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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


How Investors Can Take Advantage of Attractive Valuations

From an email sent to IIM investors on July 20, 2022…

As the economy responds to inflationary pressures, investors continue to struggle with daily price swings across the stock market. This level of market volatility can be disorienting, and some may even want to wait it out on the sidelines. While that may be tempting, history shows that this is neither the best approach to lower risk nor to take advantage of a future recovery. Instead, long-term investors can use valuations as a north star to navigate choppy waters.

So what do valuations tell us about long-run returns today?

First, it’s important to discuss why valuations matter. In short, valuation measures are the best tools that investors have to gauge the attractiveness of the stock market over years and decades. Unlike stock prices on their own, valuations don’t just tell you how much something costs, but tell you what you get for your money in terms of earnings, book value, cash flow, dividends, and other fundamental measures. After all, holding shares of a company means you are entitled to a portion of its profitability, so paying an appropriate price for that can improve the odds of future gains.

Valuations are highly correlated with long-run returns

Valuations are correlated with long-term portfolio returns for that reason – i.e., buying when the market is cheap improves the chances of success, and vice versa. The chart above shows how the forward price-to-earnings ratio, which uses earnings estimates over the next twelve months, correspond to subsequent 1-year and 10-year annualized returns. The dots for 10-year annualized returns cluster more tightly around the trend line than do 1-year returns, which can vary significantly.

The fact that any metric is this highly correlated with stock market returns is, well, amazing. To a large extent, the reason this pattern exists is exactly because it is so difficult to stay invested when markets fall – and valuations are therefore the most attractive. Just think about how most investors feel today, or back in March 2020, or during 2008. Staying patient is much easier said than done, but the data emphasizes how important that is to achieve your financial goals.

There are other reasons valuations are much better indicators than prices alone. Prices can rise over long periods of time, just as they have for the U.S. stock market over the past century – despite plenty of bear markets and short-term corrections. Comparing prices today to previous peaks and troughs doesn’t make much sense across these distinct time periods. Valuations, on the other hand, “normalize” prices by some important measure such as sales, earnings or cash flow, and can therefore be a guide across different market cycles. That kind of adjustment makes prices more comparable over time to determine whether an asset class, sector or individual investment is especially attractive.

Today, various measures of value are far more attractive than they were even six months ago. As the chart below shows, the price-to-earnings ratio of the S&P 500 has fallen from near the peaks last seen during the dot-com bubble of the late 1990s and early 2000s, back toward the long run historical average. This closely-watched measure using next-twelve-month earnings estimates is hovering around 16.1x. Similarly, the Shiller P/E ratio, also known as the cyclically-adjusted P/E (since it uses ten years of inflation-adjusted earnings) has declined to 28.9 from almost 39 at the end of 2021.

Stock market valuations are more attractive today

This same pattern can be found across a wide variety of valuation measures, from price-to-sales to dividend yields. Across asset classes, especially public equities, valuations are much more attractive today than at any point since mid-2020. Could valuations fluctuate further? Of course. If the market declines, valuation levels could look even more attractive. Conversely, if earnings decline as the economy decelerates, this could push valuations higher – since lower profits mean that share prices are more expensive.

The point is that valuations are not a timing tool. As mentioned above, valuations have very little historical correlation with returns over shorter stretches of time, including one-year periods. It’s over several years or more that they begin to correspond most highly to more attractive expected returns. And for that reason, valuations are among the most important tools for constructing long term portfolios – even though markets can continue to rise or fall regardless of valuations in the short term.

Different sizes, styles and sectors are more cheaply valued

So, in today’s difficult market environment in which all asset classes face significant uncertainty, investors ought to focus on valuation measures, not just daily price swings. The broad market is now cheaper than it has been in years, and many sizes, styles and sectors are more attractive as well. Energy remains at the top of that list. Large-cap growth stocks, however, still look quite expensive on balance, despite this year’s drawdown. Market sentiment has shifted away from growth and in favor of areas such as value, finally, where valuations are still much more attractive.

The bottom line?

Ultimately, staying opportunistic and patient, with an eye toward relative attractiveness, can help investors to position for future growth. Where valuations go next will be important for the direction and magnitude of long run returns from here. As such, investors should continue to stay invested and patient as the cycle shifts from a bear market to an eventual recovery.

Please let me know if you have any questions. Thank you.

– Cale