We have stated many times that the stock market is currently overvalued. In the short term we don’t know if there will be a correction or if rising profits will catch up to valuations. But what about the long term? What do current elevated prices mean for long term stock market returns?
No one can answer that question with certainty, but history gives us a window into a potential answer. The chart below is helpful in this regard.
The orange line is the cycle adjusted price to earnings ratio (PE) at the beginning of any decade since 1900. Where the green bars intersect with any part of the orange line is the subsequent 10 year rate of return for the S&P 500. Please take a few moments to look at various dates to look at 10 year returns when PE is high, low, and in the middle.
As you can see, when PE is higher the 10 year stock return tends to be lower, and when PE is lower 10 year stock returns are typically higher. This makes sense as stock returns are a combination of profit increases and rises in PE. If PE is already high, it is more likely falling PE will take from returns.
PE is very high now, so it makes sense that stock returns over the next 10 years will be on the lower end, and could potentially be negative. However, this does not necessarily mean that stocks won’t grow for many years, that the 10 year return will be negative, or that stocks may not outperform other investment assets. But is does suggest that an investor should more active with stock exposure, especially when the current economic recovery, which started just a year ago, has gotten a bit older. At some point less risk and more defensive strategies may be prudent.
Keeping an eye of such things as we manage portfolios is a hallmark of Myers Capital Management.