Two years into a declining market and stocks are still dear.
Using traditional measures like the price to earnings ratio, price to cash flow, or price to book value, stocks are now selling at levels associated with bull markets, not bear markets. Absolutely no one is yelling that this market is a screaming buy.
At best, the prevailing attitude seems to be stoic: leave me alone to take my beating.
Query: Does this mean we should abandon equities?
The answer, a distinct “No,” can be found in the February issue of the Journal of Financial Planning. In “P/E Ratios and Stock Market Returns”, Ruben C. Trevino and Fiona Robertson, both faculty members at Seattle University, examine the prospective returns on common stocks from periods of high and low P/E ratios.
Their findings, in a nutshell: stock returns from periods of high P/E ratios are lower than returns from periods of low P/E ratios. Stock returns are still higher, however, than competing returns on cash or bonds. In other words, stocks are less attractive as investments, today, but they are still better than the common alternatives.
The differences in return can be dramatic. If you buy stocks in a period of low P/E ratios (under 10) your average annualized return five years later will be 18.57 percent. Buy stocks in a period of high P/E ratios (over 15) and your five year return will be about half as much, 9.28 percent. More important, the variability of your return will be nearly twice as great as in the low P/E period.
We can get a clearer picture by examining two specific periods. In 1950, stocks were selling at P/E ratios of 7.2 times earnings. Over the next five years they returned 23.89 percent a year. Over the next ten years they returned 16.16 percent. Either way, the returns were far above the long-term average.
By 1961, however, the average P/E ratio had risen to 22.4 time earnings. Over the next five years stocks returned 5.72 percent a year. Over the next ten years they returned 7.06 percent a year. Again, both returns were below the long-term average.
What does this mean in money we can spend?
Simply this. Today, you and I can expect future returns that are lower and more uncertain than the returns we could have expected in 1982 when stocks were selling at 8 times earnings.
The good old days are over.
Even so, the same examination shows that stocks continued to return more than cash or bonds. In periods of high P/E ratios, for instance, stocks earned an average return of 9.28 percent in the following five years. Treasury bills trailed stocks by 4.52 percent a year. Treasury bonds trailed stocks by 3.92 percent a year.
To be sure, in periods of low P/E ratios stocks earned more (18.57 percent) in the next five years and Treasury bills trailed by a massive 12.07 percent while bonds lagged by 11.67 percent. But stocks still tended to beat bonds and cash. A comparison of returns is shown in the table below.
Returns over a Five Year Holding Period
| Avg. T-Bill Return | Avg. Long Term Bond Return | Average Annual Stock Return | Market Premium over T-Bills | Market Premium over Bonds | |
| High P/E | 4.76% | 5.36% | 9.28% | 4.52% | 3.92% |
| Medium P/E | 5.40 | 6.31 | 12.94 | 7.54 | 6.63 |
| Low P/E | 6.50 | 6.90 | 18.57 | 12.07 | 11.67 |
Source: Journal of Financial Planning, February 2002, pg. 83
What does this mean in real life?
Over the relatively short term— five to ten years— we need to plan for lower and more uncertain returns. A 75/25-equity/bond portfolio that might return 15.65 percent a year, starting from a low P/E period, returns only 8.30 percent starting from a high P/E period. As a consequence, the growth of assets will slow dramatically.
While this is irrelevant for those in their 30’s and 40’s, anyone approaching retirement needs to consider increasing the amount of money they save or delaying retirement.
(c) Scott Burns, 2022