Market valuations and active investing

Market valuations and active investing


Derek Hamilton

  • Managing Director, Economist – Ivy Equity Boutique
  • Read bio

Historically, investors have attempted to value equity markets in many ways. One measurement that has withstood the test of time is the price-to-earnings (P/E) ratio, which can be used to measure valuations of individual stocks, segments of the market, and the market indices themselves. We look at the forward P/E ratio for the S&P 500® Index, which measures the current market price relative to 12-month forward earnings forecasts. Currently, this ratio is hovering around 20 times, which is high relative to history.

The chart below, which we've shared in the past, shows future returns for the S&P 500 based on historical forward P/E ratios, using all available data back to 1979. Future returns tend to be highest when P/E ratios are low, and vice versa. The worst future returns tend to follow market valuations in excess of 20 times.

One pushback to this would be that the current P/E ratio is boosted by the largest companies, once those companies are excluded, market valuations seem more reasonable. While that might be true, this argument offers little protection if investors are heavily weighted toward passive index funds. While it can be virtually impossible to time the market, history suggests that forward returns could be much more muted given current market valuations. In our view, this could come in the form of a market rotation to less expensive names or general market malaise. In either case, active management could be primed to outperform passive investments.

S&P 500 future returns given historical forward P/E ratios

Sources: Macquarie, Macrobond, Bloomberg, S&P Global.

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Investing involves risk, including the possible loss of principal.

Past performance is not a reliable indicator of future performance.

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

The price-to-earnings ratio (P/E ratio) is a valuation ratio of a company’s current share price compared to its earnings per share. Generally, a high P/E ratio means that investors are anticipating higher growth in the future. Earnings yield is the inverse of a P/E ratio, capturing the ratio of earnings-to-price; it represents the percentage return based on a company’s earnings per share.

The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

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