Many popular investment “gurus” advocate the Buy and Hold Strategy, yet most never discuss valuation. We believe that valuation matters most, so before we look at anything else, we determine whether an asset class is currently cheap, expensive or fairly priced. If you pay too much for an investment, all the time in the world won’t fix it, even if you have invested in an index fund.
This chart shows that if an investor purchased the index in the fall of 1929, they waited almost 30 years for it to return to the same inflation adjusted value. If an investor purchased the index in 1966, they again waited 25 years, until 1991 for it to return to the same inflation adjusted value.
So how can an investor know that in 1929, 1966 or in 1999-2000, the S&P was overpriced? One way is using the price to earnings ratio (PE). The chart below shows the PE ratio for the S&P for the same time period based on average inflation-adjusted earnings from the previous 10 years. The PE ratio can be thought of as how much an investor is willing to pay for one dollar of earnings. A PE ratio of 12 means that the market in aggregate is willing to pay $12 for $1 of annual earnings.
This chart shows that in 1929, the PE ratio reached a high of 32.46. In 1966, the PE ratio reached a high near 25 and around 2000, the S&P again reached a high of nearly 45! This is just one measure of valuation that we use to help us determine if the stock market in general is over-priced, under-priced or fairly priced. The current mean PE ratio is 16.39 and the median is 15.77. The lowest PE ratio occurred in December of 1920 at 4.78 and the highest PE ratio so far was in December of 1999, when the ratio reached a mind boggling 44.20. Today the PE is approximately 23.5, which is 43% above the historical mean, shown as a green line on the chart, which shows that once again the S&P is overpriced relative to historical norms.
On 1/1/1982, the S&P PE ratio was again at a historical low of 7.4 and the inflation adjusted S&P was at 268.62. If an investor purchased the S&P index at this point, and kept it until the PE ratio reached 43.8 on 1/1/2000, the S&P had risen to 1,823.78, which means the investors after inflation average annual return was 11.23%. Compare this to the 25 years it took from 1966 to 1991 for an investor to simply get an inflation adjusted return of their initial investment and clearly, valuation matters. Buy and hold provides little aid for an over-priced investment.
We don’t believe that anyone can consistently, accurately time the market. There was no way to know that the PE ratio was bottoming out in 1982, nor could we know in December of 1999 that the market had peaked, but we could see that in both cases a directional change was bound to occur soon. We don’t believe we can get the timing exactly right, but we do see opportunities, both for gains and losses when valuations are above or below historical norms.