Much research has been done on stock valuations, and historically buying into the market at lower valuations has seen higher returns than when buying in at higher valuations. However, the data is extremely noisy.
On this chart, the green area represents the 10-year trailing price-to-earnings (P/E) ratio of the S&P 500, commonly referred to as the CAPE ratio. You can think of this as a gauge to see if the overall price of the stock market is expensive or cheap. As you can see, we’re currently at a fairly-elevated level, around 29 dollars of price for every dollar of earnings, though far below the peaks seen in 2000.
Source: CAPE data from Robert Shiller Online Data library via Yale. CAPE stands for Cyclically Adjusted Price to Earnings ratio- which tracks current S&P 500 price versus average of inflation-adjusted earnings over previous 10 years. S&P 500 data provided by Morningstar Direct, 2017. Indexes are not available for direct investment. Past performance does not guarantee future results
It can be enticing to think it’s possible to try to time the market based on valuation ratios like these, but even the creator of this ratio, Professor Robert Shiller, cautions against using the ratio to make trades. And keep in mind you have to guess right not once, but twice — knowing when to get back into the market.
Take, for example, the last time the 10-year trailing P/E ratio of the S&P 500 broke through the current level was in February 1997. If you had sold out fearing high valuations at that time, you would have missed out on another three years of up markets, cumulating an additional 86% gain before seeing any meaningful decline.
At that point in February 1997, the S&P 500 was trading at 798; if you sold out waiting to buy back in once the market was lower, you would still be waiting 20 years later. Meanwhile, the S&P 500 is above 2,300.
Yet if you’re still worried about U.S. markets trading at high levels, what should you consider doing? Watch our latest Making Sense of Markets videos for some ideas.