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Valuation models are poor market timing tools.

That was the conclusion of our analysis of the effectiveness of the PER and ERP in forecasting 1 and 3 year returns in the stock market. In that 2006 analysis (“Does Valuation Matter?”), we looked at over 100 years of data using a forward PER for the S&P500 on the 1st Jan each year (based on the following 12 months’ actual eps) and plotted that against the S&P’s returns over the following 12 months. As the chart below shows there is zero correlation between the two variables. Similar exercises were carried out for a 3 yr return period and for the ERP (with the same result). Valuation ratios are clearly, therefore, not good market timing tools.

Valuations do, however, have a part to play in asset allocation (& general investing). As Kindleberger highlights in his ‘bubbles’ framework, all bubbles end up with rich/high valuations (which then pop when the ‘cheap money’ is removed). Equally relative valuation extremes (between 2 equity markets, 2 key assets and/or 2 sectors) are also interesting and, when paired with a changing global macro theme, highlight significant emerging opportunities.

In that vein, therefore, it's notable that the US equity market, in the past 3 months, has become expensive (on various measures). The S&P500’s equity risk premium, for example, has fallen below 3% for the first time since the TMT bubble. Other US risk premium measures have a similar message. Against real cash rates the equity risk premium is notably rich (only surpassed during the TMT bubble). Added to which, our in house valuation model, which looks at the distance from the observed to the fair value risk premium is also on strong SELL. PE ratios have a similar message (across a variety of measures - as detailed in the full publication, available on request).

From a single stock perspective, the message of the analysis is, though, more mixed.

NB This is a shortened/edited version of our quarterly asset allocation valuation publication (which examines valuation across asset classes and geographies/40 page document). If you would like a copy of the full text plus charts, pls email: Nick@longvieweconomics.com.

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#valuation #investing #longterminvesting #assetallocation #sp500 #globalequities #bonds


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