The gray dots show historical market returns when the S&P was at various P/E levels. Note how spread out they are on the left chart. Sometimes buying at high valuations gave you a really good rate of return one year later. Other times it gave you a bad return. The dispersion between outcomes is quite large.

This is why it’s impossible to say that buying richly priced stocks is a bad idea. In the short run, you get good outcomes just about as often as bad.

The intermediate-term is different. That’s the chart on the right. Note how the dispersion on the scatterplot tightens. Generally, buying at low valuations generates higher 5-year returns. Buying at high valuations yields lower 5-year returns.

If you want to be pessimistic about the market’s average annual return over the next five years, history backs you up. The more interesting question is what you’re going to do about it.


Chart of the Day

P/E Ratio and Subsequent Returns

Okay, bears. You can convince me that today’s high market valuation lowers forward returns if the time frame is five years. But, I’m not personally investing money for five years. I’m investing for five decades, if not longer. Thus, I find bearish arguments that hinge on the P/E ratio unconvincing.

Video of the day

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