Into Thin Air

by Russ Koesterich of BlackRock, 7/7/17

Stocks are getting expensive by traditional measures. Russ takes a look at what history tells us about what could happen next

Despite growing political risk and high valuations, the stock market—like the Energizer Bunny—keeps going and going, grinding upward. I believe that markets can still move higher, and there are good reasons for the ongoing rally—namely, strengthening global growth, and stronger widespread earnings. Still, most traditional valuation ratios indicate that stocks are expensive (particularly in the U.S.) and future returns are likely to be muted.

So where does that leave us going forward? History does provide some interesting insights about how markets perform in the periods when U.S. stocks are expensive—and how investors can think about ways to position their portfolios.

To begin, how expensive are stocks in the U.S.? The current Shiller cyclically adjusted price to earnings (P/E) ratio of the S&P 500 is over 29, well above its long-term average of around 17. But to put that number in perspective, the same measure was in the 40s during the dotcom bubble and has exceeded 30 less than 4% of its entire history going back to 1881. Other valuation metrics tell a similar story: Stocks are expensive, although it is not clear that they are yet in bubble territory. The lights are arguably flashing yellow, but certainly not red. It is also worth remembering that value is a poor short-term indicator of market performance.

Still, historically, when valuations have been at these levels, performance in the next few years has been significantly lower. When the cyclically adjusted P/E of the S&P 500 has been greater than 28, average annual returns over the next three years has only been 0.7%. In short, while the outlook for U.S. stocks is hardly bleak, investors should expect significantly lower returns over the next few years than what they have become accustomed to in recent years.