Long-Term Perspective: Understanding How Valuations Impact Portfolio Returns
Photo Credit: Francesca Saraco, Unsplash
The S&P 500 has rallied +50% since the start of 2023 and more than +150% from the COVID-19 pandemic low in March 2020. The rally has produced a long list of all-time highs and boosted investment portfolios, but it has made broad market indices more expensive. The S&P 500 trades at over 21 times its next 12-month earnings estimate, a level not seen outside periods like the late-1990s tech boom and the recent post-COVID recovery, when interest rates were near zero. Why do high valuations matter? History shows that valuations have a limited impact on short-term returns but play a critical role in determining long-term performance.
The chart below shows the relationship between the S&P 500’s starting valuation and future returns. The horizontal axis represents holding periods in years, and the vertical axis shows the R-squared (R2) between the S&P 500’s starting valuation and its forward return. R2 is a statistical measure that shows the predictiveness between two variables. For example, an R2 of 0.40 indicates that 40% of the changes in one variable can be attributed to changes in the other variable. In comparison, the remaining 60% is due to different factors or random variation. The left side of the chart tracks short holding periods of only a few years, revealing a low R2 between valuations and forward returns. The takeaway is that the S&P 500’s starting valuation doesn’t explain a significant portion of its short-term return. However, the R2 increases as you move across the chart, showing that valuation explains a more significant portion of longer-term returns. For a 10-year holding period, the S&P 500’s starting valuation explains ~80% of the variability in returns, highlighting valuation’s importance for long-term investors.
Historical Relationship Between Valuation and Holding Period
The chart below expands on the importance of valuations by plotting the S&P 500’s starting valuation against its next 10-year annualized return. The starting valuation represents the S&P 500’s normalized price-to-earnings (P/E) multiple, which is calculated as the current price divided by the average inflation-adjusted earnings over the past ten years. The line slopes from the top left to the bottom right, indicating that forward returns decrease as the starting valuation increases. The current normalized P/E ratio of 37 times is marked on the chart, suggesting the S&P 500 could produce a low single-digit annualized return over the next ten years.
S&P 500 P/E vs Forward 10-Year Annualized Return
The previous statement carries significant weight, but it is important to put context around historical analysis like this. While past performance offers valuable insights, it does not guarantee future outcomes, and timing the market is difficult. The first chart shows that valuations are not reliable indicators of short-term market returns, and markets can remain expensive longer than expected. However, given the rarity of today’s starting valuation, it is important to acknowledge the potential impact on forward returns when setting expectations for the years ahead.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
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