What High Stock Valuations Mean for Your Financial Plan

Even with the recent stock market drawdown this week triggered by the Fed signaling fewer forthcoming rate cuts, the S&P 500 remains on track for another year of strong +20% returns in 2024, having already reached over 60 all-time highs. This follows a 26% gain in 2023.

With prices growing at such an impressive rate, corporate earnings in the aggregate have difficulty keeping pace. As a result, the stock market, particularly the S&P 500, is expensive by several measures including Price to Earnings Ratios.

The below graph shows the Cyclically Adjusted Price to Earnings Ratio (CAPE) of the S&P 500 since 1970. The December 2024 measure is 38x, well-above the average of 22x since 1970. In other words, the market is demanding buyers to pay more for every $1 of future corporate earnings.

Data from ShillerData.com. The Cyclically Adjusted Price to Earnings (CAPE) Ratio is calculated with current price divided by the average of 10-year historical earnings adjusted for inflation. 2024 Measurement as of December 2, 2024.

Of course, there are narratives to explain these higher valuations. These include factors like low interest rates, anticipated productivity gains from AI, and the argument that traditional valuation metrics are less relevant due to new business models and accounting changes.

While these all have merit - and I agree that the equilibrium is likely above the 22x average of the last 50 years - it's important to avoid a "This Time is Different" mindset. A CAPE approaching 40x indicates that stocks are expensive relative to the past. Narratives are important, but so is empirical data and a historical context.

Yes, the stock market is expensive, but what does that mean for future investment returns?

Do Valuations Even Matter?

The price of a stock, or stock index, is determined by corporate earnings and the valuation multiple (PE ratio) that the market is willing to pay for those earnings. Over the long-term, corporate earnings are the dominant force of price, but in the short-term the more volatile and fickle valuation multiple can be dominant.

The below chart illustrates the relationship between multiple valuations and investment returns the following year (+1) for the S&P 500. Visually, it is obvious there is no relationship between current valuations and investment performance over the next year. Statistically, there is also no relationship, either.

Data from ShillerData.com. PE ratio calculated with the average historical 10-year earnings adjusted for inflation. 12.2.2024

However, as the time horizon is extended to 10 years, valuations do matter! The graph below shows the relationship between starting multiple valuations and annualized investment returns over the sequential 10-year period. This is important, especially for long-term investors, because it supports the notion that the price you pay for an investment is a key determinate of the return you can expect from that investment.

Data from ShillerData.com. PE Ration calculated with average historical 10-year earnings adjusted for inflation. 12.2.2024

Navigating a Lower Return Environment

So, what do you do with this information?

Once again, I believe it is prudent to plan for lower investment returns over the next 10 years. Even if the optimistic scenarios unfold as expected, much of the growth and profit potential may already be priced into the market. On the flip side, slowing earnings growth coupled with multiples contracting toward their historical average would create a double whammy for stock prices.

Although your individual approach depends on your life stage and circumstances, here are some general guidelines to navigate a low return future and reach your long-term goals.

1.) Stick to Your Investment Allocation - Don’t try to time the market. Yes, stocks are expensive by many measures, but that doesn’t mean much in the short term. If your allocation is logical and well-suited to your goals, it’s likely to remain resilient over a full cycle, even if it underperforms for a while.

2.) Dollar-Cost Averaging – Continue saving and investing in a consistent, structured way. You’ll inevitably buy into expensive markets, but you’ll also have the opportunity to purchase shares when prices are lower. By investing the same amount regularly, you’ll buy more shares at lower prices, without needing to time the market.

3.) Save Aggressively: Above-average returns over the past 10+ years have helped many people compensate for suboptimal savings habits. Given current valuations, there’s a chance the next decade won’t provide the same tailwind. A solid savings plan is the best way to offset a lower-return environment. An alternative solution is increasing your lifetime earnings which typically translates to deferring retirement.

4.) Tilt Your Portfolio Toward Lower Valuations – If you have an interest in a more active style of investing, consider tilting your asset allocation—even slightly—towards areas of the market with lower relative valuations such as Smaller Company and International Stocks. As mentioned earlier, there is empirical data showing that valuations are related to long-term returns (as well as other factors such as company size and profitability).

If you are interested to learn how Taurus Financial Planning can help you build, implement and monitor a resilient financial plan, schedule a quick introductory call.

Yes, Stocks are Expensive and Valuation Matters

Yes, the stock market is expensive, and valuations do matter when considering expected long-term investment returns. However, this doesn't necessarily require any changes to your investment portfolio, as long as your allocation is logically aligned with your goals.

The key takeaway is that, given current valuations, it’s prudent to incorporate lower investment returns into your financial planning and base major life decisions, like retirement, on these more conservative return assumptions.

Thanks for reading,

Mark Chisenhall, CFA, MBA

Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.

Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.