In 2000, the S&P 500 opened the year at 1,469.25. By the end of 2009, it was sitting at 1,115.10 . This has made life easy for a financial journalist, as quoting the terrible absolute performance of the U.S. stock market makes for emotional subject matter that resonates strongly with one’s readers. However, I believe that most of the material put forth has looked at U.S. stock market performance in the wrong light.
One of the metrics we follow closely at Wealth Management Associates is the work that Professor Robert Shiller does with the price/earnings ratio of the S&P 500. In its most common form, a price/earnings ratio is the price of a stock divided by its most recent earnings per share. The issue that you run into by calculating it this way is that the formula is very dependent on what stage you are at in the business cycle. If it’s a time of rapid economic expansion, a company’s earnings per share is likely to be higher than where it will be during normal times. Conversely, during a recession a company’s earnings are often sharply lower as it struggles to remain competitive.
What Professor Shiller has done to adjust for this is take the average earnings per share over the last ten years. Doing so lessens the variability you get from analyzing a stock at a single point in time during the business cycle, and helps to give a more accurate reading of a stock’s value.
In analyzing over 100 years of data, Professor Shiller has found that the average price/earnings ratio for the S&P 500 is roughly 15. His thesis has been that when this value drops below 15, investors should overweight stocks since they are more attractively valued; vice versa, investors should underweight stocks when this value rises significantly higher than 15. As the graph below indicates, when you examine your investment results over a 20-year period the evidence is quite compelling.
During several periods where the price/earnings ratio was higher than 20, you would have experienced a 20-year annualized return that was either negative or less than 5%. The reason for such low returns is that when stocks trade at high valuations, they have very optimistic projections built in for future growth. Since these projections tend to come at the end of an economic expansion, results disappoint as the economy slips into recession.
So how does this apply to the value of U.S. stocks back in 2000? At the beginning of the decade, the S&P 500 had a P/E ratio of 43. 1999 and 2000 represented the most expensive valuations in the history of the U.S. stock market, as the P/E ratio stayed above 40 for nearly two years (it dipped to 39 in October of 2000 and eventually dropped to 37 by the end of the year). By contrast, in 1929 the U.S. market peaked at a P/E of 32.
If we’re starting with the thesis that periods of high stock market values tend to be followed by poor performance, I believe that viewing the last ten years as a “lost decade” is an incomplete analysis. There are only two ways for a stock’s P/E ratio to drop: either earnings have to increase or the share price has to drop*. Given that the U.S. stock market was so expensive at the start of the decade, falling share prices were a necessary by-product of the technology boom. I’m not trying to suggest that you should be happy about the performance of the S&P 500 over the last ten years; nobody likes to lose money. The point I’m trying to make is that market valuations are an important determinant of future returns.
And ten years later, a look at Professor Shiller’s data shows that the S&P 500 is currently at a P/E of 19.5. That’s not anything to get excited about, but it’s a much more reasonable value than the mid-40’s values we saw at the turn of the century. Pretty soon, we might even be optimistic about future stock market performance!
* A stock’s P/E ratio will also drop if earnings increase faster than the rate at which the share price increases. The example above was for simplicity’s sake.
The S&P 500 is an unmanaged index of common stock considered to be representative of the stock market in general. It is not possible to invest directly in an index. Past performance does not guarantee future results.