High or Low, P/E Valuations Don't Show Where Stocks Will Head Next

In my recent interactions with Fisher Investments' institutional and individual clients, a common theme has emerged: Many are concerned stock market price-to-earnings valuations are too high for the bull to keep charging.

This sentiment is reinforced by media coverage, which argues the same thing daily. Even Fed Chair Janet Yellen got in on the act recently, claiming valuations were "somewhat rich." While it is true valuations are a shade above long-term averages, in my view, there is ample evidence proving valuations -- high or low -- say nothing about near-term stock returns.

Let's start by considering trailing and forward price-to-earnings ratios (P/Es) for the S&P 500. At 17.7, the gauge's forward 12-month P/E is above its 15.4 average this century. Prefer trailing P/Es? At 22.0, you'll reach the same conclusion -- P/Es are above-average. They aren't near 2000's dot-com bubble heights by any stretch, but they aren't what a traditionalist would call "cheap," either.

While I don't dispute these facts, I do quibble with their interpretation, because most folks presume high P/Es mean stocks are expensive and soon to fall. Yet history disagrees. S&P 500 calendar-year returns following the 10 highest start-of-year P/E ratios show no discernible pattern. Sometimes stocks are up big like 1998 and sometimes they are down such as 2002 -- but on average, they do just fine.

Exhibit 1: S&P 500 One-Year Returns Following History's 10 Highest Trailing P/E Ratios

Source: Global Financial Data as of 4/11/2017. S&P 500 annual price return, 12/31/1926 - 12/31/2016 and S&P 500 Trailing 12-Month P/E, 12/31/1926 to 12/31/2015. Similarly, since 1926 (the S&P's reliable history), there is zero relationship between start-of-year P/Es and returns over the following year, as the scatterplot below implies.

Source: Global Financial Data as of 4/11/2017. S&P 500 annual price return, 12/31/1926 - 12/31/2016 and S&P 500 Trailing 12-Month P/E, 12/31/1926 to 12/31/2015.

The fact is, "somewhat rich" valuations often get "somewhat richer" -- and cheap stocks can get cheaper. So much for P/Es being predictive.

Now, some will probably look at forward and trailing P/Es askance, claiming the lack of predictive quality is because earnings are too volatile -- too tied to economic cycles. Hence, they may favor "smoothed" price-to-earnings ratios, like the Cyclically Adjusted P/E, or CAPE.

CAPE attempts to smooth out those problematic economic cycles by comparing stock prices today to a decade's worth of inflation-adjusted earnings. Many adherents will be quick to volunteer that its high levels today are reminiscent of 1929, 2000 and 2007.

But before concluding CAPE surely signals big trouble ahead, consider: It also allegedly indicated trouble in December 1996, when then-Fed head Alan Greenspan cited it in a speech wondering if investors weren't irrationally exuberant.

It was well above its long-run average for most of the 2002-2007 bull market. CAPE crusaders have been claiming it signals trouble for this bull since 2013. More importantly, the reason for all these false signals is that CAPE is a broken, flawed indicator. It compares apples and oranges -- inflation-adjusted earnings with nominal stock prices.

Moreover, going back 10 years includes 2008-2009's abysmal earnings, inflating CAPE. But in a few short years, as those earnings fall out of the calculation, CAPE (all else equal), will fall. Is that inherently bullish? Not at all.

Valuations, on their own, won't tell you where markets are heading, but they can be a useful gauge of sentiment and expectations. Maturing bull markets often have valuations rise for years before reaching a euphoric top.

As investors gain confidence, they are willing to pay more for a dollar's worth of earnings. When folks commonly fear valuations signal trouble -- and aren't dismissing them as they did in 2000 -- it's a good indication euphoric sentiment remains at bay. Don't fret over valuations here and now -- enjoy the bull market. In my view, there is more to come.

William Glaser is Executive Vice President of Research at Fisher Investments and a member of the firm's five-person Investment Policy Committee.

Fisher Investments is an independent, fee-only investment adviser serving investors globally. To learn more about Fisher Investments, please visit www.fisherinvestments.com.

The content in this article represents only the opinions and viewpoints of the author. It should not be regarded as personalized financial advice and no assurances are made the firm will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.