Equity markets are currently trading at elevated valuations. The implication for long-term investors is that future returns are likely to be depressed, and risks heightened.
Our previous analysis showed that – across a range of different valuation measures – the US equity market is trading at its highest valuation in over two decades. One of the measures presented was the forward price-to-earnings ratio, which compares the price of the stock market to its expected earnings over the next twelve months. This ratio can be used to demonstrate the relationship between valuations and longterm equity returns.
In the chart below, we plot the forward price-to-earnings ratio of the US equity market at the end of every month since 1985 along the X-axis. For each of these valuation points, we then plot the annualised return generated by the US equity market over the subsequent ten-year period on the Y-axis. The dark blue diagonal line running from top left to bottom right displays, on average, the relationship between valuations at the point of investment and the subsequent returns earned.
US Equity Valuations at Point of Investment and Subsequent 10-Year Returns
The chart highlights the clear historical relationship between starting valuations and subsequent returns: when valuations are low, investors have typically enjoyed strong annualised returns over the subsequent decade; when valuations are high, returns over the next ten years have, without exception, been much lower.
Today, the Forward P/E ratio of the US equity market stands at 22.5x – a level only marginally below that seen during the dotcom bubble of the early 2000s. Historically, valuations in this region (represented in the chart by the vertical grey line) have been followed by long-term returns ranging between +3% and -4% per annum over the subsequent decade. Meanwhile, investors can currently earn relatively secure yields of 5-6% per annum on high quality short-dated bonds.
For those interested in further detail regarding the relationship between valuations and returns, we would recommend reading the latest memo published by Howard Marks, The Calculus of Value.
