There’s a lot here, especially for readers unfamiliar with terms like CAPE ratio (more below) or who don’t have experience analyzing scatter plots.

Here’s a summary.

• The more expensive stocks are, the lower their likely future return. In the left chart, as the data points shift from left to right (meaning years when stocks valuations are higher as measured by P/E ratios), the future returns are lower.
• Today, stocks appear to be expensive. On the right chart, you can see the 2024 P/E ratio is over 30. Most data points over the past 35 years show lower valuations.
• The relationship between current valuation and future returns only holds for long-term future returns. Compare the chart on the left, which shows a pretty clear relationship, and the chart on the right, which shows no obvious relationship. Why? Because in the right chart, the future is the next 1 year. In the left chart, the future is the next decade. To give a specific example: in 2024, valuations were high, but the market still did well that year. Note: these charts use CAPE ratios, which are a type of P/E ratio. Instead of using the most recent year’s earnings, a CAPE ratio uses an average of the last ten years of earnings, adjusted for inflation. That reduces the impact of one crazy year (think 2020).

What do you do with this insight?

If you are a serious investor, you are playing the long game. That’s certainly Old Peak’s strategy. You might expect me to write that you do nothing – just stay the course. And that is our view … with one large caveat.

Today’s seemingly lofty valuations, and the real possibility the next 10 years will be difficult for investors, are an opportunity to ask yourself if your current investment mix truly reflects your risk profile. Sometimes, especially after the market has gone up almost relentlessly for 10+ years, it’s easy to think you can handle risk. Even when the market fell during that period (think the -30% COVID market drop in 2020), it recovered quickly. But try to imagine a market that falls meaningfully and stays low for a few years. Are you still okay with your current mix of stocks vs bonds?

If you are, great.

If not, seriously consider selling some stock and adding more low-risk investments.

No one knows what will happen in the near or longer future. But this analysis suggests the next decade may be difficult for the stock market. Forewarned is forearmed.