Do Valuations Matter?

When it comes to maximizing investments gains, the amount of time you spend in the stock market is far more important than when you get in. When I make this case, I tend to get several questions about the role valuations should play in investment timing decisions.

Let me reiterate: Length of participation in the market is far more important than timing your entry into the market. That said, we are all better off as investors when stock valuations are low. These two points may seem at odds, but let’s walk through why valuation, expressed as a stock’s Price Earnings ratio, or “P/E”, does matter for long-term returns, and then plug it into the bigger picture.

When valuations are low, we are better off as investors in stocks. Why? Because the stocks are cheaper. And cheaper is the operative word here. Another way to look at this point is to consider how much we are paying for $1 of earnings. Are we paying $10, or $15? Historically, paying $10 is better.

With the help of the Ned Davis Research Group, I went back and analyzed forward stock market returns when investing at different valuations. What I wanted to discover? How do markets fare over the next year, on average, when the P/E ratio is high versus mid range versus low range? Here’s what I found:

And I want you to commit this next point to memory: It’s not about the market’s odometer level; it’s about what we are paying for the current odometer level.

Take a look at the data for various odometer levels, what we pay, and what we earn:

1. Stocks are on sale, or below sticker price. When valuations are low, the P/E ratio is at 9.5 times or lower, expected returns are high, to the tune of 20% per year. That’s right, per year.

2. Stocks are at sticker price. On the other hand, when stocks are fully or appropriately valued, with the P/E ratio in the mid range of 9.5 – 16.5 times, expected returns come in at around 5% per year.

3. Stocks are above sticker price. In this scenario, valuations are greater than 16.5 times, meaning the P/E is high. Returns are relatively flat over the next year.

Incidentally, this is where we find ourselves today – just north of sticker price levels at 18. While today’s market is at a historically high level, that matters less than what we’re paying for that level. Back to our analogy, we’re paying a bit more for the odometer level these days. Not tremendously more, just a bit more. An important point to remember is that we don’t stay in any of these three ranges listed above forever. We move in and out of the categories as the market changes and shifts.

So, yes, valuations matter. What also matters is spending time throughout the three categories above. Think about it. To control your point of entry with valuations, you would have to time the market perfectly – and not just once, but over and over again. We know that this is an impossible game. It’s nearly impossible to foretell the market and to control valuations at your entry point.  But, your own discipline and participation are much easier variables to control.  This is because it’s up to you.

Investing success is less about perfection and more about participation. Period.

As long as you have time (meaning years, not days), the amount of time you are invested handily trumps how you timed your purchase, i.e., when you “got in.” The best context to use here is of participation and time, not the unrealistic context of market timing perfection.

Check Out: How Markets React To Crisis: Why Recessions Are Scarier Than Geopolitical Events

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