The Stock Market is Overvalued | PE Ratio Long-Run Investment Returns

In the short-run, the stock market is a voting machine, in the long-run, it is a weighing machine.

That quote comes from Benjamin Graham, Warren Buffett’s mentor. And it gives profound insight into intelligent investing. In the short-term – weeks, months or even a few years – the stock market can move unpredictably. The world’s best investors can’t consistently tell you which way will it’ll move. 

Market prices and valuations can stretch way past their underlying fundamentals. This is largely due to mass investor psychology and relating it to the quote, it’s the voting machine at work. But over the long-run, there’s mean reversion and balance… 

To put short-run pricing into perspective, just as you would submerge a beachball below the surface of the water, pressure builds. And the further you push it below the surface, the faster it snaps back into equilibrium. 

We don’t know how long someone will hold a beach ball below the surface or how long stock mispricing will extend. There have been many financial bubbles. But over the long-run, they generally bounce back to the surface or the averages. 

That’s why I’m personally a long-term investor, along with tax advantages and a few others benefits in mind. Still, I like to track the stock market’s current valuation. And one telling metric is the S&P 500 PE ratio. It’s been a pretty good indicator of future stock market long-run returns.

Stock Market PE Ratio Long-Term Returns

I’ve compiled over 60 years of stock market returns, along with the PE ratio and have found a useful trend. The chart below matches up the rolling S&P 500 PE ratio and the following 10-year returns… 

Stock market PE ratio and S&P 500 long-term returns

When PE is high, long-term returns go down. This is an inverse relationship and here’s a better correlation chart… 

S&P 500 PE ratio and long-term returns correlation

There’s a good deal of dispersion but there’s still a clear trend. And on the outsides or extremes, there’s less variance… but there’s also less data. Now, how is this useful for investors today? Well, at a current PE ratio of over 28, the stock market could very well return close to 0% over the next decade. 

Now, it’s important to note, that this is based off of history as a guide. Really, that’s the only thing we have to make informed decisions going forward. But on occasion, there are new normals or regime changes. And the Fed is manipulating the stock market at an unprecedented level. It’s artificially pushed down interest rates and that’s propped up many asset prices. 

For example, home prices are at all-time highs once again, even after adjusting for inflation. The housing market is a beast of its own so I put together a video on that topic: Housing Bubble 2020

Now, two last notes before I sign off for the week. Up first, how am I personally investing with an overvalued stock market? As always, I’m looking at individual companies. On average, it’s harder to find better deals, but there are still a few gems when digging through the rough. Which, if you stick around, you’ll find out when I invest in one. 

Now, my final note is about an idea that ties closely to what I’ve shared today. It’s measuring the stock market’s valuation with the Fed model. Feel free to check it out and also, please leave any comments or questions down below. I’m usually pretty responsive.

Invest mindfully,

Brian Kehm

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