Chart of the week
Valuation is Destiny
What does this chart show?
From 1926 - 2017, the price an investor paid for inflation adjusted S&P 500 earnings had a strongly negative correlation with the return they received over the next 10 years. Buying more expensive stocks earned less future return, and buying less expensive stocks earned more future return.
Note - ‘Expensive’ in this chart is proxied by the cyclically adjusted price-to-earnings ratio, the CAPE ratio, which reflects the average inflation-adjusted earnings from the previous 10 years.
Why does it matter?
Despite historical precedent and academic research, buying expensive stocks, as measured by the CAPE ratio, has been the go-to strategy since the mid 2010s. The S&P 500 led by big tech has been the only show in town. It has made investing in reasonably priced international stocks, that matched the S&P in the 40 years prior, seem like a stupid idea. Sound investment discipline anchored in valuation slowly eroded year by year.
Then came the COVID stimulus which turned the markets into a full-blown casino. Investors paid any price to pile into profitless stocks, crypto, and other things. Many seasoned asset managers were still recommending expensive stocks at the beginning of 2022 before being caught badly offsides. The narratives around expensive stocks are always so seductive, and buying them always feels so good in the present.
Despite the serious correction in expensive stocks last year, those stocks1, and the S&P 500 as a whole, are still expensive. The S&P 500’s CAPE ratio (29) is well above the mean (17) and near previous all time high levels2. But this year investors are back at it, returning to the playbook of the recent past. It will likely be awhile until we find out how that will end up, but this chart makes it clear.
The Bottom Line
For long term investors, the price you pay now for future cash flows is a strong indicator of your future returns, but the stock market is the only place where buying cheap things is uncomfortable. As Corey Hoffstein says - No Pain, No Premium
Credits - The data from this chart came from Larry Swedroe, and the title of this chart comes from a saying I heard from Lewis Johnson
