At longer time frames, the basic relationship generally still holds: Higher U.S. stock market valuations are associated with lower future returns. In addition, the downside risk is more pronounced. When U.S. stocks are cheap, even bad periods have typically yielded positive longer-term returns. In contrast, high valuations have been much more likely to lead to bad outcomes.
To be sure, valuation tells you very little about returns over the short term, i.e., a horizon less than one year. And even at longer horizons, future returns don’t neatly correlate with past valuations.
In fact, according to our analysis, though higher U.S. valuations were associated with lower future returns, there were numerous instances in the past, particularly in the mid-to-late 1990s, when very high U.S. valuations coincided with strong returns over one- and three-year horizons. In other words, markets have shown a remarkable ability to levitate for prolonged periods, when valuations are highest and momentum is strong.
What Investors Should Make of Today’s Stock Prices
The takeaway for investors is that while U.S. stocks are perfectly capable of turning in a stellar year or so, over the longer three- to five-year time frame, we believe investors should expect significantly lower U.S. returns than they have become accustomed to over the past six years. At the very least, today’s stretched valuations suggest a multi-year period of subpar U.S. returns and that investors should proceed with caution.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
Terry Simpson, CFA, contributed to this post. He is a Global Investment Strategist for BlackRock.