In this blog post we discuss how long term strategic investors can think about and use market valuation information.
It's early in 2015 and we are trying to decide if the US stock market is over valued, still fairly priced or possibly under valued (not many believe it is undervalued at this stage of the recovery). The many and varied opinions on this topic is what creates a market of buyers and sellers.
As a refresher, market valuation is measured by the P/E (price/earnings) ratio; in our case, of the S&P 500 which as of the end of 2014 stood at 16.2(trailing), 18.6(forward), or 27.3 (Schiller PE 10) depending on which version of the P/E quoted. The P/E for the S&P 500 is the sum of the P/Es for all the individual company stocks that comprise the S&P 500. The price earnings ratio tells us how much a buyer will pay for a dollar of earnings.
How can a long term strategic investor successfully use P/E information? Alone, the numbers are meaningless but as a comparative tool with an understanding of the two relative variables, the information can become useful (due to the two variables, P/E can be high or low for many reasons and across different sectors).
Certain types of investors focus on market valuation to signal short term buy and sell decisions. I disagree with the usefulness of this short term trading technique, but I do believe strategic long term investors can use market valuation to gauge future expected returns and thus progress toward their financial goals.
This use of market valuation is somewhat intuitive, just think of real estate. If you buy when prices are high, future gains will be lower. Even if you make a tidy profit, you still would have made more if you originally purchased "on sale". This is why Warren Buffet likes bear markets. He goes shopping for companies on sale due to no fault of the healthy company but simply because the spot market price is down.
Here is a chart that gives some guidance as to expected future earnings based on current P/E10.
Schiller PE 10 Ratios (based on Schiller data tables)
So in a market like we see today based on a PE 10 of 27.3 at the end of 2014, you could expect earnings during the next 10 years to range from -3.50% to 11.19% and the low average of 3.98%. This should be helpful to you in adjusting your expectations and managing your financial plan.
While there is nothing in the P/E ratio which I believe can signal buy today or sell tomorrow, I do believe a second related use of the P/E ratio for long term investors is to gauge the amount of speculative behavior accumulating in the market. If the denominator (earnings) remains stable, yet price is increasing this can be a warning of increased hubris and froth in the market. It will usually be accompanied by an overall attitude of optimism. When this happens it is again time to pay attention to Warren Buffet's wisdom "be fearful when others are greedy and greedy when others are fearful".
In summary, observation of market valuation is not a good foundation for a successful long term investing strategy, but the information is useful for gauging a range of future expected returns and judging the amount of speculation building into the market. The long term strategic investor can taken advantage of building these observations into their financial plan.