Valuations Aren’t Great Timing Tools

Stocks have had a tremendous run since last fall (at least until yesterday), with four straight positive months, a series of record highs for the S&P 500, and, finally, one for the Nasdaq, and a more than 20% advance for both indexes.

When stocks do this well, we inevitably hear warnings about high valuations from strategists and pundits. For LPL Research, valuations and corporate fundamentals are major inputs into asset allocation decisions, so this is not intended to dismiss its importance. But good investment decisions, particularly over the short-to-intermediate term, are more comprehensive and incorporate several different disciplines — including technical analysis, in our opinion. Why is that so important? A big reason is traditional valuation metrics have historically not been good indicators of short-term performance.

A scatterplot chart with the S&P 500 Index price-to-earnings ratio (P/E) on the horizontal (x) axis and subsequent one-year return on the vertical (y) axis illustrates this point. If this relationship was well correlated, then the dots would form a downward-sloping pattern from upper left to lower right, indicating higher valuations precede lower returns, and vice versa.

But this scatterplot, including data back to 1990, shows no relationship whatsoever. Essentially, P/E offers very little insight into whether stocks will do well or not in the coming year.

P/E Ratios Have Not Historically Been Good Predictors of One-Year Performance 

Source: LPL Research, FactSet 03/05/24
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

If you are searching for the downward-sloping chart pattern described above, where higher valuations precede lower returns and vice versa, you need only extend the time horizon. When comparing P/E to subsequent 10-year returns, you will notice that predictive pattern — the dots start in the upper left quadrant with low P/Es preceding higher returns, and move to the lower right quadrant, signifying higher P/Es, and lower subsequent returns. In other words, valuations are important for long-term buy-and-hold investors, but not so much for traders or your typical tactical asset allocator.

The current P/E for the S&P 500 is near 23 on a trailing 12-month basis and suggests modest, low-to-mid-single-digit returns over on the next decade. That forecast may end up being overly pessimistic given the potential for a further structural shift higher in valuations as in prior decades, but it does suggest that another decade of double-digit annualized returns, which investors have enjoyed over the past 10 years, is unlikely.

P/E Ratios Have Historically Been Excellent Predictors of Ten-Year Performance

Source: LPL Research, FactSet 03/05/24
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Tying this example to the current environment, our message is this. Stock valuations are clearly elevated, especially technology stocks benefiting from the artificial intelligence boom. We’re probably overdue for a pullback. But fundamentals are quite good right now, so these elevated valuations may persist throughout 2024 and potentially even longer. (We wrote about big-cap technology company earnings in our March 4, 2024 Weekly Market Commentary.)

That leaves us watching technical indicators for signs of a breakdown in this market’s uptrend and looking for evidence of fundamental deterioration, which has not yet materialized. In the meantime, LPL Research recommends staying invested and maintains its neutral tactical stance on equities.