3 months ago • 2 mins
In the short term, the stock market is like a trendy nightclub. Here, it’s all about the vibe of the moment: market mood, latest news, and technical moves. And valuations, they’re like the wallflower at the short-term party – not getting much attention.
But in the long run, the stock market is more like a quiet, studious library. Over periods longer than ten years, it’s almost all about valuation. In fact, the starting valuation of a US stock index explains over 80% of the returns you’ll see in these longer horizons. That’s useful in practice: as you can see in the chart, the starting level of valuation (light blue) could predict what returns you’d actually achieve over the next decade (dark blue) pretty accurately.
The simple rule of thumb is this: the lower the starting valuation, the higher your potential gains. That’s because valuations are lowest when investors are overly fearful: as negative sentiment is more likely to push prices well below their fundamental value. But eventually the environment will normalize, and those improving valuations will push stock returns higher.
To make eye-catching, double-digit returns over a decade, historically you’d have to invest when the price-to-earnings (PE) ratio was below 18x. Think of it this way: if you start with average valuations, you’ll likely see average returns. And if you buy when valuations are high, you’ll likely see modest, or even negative, returns.
The current PE ratio is sitting at 22x – not sky-high, but definitely above the norm. At this level, you’re looking at a potential annual return of around 4% over the next ten years – a whole lot better than the flat zero returns predicted back in 2021, but a painful distance from the robust gains we’ve seen in the previous decade.
There are three key takeaways from this. First, a 4% return on stocks doesn’t seem too enticing, especially when you can get similar returns from much safer Treasury bonds. Second, a double-digit annualized return over the next decade is unlikely if you invest now. Sure, it’s possible that stocks will do better than what their valuations predict – and returns could even be higher over a shorter time horizon – but as history shows, that’s unlikely. Third, achieving higher long-term returns just might require investing in stocks that are trading at more attractive valuations. This could mean exploring markets in Europe, the UK, and Asia, or diving into less-glittery sectors like energy, utilities, and financials. Or, for those interested in stock-picking, it may mean checking out this hedge fund manager’s “magic formula”.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.