The 2000 tech bubble may be responsible for a myth in stock market investing. Here’s the myth: high valuations (P/E ratios) give way to long and steep bear markets. It seems like a logical idea and takeaway, but history doesn’t support it.

When the market crashed in 2000, many dot coms were trading at outrageous P/E ratios, and the S&P 500 was expensive – trading at a 25.2x forward P/E. Every reader remembers the bear market that followed.

In recent years especially, I see quite a few comparisons of the current market’s valuation to its valuation in the late 1990s, and some prognosticators seem to imply that the higher the stock market’s valuation goes, the closer we may be to a big and long bear market. But examining history shows that high valuations do not necessarily lead to the high magnitude and long duration bear markets. In fact, the opposite is true.1

In a recent study that looked at all bear markets since 1900, it was found that there is little correlation between CAPE (cyclically adjusted P/E) ratios and the size/scope of bear markets. Some of the biggest bear markets in history started when CAPE ratios were relatively low, and some of the smallest and shortest bear markets started when valuations were elevated. For all the bear markets examined from 1900 onward, more than 50% of them were longer when their valuations were lower than the long-term average P/E at the outset.

One specific example was the fierce bear market that went from September 1939 to April 1942. The U.S. economy was battered from the Depression, and World War II was an existential threat to the nation. But when the bear market started, stocks were largely undervalued – the CAPE ratio was sitting at 16.45. Other factors triggered the bear market, and expensive stocks weren’t one of them.

Investors are constantly searching for ways to ‘value’ the market. Valuations help us determine when stocks are cheap and therefore attractive, or when they’re expensive and should be avoided. But valuations alone should not direct an investment strategy. There are too many other factors to consider: interest rates, inflation, earnings growth, geopolitical forces, technological innovation, and so on down the line.

Looking at valuations in a vacuum will not give an investor the full picture of the economy and stock market, in my view. I have also written before about a weakness I see in the CAPE ratio as a valuation tool. Investors should note that the CAPE ratio uses decade-old earnings data, which is great for historical comparisons but tells us virtually nothing about what lies ahead (which is exactly what we need to know to inform investment decisions).

Factors like cheap energy, falling commodities prices, productivity gains, currency fluctuations, and new technology (to name just a few) can contribute significantly – or conversely weigh down – a company’s future earnings. A stock’s price today is greatly influenced by what investors are willing to pay for expected earnings, meaning that sentiment and growth forecasts play key roles. The CAPE ratio doesn’t account for either. If they did, and you relied on the CAPE metric as a proxy for when to invest in the last twenty years, you may have never owned equities! For a long-term growth investor, that would have been a mistake.

Bottom Line for Investors

If today we saw a confluence of negative economic data alongside a high and rising CAPE ratio or other valuation measures, then we’d probably have something to fear. But I don’t see this.

The forward P/E on the S&P 500 is currently around 21x, which is probably lower than most investors would have guessed and should be looked at relative to longer duration U.S. Treasury bond yields (which remain low historically). We also have S&P 500 companies turning in record earnings and raising estimates for future quarters – S&P 500 earnings per share (EPS) estimates for 2021 have jumped from $167 at the beginning of the year to $191 six months later.

In my estimation, the global economy is set for more expansion ahead, not the opposite. And I believe stock prices should do what they’ve almost always done ahead of further economic expansion – go up. And that’s even if the P/E of the market is above 20x.

Disclosure

1 Wall Street Journal. July 5, 2021. https://www.wsj.com/articles/how-long-might-the-next-bear-market-last-11625499653?mod=djemMoneyBeat_us

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