As US stocks rebounded in the months following March 23’s low, many doubted the rally’s staying power. Among the many reasons pessimists cited was this common refrain: Stocks are pricey based on most valuation metrics, implying weak returns ahead—maybe even a renewed downturn. In Fisher Investments’ view, this overrates valuations’ predictive power.
Valuations are metrics seeking to help determine whether a stock price reasonably reflects a company’s fair market value. One of the most common: the price-to-earnings (P/E) ratio, which compares a company’s share price to its earnings per share. Headlines usually focus on one of 3 versions: the trailing P/E (stock price to the past 12 months of earnings); the forward P/E (stock price to analysts’ estimate of earnings in the next 12 months); and the cyclically adjusted P/E, or CAPE (stock price to the trailing 10-year average of inflation-adjusted earnings). Despite these differences, many investors use P/Es similarly: as a timing tool. P/Es rising above their long-term average is a warning, the thinking goes, that stocks are getting expensive. That presumes cheap stocks are poised to climb whereas pricey ones will fall—or, at least, trail the cheaper ones.
But history reveals valuations lack predictive power. One reason: They reflect prices, and markets are highly efficient, meaning they reflect widely known information. Prices incorporate all the news, data, opinions, scheduled events and forecasts available to market participants in real time. Earnings reflect companies’ past profits. Neither is meaningful for forward-looking stocks, which care about the economic and political factors affecting profits over the next 3–30 months.
CAPE is an extreme illustration of valuations’ shortcomings. Consider: Why would earnings from the past 10 years tell you anything about earnings in the next year—let alone the next decade? That implies companies’ decimated profits during the 2008–2009 financial crisis would have been meaningful to investors formulating an outlook for 2012, 2015 or even 2019. Moreover, based on CAPE’s long-term historical average, stocks have been pricey over the past three decades. From 1871 to 1989, CAPE’s monthly average for the S&P 500 was 14.4. [i] The monthly average from 1990 to today is 25.9—a whopping 11.5 points higher. [ii] Yet the past 30 years include history’s 2 longest bull markets—evidence, in our view, that stocks don’t care about CAPE.
Bear markets can also skew valuations in unique ways. The coronavirus pandemic highlights the limitations of the forward P/E, which relies on analysts’ future earnings estimates. The pandemic-driven economic shutdown and resulting uncertainty have rendered forecasts even more guesswork than usual. Many companies outright retracted their earnings “guidance” for the year, giving analysts less information than usual to weigh. Professionals’ expectations for future economic conditions vary enormously, too, influencing their earnings forecasts. Before Q1 earnings season began, several major banks projected big double-digit declines in profits due to COVID-19’s fallout. Yet these analysts’ estimates varied greatly since outlooks regarding the downturn’s duration weren’t uniform, either. [iii]
Even in more typical bear markets, the “price” component of the ratio tends to get the most attention. However, what happens to the denominator—earnings—can lead to some counterintuitive conclusions. If earnings take a beating and plunge more than stock prices, the P/E would rise. By that logic, stocks would be getting expensive. But prices rise before earnings recover at the start of new bull markets, as recent history illustrates. Towards the end of the 2007–2009 bear market, trailing P/Es skyrocketed. In December 2008, the trailing P/E hit a new all-time high of 59.0, blowing past March 2002’s 46.7. [iv] In March 2009, it hit triple digits and stayed around those levels through July 2009. [v] Yet March 2009 was also when the last bull market began—a great time to own stocks, despite what that triple-digit trailing P/E said.
Despite all the attention they receive, valuations won’t tell you anything about future market returns. In Fisher Investments’ view, investors should base their investment decisions on what they see coming rather than information the market has already moved beyond.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: Multpl.com, as of 06/09/2020. S&P 500 CAPE, monthly average, February 1871–December 1989. [ii] Ibid. S&P 500 CAPE, monthly average, January 1990–June 2020. [iii] Source: “Looming Earnings Season Offers Next Test for Rebounding Stock Market,” Karen Langley, The Wall Street Journal, April 12, 2020. [iv] Ibid. S&P 500 Trailing P/E for March 2002 and December 2008. [v] Ibid. S&P 500 Trailing P/E, March 2009–July 2009.
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