After I suggested this week that the high valuation of stocks — relative to corporate earnings — was one of the forces weighing on the market, Felix Salmon asked on Twitter whether there was really a relationship between valuations and stock movements.
It’s a good question. In the short term, the answer is surely no. Knowing that stocks are expensive tells you nothing about what they’ll do today, this week or this month. Over the longer term, however, there is a relationship: When stocks are more expensive, they have lower future returns on average.
Since 1881, when the Standard & Poor’s 500-stock index has had a price-earnings ratio of at least 24 — just a bit below where it is now — the average return over the next 10 years is negative 3 percent.
By comparison, the average 10-year return over that entire period, regardless of P/E ratio, is 36.3 percent. (All the calculations here are based on monthly data and on a P/E ratio using the previous 10 years of corporate earnings.)
The relationship isn’t perfect, by any means. But it’s noticeable.
More Expensive Stocks, Lower Average Returns
Annual average return on the Standard & Poor’s 500-stock index over a 10-year period since 1881, organized by the price-earnings ratio at the beginning of the period. Each dot represents one month.
There have been times — like the last few years — when stocks are expensive and they continue rising rapidly regardless. So it is not out of the question that stocks will rebound from their recent decline and rise over the next few months or years. More often than not, though, high-priced stocks lead to mediocre returns, at best, over the ensuing decade.