Over the weekend, I read two important pieces that address the issue of valuations and subsequent returns. The first was an article by Sam Ro at Business Insider discussing the markets P/E ratio as a predictor of returns over the next 12-months. To wit:
"'P/E has a poor track record for predicting shorter-term returns,' BMO Capital Markets' Brian Belski writes.
Belski tested the relationship between P/E and the 12-month returns using R2, a statistical measure which reveals how well a regression line — the line of best fit you see — explains the relationship. The higher the R2, the better job a P/E ratio does in explaining returns.
'According to our work, the simple P/E ratio explains a significant portion of longer- term stock market returns. On the other hand, P/E ratios have little explanatory power for holding periods up to 10 years. The fact of the matter is that P/Es aren't that reliable over any given period. It's just worse in the short-term, which at ten years is still a rather long time. Therefore, we believe investors are likely overstating the importance of elevated P/E levels as it relates to potential market performance in the coming months.'"
Brian is correct, valuations are extremely poor short-term indicators for market performance particularly when markets are beginning to push higher due to "exuberance" as price momentum takes hold. It is the "fear of missing" out by investors that leads to "irrationality" in the financial markets.
The second article was by the Office Of Financial Research (full article below) which discussed various measures of historical valuations and the implications to financial stability.
"Extreme asset valuations can have implications for financial stability. Although the bursting of the technology stock bubble in the early 2000s did not disrupt the functioning of financial markets, the other two major crashes of the past century, following the 1929 and 2007 peaks, contributed to widespread financial instability.
Broadly speaking, systemic crises tend to be preceded by bubbles in one asset class or another. Brunnermeier and Schnabel identified four factors that accelerate the emergence of asset bubbles: expansive monetary policy, lending booms, foreign capital inflows, and financial deregulation. They concluded that the financing of bubbles is much more relevant than the type of asset bubble, noting that 'bubbles in stocks may be just as dangerous as bubbles in real estate if financing runs through the financial system.' They also noted that the spillover effects of bubbles bursting are most severe when accompanied by a lending boom, high leverage, and liquidity mismatch of market players.
Adrian, Covitz, and Liang defined systemic risk as the potential for widespread financial externalities, whether from corrections in asset valuations, asset fire sales, or other forms of contagion, to amplify financial shocks and, in extreme cases, disrupt financial intermediation. They noted that systemic risks may arise from vulnerabilities such as leverage, maturity and liquidity transformation, compressed pricing of risk, interconnectedness, and complexity. For these reasons, it is important for regulators to consider potential systemic risk implications when asset prices approach extremes.
The U.S. stock market may pose fewer financial stability risks because liquidity transformation is less relevant compared to other financial markets, such as certain fixed-income markets. However, other vulnerabilities that may amplify shocks could be more relevant to assessing financial stability risks. These include leverage, compressed pricing of risk, interconnectedness, and complexity."
Fundamental market measures, such as valuations, and economic analysis are extremely poor indicators of short-term market performance. This is why, as I discussed in "Think Like A Bear, Invest Like A Bull" that:
"Currently, there is little value available to investors in the market today as prices have been driven higher by repeated Central Bank interventions and artificially suppressed interest rates.
Therefore, while [fundamental] analysis suggests that portfolios should be heavily underweighted 'risk,' having done so would have led to substantial underperformance and subsequent career risk.
This is why a good portion of my investment management philosophy is focused on the control of 'risk' in portfolio allocation models through the lens of relative strength and momentum analysis.
The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as 'greed' and 'fear' overtake logical analysis."
As you are aware, I regularly point out valuation concerns, because they are so crucially important over the longer term as OFR points out. But to refine the risks to investors further, my good friend and colleague Doug Short, recently provided an excellent summation. To wit:
The S&P 500 is likely to decline severely during the next recession, and future index returns over the next 7 to 10 years are likely to be low.
Given this scenario, over the next 7 to 10 years a buy and hold strategy may not meet the return assumptions that many investors have for their portfolio.
Asset allocation in general and tactical asset allocation specifically are going to be THE important determinant of portfolio return during this time frame. Just buying and holding the S&P 500 is likely be disappointing.
Some market commentators argue that high long-term valuations (e.g., Shiller's CAPE) no longer matter because accounting standards have changed, and the stock market is still going up. However, the impact of elevated valuations — when it really matters — is expressed when the business cycle peaks and the next recession rolls around. Elevated valuations do not take a toll on portfolios so long as the economy is in expansion.
Importantly, the attendant table of returns is also quite sobering:
I certainly encourage you to read to full OFR report below. However, as I stated above, while valuations do not matter at that moment, they will and when they do they will matter a lot.
As the OFR concludes:
"Markets can change rapidly and unpredictably. When these changes occur they are sharpest and most damaging when asset valuations are at extreme highs. High valuations have important implications for expected investment returns and, potentially, for financial stability."
To that point – I completely agree.