by Jeffrey Buchbinder, CFA, Chief Equity Strategist, and Research Team, LPL Financial
Additional content provided by Brian Booe, Analyst, Research.
Itâs been a fun year for stock market investors. The S&P 500 has rallied over 22% this year, setting nearly 50 record highs as the current bull market recently celebrated its second birthday. Throughout the record-setting rally this year, even as corporate profits broadly backed lofty valuations, market watchers from Wall Street to Main Street have cited stretched valuations. But, as valuations get even more stretched following the latest rally, we ask, does todayâs fun signal a dimmer decade ahead?
When comparing the subsequent 10-year forward returns for the S&P 500 with the benchmark equity gaugeâs trailing 12-month price-to-earnings (P/E) ratio, the resulting relationship is eerily tight. Based on data since 1990, 10-year stock returns tend to be more modest if the starting point for valuations is high (and vice versa). Currently, the S&P 500 is selling for 21.8 times, well above recent and historical averages, such as the five-year average of 19.8. Recent studies have drawn investorsâ attention to this relationship, including a recent publication from Goldman Sachs stating elevated P/E ratios and market concentration, among other factors, signal annualized returns over the next 10 years could be around 3%, well below the 11% average since 1950.
S&P 500 Ten-Year Returns vs. S&P 500 P/E
Source: LPL Research, FactSet, Haver Analytics, Yahoo Finance, 10/28/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
Near-Term Results May Vary
The correlation between 10-year returns and valuations is compelling, but it does not mean stocks are set up for lackluster performance every month, quarter, and year for the next decade. For example, shorter time frames have historically displayed a weaker correlation between P/E ratios and annualized forward returns (which is why we often say valuations are not good timing tools). When running the same test for one-year returns, there is virtually no correlation between the indexâs 12-month trailing P/E and its subsequent one-year return. As shown below, the S&P 500 has returned upwards of 20% multiple times at valuation levels higher than current levels. On the other hand, the index has experienced negative returns when at lower valuation levels, indicating this index is not sentenced to poor returns solely due to an elevated P/E ratio.
S&P 500 One-Year Returns vs. S&P 500 P/E
Source: LPL Research, FactSet, Haver Analytics, Yahoo Finance, 10/28/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.
Potential Productivity Could Buoy Longer-Term Returns
Again, thereâs no denying the stark relationship between P/E ratios and long-term forward returns, but an annualized return of 3% over the next ten years is likely too low. Productivity gains from technology investments (artificial intelligence and otherwise) are likely to boost the profitability of S&P 500 companies and support both earnings growth and valuations. In fact, based on historical data since the inception of the S&P 500 and its predecessor index, the S&P 90, the probability of achieving better than a 3% annualized return over a 10-year rolling period is about 90%. And the index suffered losses over any 10-year period during only the Great Depression and the Great Financial Crisis. So, while below-average returns are likely over the next decade because of high valuations, we would expect productivity gains to help drive profitability in support of mid-to-high-single-digit returns â still a few points below the long-term average.
Even short-term returns could easily be above 3%, While earnings growth for the Magnificent Seven (Mag 7) stocks, which have largely driven the current bull market, are expected to ebb as year-over-year comparisons grow more difficult and artificial intelligence (AI) related themes remain resilient. Despite some skepticism around AI, recent earnings and guidance updates have continued to support the theme and growth expectations as AI spending and adoption remain on the rise. Furthermore, growth for the other 493 index constituents is forecasted to ramp up, as Wall Street expects double-digit earnings growth over the next five quarters, helping close the gap between the 493 and the Mag 7.
Summary
Historical trends point to the possibility of below-average long-term returns, however, short-term trends are harder to predict when only using P/E ratios. Nonetheless, the more a market inflates during good times, the bigger downside moves tend to be once the good times end.
LPLâs Strategic and Tactical Asset Allocation Committee (STAAC) maintains its tactical neutral stance on equities. High valuations introduce risk if earnings donât come through, but market momentum remains strong and seems to be telling us earnings will deliver. That said, the Committee acknowledges the potential for short-term weakness, especially with lingering geopolitical threats in the Middle East and as the U.S. presidential election quickly approaches. Equities must also readjust to what we expect will be a slower and shallower Fed rate-cutting cycle than markets are currently pricing in, although both post-election seasonality has historically been favorable for stocks.
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