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What can we learn from equity valuations?

February 1, 2019 | Commentary

  • After a challenging 2018 in global equity markets, investors are anxious to get some intelligence on what 2019 might bring.  January has started off favorably, but the honest answer is that nobody can predict with certainty what any individual calendar year will do.
  • The U.S. equity market may have earned on average 8-10% annually over many decades, but specific years earning that average are exceedingly rare, and the range of outcomes is wide.  Looking at rolling 5-year returns reduces the variance of returns considerably and also lowers the chance of total negative periods.
  • Equity market valuation, as captured by a simple forward P/E ratio, can offer some guide to future returns.  Buying stocks when they are historically cheap raises the chance of a good return in the future.  When the investment horizon is extended from one year to five, the last twenty-five years of U.S. history show few examples where stocks began as cheaply as they started 2019 that ultimately produced negative total returns.
  • Last year P/E ratios for stocks around the world fell as indexes tumbled while earnings remained flat or grew.  On a simple comparison basis, P/E’s in the U.S. may be cheap versus 2018 and historical averages, but they are higher than in most global developed and emerging markets.  This is not an argument to swing portfolios to more international stocks. Economic and risk conditions outside the U.S. may warrant lower valuations.  It is, however, a hopeful sign for the diversified investor that their broad equity holdings have a reasonable chance of performing well over the next several years.

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