High valuations don't guarantee weak investment returns

Recently, a lot of investors have been pointing to the U.S. stock market’s “high valuations”. They believe this means that the U.S. stock market will underperform over the next few years.
There are various ways you can measure the broad stock market’s valuation. All of these valuation indicators point to the same thing: the U.S. stock market is “expensive”, but valuations are much lower than they were in 1999/2000. More on this later.
*Read our article on why 2017 is not like 1999.
Here’s the Shiller P/E 10.

Here’s the ratio of the stock market’s total market cap to U.S. GDP

Here’s the S&P’s trailing 12 month P/E ratio.

For starters, you can see that valuation cannot predict bull market tops. U.S. stock market valuations were extremely high by the mid-1990s. The stock market soared for another 5 years despite the high valuations.
*P/E ratios spiked in 2008 because corporate earnings fell much faster than stock prices.
As you can see in the following chart, the average “valuation” for the U.S. stock market is much higher post-1997 than it was pre-1997. One reason for this is because global interest rates are much lower. By some accounts, global interest rates are at the lowest they’ve been since the Great Depression. With rates so low, stocks have become more attractive than bonds in the minds of investors. Hence average long term valuations are higher.

Cautious investors are wrong to say that “high valuations mean the U.S. stock market will underperform over the next few years”. The market usually soars during the final few years of a bull market.
*Our model says that this bull market has at least 1-2 years left.
As a savvy investor, your job is to ride the last “big rally within this bull market” and profit handsomely from it. Don’t sit on the sidelines. Ride the rally and then sidestep the next bear market.
The good news is that you don’t need to catch this ENTIRE “big rally”. Our model is usually a little early in predicting bull market tops. But because we invest in UPRO (3x S&P 500 ETF), all of the S&P’s gains that we do catch are magnified by 3x. Catch the easy parts and avoid the final bit of the bull market – that’s the most dangerous bit.
So why does the stock market soar usually soar in the last leg of the bull market? There are a few reasons:

  1. Nominal economic growth is strongest during the final leg of economic expansions.
  2. Inflation usually picks up, so nominal earnings growth is strong as well.
  3. All the “cautious” investors who were sitting on the sidelines throw prudence to the wind and buy stocks. Their buying causes the stock market to rise even faster. (As a smart investor, your job is to join the masses but be one step ahead of them and avoid the inevitable bear market).

Here are some historical charts demonstrating the massive rallies that stock markets experience at the end of bull markets. We’re looking at the market’s gains in the final 2 years of each bull market.

October 2005 – October 2007

The S&P soared 32%. In this case, UPRO would have been up more than 100%. (UPRO was not available back then. UPRO doesn’t just multiple all of the S&P’s gains by 3x. It multiplies the S&P’s daily gains by 3x. So when the market experiences a strong rally, UPRO compounds exponentially).

March 1998 – March 2000

The S&P soared more than 38%. A hypothetical UPRO would have soared more than 120%.

January 1971 – January 1973

In the midst of the choppy 1970s, the S&P rallied 30% from January 1971 to January 1973. A hypothetical UPRO would have soared more than 100%.

December 1966 to December 1968

The S&P rallied more than 36%. A hypothetical UPRO would have been up more than 110%.

Massive gains in the final years of a bull market aren’t just limited to the U.S. stock market. Other foreign stock markets experience strong gains in the final years of their bull markets as well. Hence, valuation doesn’t impend stock market gains, unless a bear market has begun.

3 comments add yours

  1. I think what matters during times of high valuations is how fast or slow earnings are growing. High valuations can sustain growth for a while but if earnings don’t eventually move then there’ll probably be a move in the downward direction in the short term. That’s why it’s good to see Q1 earnings actually grow again this year!
    You also have to keep historical context in mind and whether there’s any alternative investments to dump your money into beyond the stock market. Yea, I might be paying 25x earnings for a company but the alternative is paying 46x for a bond yielding 2.15% that won’t grow earnings for me. I’d rather stick with stocks for now as they still offer a more attractive long term return at this price point(even if it might not be the historical market return unless earnings continue growing)

  2. I have to agree here. I remember the 2008 real estate bubble and 2000 dot-com bubble. The “top” is associated with widespread euphoria. When your bag boy at the supermarket is offering hot stock tips, you know its time to tighten your stops.

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