Each week, the American Association of Individual Investors (AAII) publishes a popular sentiment survey that provides a view of investor psychology. Given the strong market performance this year, investors are unsurprisingly feeling very optimistic. Since the summer, sentiment has largely been more bullish than average and, at times, has even touched levels that could be considered extreme.

Further examples of a clear bullish bias among investors were provided by a recent article in the Wall Street Journal⁽¹⁾. According to the article, U.S. stock funds took in nearly $56 billion in the week ended 11/14, representing the second-largest weekly inflow in records going back to 2008.

Source: Wall Street Journal

Other signs of excessive optimism have come from the options market. Trading in call options, which represent a risky bet on further price appreciation in the stock market or specific underlying stock, have spiked. In fact, November has recorded three of the highest daily call option trading volumes going back to 1973.

Clearly, investors are feeling good about the outlook for stocks, and are putting their money where their mouth is. This begs the question: are there any reasons investors should strike a more cautious tone? The answer is yes. 

One of the most dependable predictors of long-term stock returns is the starting valuation. Popular valuation measures, such as the price-to-earnings (P/E) ratio, evaluate current prices relative to a fundamental measure of business performance. Valuation ratios allow an investor to assess if a stock is attractive relative to other stocks or its history. Simply put, the less you pay to purchase an asset, all else equal, the higher the return will be.

The chart below demonstrates the strength of the relationship between starting valuation and subsequent return.

Source: Morningstar Direct. Data from Jan 2000 through October 2024. Stocks represented by the S&P 500. For each monthly P/E Ratio we calculated a subsequent 10-year return. This resulted in 178 full 10-year periods, with the most recent stretching from 11/1/2014 through 10/31/2024. We then sorted the monthly P/E ratios from lowest (attractive) to highest (expensive) and grouped them into quintiles. Finally, We then calculated the average 10-year return across each quintile.      

As you can see, there is an obvious relationship between the P/E and the subsequent long-term return. Periods with a P/E ratio in the lowest quintile saw subsequent annualized returns of 14.11% on average. Returns then fall as you move across the increasingly expensive quintiles. Periods with a P/E ratio in the highest quintile saw subsequent annualized returns of just 2.65% on average.

This data represents a somewhat ominous signal for investors. As of the end of October, the P/E for the S&P 500 Index of large-cap U.S. stocks was a blisteringly high 26.9. This puts the current P/E firmly in the most expensive quintile, ranking in the top 3% of all monthly P/Es going back roughly 25 years. 

An important caveat is that while valuation ratios are among the best predictors of long-term returns, they do a poor job over short intervals. Even a metric as useful as valuation is an inadequate tool to enable consistent market timing. Still, valuation remains incredibly useful for setting reasonable return expectations.

Luckily for investors, not all areas of the market are as richly valued as the large-cap stocks of the S&P 500. The U.S. small-value stocks of the S&P 600 Value Index, for example, have P/E ratios that are below their average over the last 25 years. Small-value stocks in international markets are similarly attractively valued. Tilting portfolios to these more attractively valued segments of the market can improve expected returns at a time when the S&P 500 is this expensive. 

1. Banerji, Gunjan. "Investors Are Betting on a Market Melt-Up." The Wall Street Journal, 17 Nov. 2024, www.wsj.com/finance/investing/investors-are-betting-on-a-market-melt-up-3a007dd4?mod=finance_lead_story.

Source: MarketWatch

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