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Commentary & Insights

Insight, Investing

The Cost of High Expectations: Why an 'Expensive' Market Predicts Lower Returns

12 April 2024
Market Crystal Ball

By Jack Rabuck

“Risk comes from not knowing what you're doing.” —Warren Buffett

10-Year Forecasts for US Stock Returns: 

Morningstar Investment Management: 5.7%
Schwab: 6.1%
Vanguard: 5.7%

If these numbers seem low to you, you are not alone! But why do Morningstar, Schwab, Vanguard, and many others predict lower returns for the US Stock market than what we’ve seen historically?

The answer lies mostly in a little throwaway-phrase you may have heard – “the market is expensive.”

There are many ways to quantify whether the market is expensive, but by far the most common is the Price to Earnings Ratio, or P/E Ratio. Imagine a company whose stock costs $150 per share, and which generates earnings of $10 per share. If we do the math, 150 / 10, we find the P/E Ratio is 15. 

What if the earnings of that company stay the same, but the stock trades up to $250 per share? Now: 250 / 10, P/E Ratio of 25.

The stock is “more expensive” in the latter scenario. In the context of the stock market, “cheap” is the opposite of this “expensive.”

The Role of P/E Ratios in Market Returns

The P/E Ratio has historically been a barometer of market valuation. An increasing P/E Ratio can indicate that investors are willing to pay more for a dollar of earnings, often driven by optimism about future growth. However, this increase can also signal an overvaluation of stocks, leading to concerns about sustainability.

A whole bevy of academic research can be found on this topic; Trevino and Robertson have authored some well-known papers, as have Weigan and Irons.

But today we will not focus on the academic side of things, rather let us focus on the intuition behind the theory. 

Illustrating the Effects of High P/E Ratios

Consider a simple example taking place over 10 years. We assume the earnings of the business are growing at 8% per year and the price of the stock starts at $100.

We’ll look at three scenarios – one where the stock starts with a P/E Ratio of 15 and at the end of the 10 years, is at 25. A second where the P/E Ratio stays the same throughout the period. And a third where the P/E Ratio goes from 25 to 15.

Scenario 1: Increasing P/E Ratio (from 15 to 25)

  • Final Stock Price: $359.82
  • Annual Return: 13.66%

Scenario 2: Flat P/E Ratio 

  • Final Stock Price: $215.89
  • Annual Return: 8.00%

Scenario 3: Reverting to Norm (from 25 to 15)

  • Final Stock Price: $129.54
  • Annual Return: 2.62%

Scenario 1 might be interpreted as where we are today – historical P/E Ratios tend to have an average of around 15, and the S&P 500 today (April 2024) is around 25. For 5, 10, and 15 years, we’ve had strong returns – as of this writing, returns for the S&P 500 fund IVV have been 15.00%, 12.91%, and 15.60% per year, respectively.

Scenario 2 can be thought of as when the market doesn’t change what it will pay for stocks (they can stay cheap, stay “normal,” or stay expensive), but reflects the underlying reality of the companies’ growth – in the case of our example, with 8% earnings growth, the stock grows 8% per year. It does not actually matter whether P/Es stay at 15 or stay at 25 as long as they stay.

Scenario 3 can be thought of as the opposite of Scenario 1 – even if earnings are growing, if the price people are willing to pay for those earnings (i.e., the P/E Ratio) is going down, returns can be greatly reduced. This is the effect that is largely responsible for the muted future return expectations we looked at up top. 

Why a Reversion to Lower P/E Ratios is Anticipated

Many analysts predict a reversion of P/E Ratios to historical norms for several reasons (with caveats):

  1. Economic Cycle Maturity: As economic cycles mature, growth often slows, leading investors to become less willing to pay high premiums for earnings.

    But economic cycles can be notoriously long, difficult to predict, and are sometimes not even correlated to the stock market!

  2. Interest Rate Changes: Rising interest rates can make bonds more attractive compared to stocks, potentially leading to a reevaluation of stock valuations.

    But interest rates can themselves be finicky! The consensus now (in Q2 2024) is an anticipation of rate cuts in 2024. And even if we knew for sure what will happen with overnight rates (the ones most closely controlled and talked about in the context of the Federal Reserve) in 2024, sometimes long-term rates and short-term rates don’t move the same amount or even in the same direction!

  3. Market Corrections: Periods of high valuations are often followed by market corrections, which bring P/E Ratios back in line with historical averages.

    But market corrections (such as we saw in 2022) are tremendously hard to predict and have no guarantee of coming – many a stock investor has missed more in gains in the meantime than they have saved by staying on the sidelines waiting for a correction to come.

The Implications for Future Market Returns

Given these factors, a reversion to lower P/E Ratios could dampen future market returns. This would be a significant shift from the high-return environment driven by expanding P/E Ratios seen in recent years. Investors accustomed to the buoyant market conditions of the past may need to recalibrate their expectations.

Practically speaking, this means it may be wise to follow the lead of the prognosticators cited at the beginning (Morningstar, Schwab, and Vanguard), and temper future stock market return expectations. We don’t know if the future will look more like Scenario 1, 2, or 3, but we will all do well to (mixing our metaphors) remember that coming off of the tailwinds of Scenario 1, either 2 or 3 will feel like peddling uphill.