As the economy responds to inflationary pressures, investors continue to struggle with daily price swings across the stock market. This level of market volatility can be disorienting for even the most experienced investors, and some may even want to wait it out on the sidelines. While this may be tempting, history shows that this is neither the best way to respond to nor to take advantage of a market downturn. Instead, in challenging markets such as these, long-term investors can use valuations as a North Star to guide them.
It’s important to discuss why valuations matter. In short, valuation measures are the best tools that investors have to gauge the attractiveness of the stock market. Valuations don’t just tell you how much something costs – they tell you what you get for your money in terms of earnings, cash flow, dividends, and other company fundamentals. Holding shares of a company means you are entitled to a portion of its profitability, so paying an appropriate price for this can improve the odds of future gains.
Chart: Stock market valuations are more attractive today
To a large extent, the reason this pattern exists is exactly because it is difficult to stay invested when markets fall and valuations are the most attractive. Just think about how most investors feel today, or back in March 2020, or during 2008. Staying patient is much easier said than done, but this data emphasizes how important it is in order to achieve financial goals.
Today, the broad market appears to be far more attractive than it was even six months ago, based on these valuations. As the chart below shows, the price-to-earnings ratio of the S&P 500 has fallen from near the peaks last seen during the dot-com bubble of the late 1990s and early 2000s, back toward the long run historical average. This closely-watched measure using next-twelve-month earnings estimates is hovering around 16.1x.
However, the point is that valuations are not a tool for market timing. Valuations have very little historical correlation with returns over shorter time periods, including one-year periods. It’s over several years or more that they begin to correspond to more attractive expected returns. For this reason, valuations are among the most important tools for constructing long-run portfolios. This is true even though markets can continue to rise or fall regardless of valuations in the meantime.
Thus, in today’s difficult market environment in which all asset classes face significant uncertainty, investors ought to focus on valuation measures and not just daily price swings. The broad market is now cheaper than it has been in years, and many sizes, styles, and sectors are more attractive as well. Large-cap growth stocks are still quite expensive after their significant run, despite this year’s drawdown. However, market sentiment has shifted in favor of areas such as value whose valuations are still much lower. Ultimately, diversifying across all of these areas, with an eye toward relative attractiveness, can help investors to position themselves for future growth.
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