February 7, 2020
There are several graphs circulating around that show measures of valuation and historical forward returns. All of them draw you to see that the starting point is important. When financial assets (stocks) are richly valued, the future returns are lower than when starting values are lower. This is the essence of buy low . . . . . It’s harder to make money when you buy high.
We all have been conditioned by statements that the market average return for some prior period was 7% or 8% . . . or more. But what should go with that is that the Price to Earnings ratio (P/E) average was also in the 14 – 15 zone. Today we sit with the P/E ratio in the high zone near 20 or more. Pick your method of calculation to get the number you like, but trailing P/E’s are north of 20. Look at the chart – note that there aren’t many dots north of 20. That should raise a flag in and of itself. We are in unusual market conditions. Then scroll over to the left axis and see that forward returns are NOT 8%, but more in the 4%-5% range.
Why this is important is that many financial programs and advisor planning calculations are based on long-term historical average returns near 7%-8%. Not using the more expected lower returns will lead to over-expectations of wealth in the future and therefore over-expectations of lifestyle options.