Stock Market Valuations Remain High Despite Market Weakness
What Does That Say About Future Returns?
A basic premise of investing is that the price you pay has a major influence on the ultimate return of that investment. From this notion comes the fabled “buy low sell high” philosophy.
The chart below illustrates that as forward S&P 500 P/E ratios reach the high teens’ future returns fall below 5% per annum. If they approach 23x (as they have recently been), subsequent 10-year returns turn negative. The market weakness thus far in 2022 suggests that the process may already be underway.
The level of investor optimism reflected by the current level of market valuation appears at odds with the economic realities of a tenuously postured global economy. The combination of inflationary pressures and rapidly rising interest rates, the high probability of a recession, and the poorest geopolitical climate since WWII suggests that corporate earnings will be under pressure.
Future market returns will presumably be under pressure from slowing earnings growth. This negative market trend could be greatly exacerbated should a change in investor sentiment demand lower P/E ratios, as seems reasonable.
We remain of the view that market volatility for U.S. equities in the 2020s will be unusually high, in contrast to the previous decade, which exhibited the lowest volatility on record.
The anticipated volatility will present risks but also great opportunities. The years ahead will be challenging, punishing passive and inattentive investors, and rewarding the active and prepared.
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